Markets like gridlock – but they shouldn’t take it for granted
The markets got what they expected out of the US elections: political gridlock, which means no meddling by politicians. But it’s only a temporary reprieve, says John Stepek. Here’s why.
So the US mid-term election results are in.
This time around, voters didn't spring any surprises. The Democrats won control of the House of Representatives, while the Republicans kept control of the Senate.
That's pretty much what markets expected. And because they got what they expected, they ticked higher.
So what happens now?
Markets love it when governments can't fiddle too much
The key thing to take away from the US election results is that we're now back to a gridlock situation. Markets tend to quite like this. A split like this makes it hard for governments to push through any big, aggressive changes.
Change even sensible change which is beneficial in the long run is traumatic. Change takes time to bed in. Change contributes to uncertainty. We all need change, but it's nicer to have it in manageable doses. That's human nature.
So you can see why markets are breathing a sigh of relief. And as I said the other day, they needed an excuse to go up after the October wibble. Can it last?
Let's look at the implications of the vote. The main one is that it'll make it harder for the Trump government to drive through any more tax cuts or fiscal stimulus.
You might think that would be viewed as bad news. However, you have to remember that the main thing worrying markets right now is the Federal Reserve and interest rates.
More stimulus would have put more pressure on the Fed to raise rates. And it would also have increased the US deficit. And it would also have pushed up bond yields. So markets prefer the idea that a clogged-up Congress will leave both the bond vigilantes and the Fed feeling more relaxed.
In all, that rather helped to explain the overall market reaction. The dollar weakened (as you'd expect if the pressure on rates eases). Bonds rose (again, as yields fall, prices rise). And stocks gained too (less fear of higher rates, means happier stock market investors).
So is this a temporary reprieve? Probably.
The problem now as I've said a few times is that we're in an inflationary environment at a time when most investors are still in a deflationary mindset.
That's slowly shifting, but at some point soon I'd expect the economic data to spring a surprise that forces investors to confront the idea that rates may rise further and faster than they hope, or that inflation might wreak genuine havoc on corporate profits.
How Trump could spur a run on the dollar
And what about Trump? Are his hands tied now? Hardly.
Yesterday afternoon I attended a very interesting talk at the House of Commons organised by the New City Agenda think tank with Michael Lewis, the author of The Big Short, Liar's Poker, The Undoing Project and lots of other popular books on finance that you may well have read.
I can report that he's as good a speaker as he is a writer, by the way, so if you ever happen to have the chance to see him, it's worth going along.
His latest book The Fifth Risk is about the state of politics in the US. I haven't read it (it's now on my list), but he does seem to tap a similar theme to ex-Federal Reserve governor Paul Volcker's memoirs the idea that America needs to rediscover its respect for the notion of public service.
This rising undercurrent in the US of a backlash against the idea that "government is the problem" is intriguing, by the way, and it's something I think we should return to in a future Money Morning, once I've had a chance to think about it a bit more.
Lewis clearly isn't a fan of Donald Trump, although he does empathise with the fury created by the 2008 crash and the sense of gross unfairness it engendered among the 99.9% of us who were not on the receiving end of no-questions-asked government bailouts.
Anyway, a member of the audience asked him where he thought the next financial crisis might come from. After the usual preamble about not taking forecasts seriously, Lewis did have a go at painting a scenario that could lead to another crisis.
He began by making the point that the next crisis is highly unlikely to look the same as the last one. People might still be angry with the banks, but they are in much better shape, and they are more tightly regulated, than they were pre-2008.
He then noted that the one thing most people aren't really talking about anymore is the sheer scale of US debt. He argued that the next crisis could come from that direction.
What if, he said, Trump declares (at a rally, or on Twitter) that the money that the US owes China (in the form of US Treasuries) is effectively null and void, because of China's unfair trade behaviour over the decades? What if his audience applauds that idea? What if he sees this as a big vote winner in the run-up to 2020?
How would markets react to the notion that the US might not be a cast-iron credit risk? Or that certain Treasuries those owned by China were now less equal than others? The answer, of course, is "badly". In fact, Lewis reckons it could spur a run on the dollar which sounds quite likely in that scenario.
Of course, it's just a possibility, and there are plenty of other surprises both good and bad that could occur over the next year.
But the point is markets might think that gridlock acts as a restraining device. Instead, it might make Trump focus even more aggressively on the things that he can continue to change, particularly if he ends up under personal pressure on things like his tax returns and the rest of it.
Given that the market is still very expensive in the US, this post-election bounce may well be a relatively short-lived reprieve a final Santa Claus rally before tougher times ahead.
Let's see. Keep a close eye on the inflation data.