The Monthly View – November 2020

Overnight more votes were counted in Michigan and Wisconsin, 2 states Trump won in 2016. Biden is the winner and now has a likely path to the 270 votes needed in the electoral college.  Arizona (called for Biden by some, but not yet official), Georgia and even Pennsylvania may go his way. However, many of the states have razor thin margins and the Trump campaign has already filed lawsuits to challenge results and force recounts. Multiple states allow automatic recounts if the margin of error is sub 1% anyway. When all is said and done, including what is likely to be multiple trips to the Supreme Court, it is starting to look like Biden is the likely President elect.  Trump still has paths to win, but it is getting increasingly unlikely, though not impossible.

However, the story is very different in the House and Senate. Democrats have gained 1 seat so far and there are 5 seats remaining. We won’t know the tally for some time (weeks actually, as there will be at least one run-off in Georgia), but a Republican Senate is increasingly likely. While the House will almost certainly remain under Democratic control, it was not a good showing with Republicans gaining 5 seats so far.  In short, if Biden wins the Presidency, he will confront a less united House and a Republican Senate. This potentially means smaller stimulus plans, continued division on healthcare, and a lot of focus on 2022 mid-term elections. We will have to rely on McConnell and Biden remembering their work together in the Senate over the last few decades and hoping they can find some sort of compromise.

Despite many bold predictions of a ‘Blue Sweep’ in which Democrats gained (or re-gained) all Trumpian red territory of 2016 and then some, as of this morning it looks like only Arizona, Michigan and Wisconsin flipped from red to blue. Four states remain outstanding: Georgia, North Carolina, Nevada, and Pennsylvania.  Democratic hopes for Florida and Texas faded early in the night on Tuesday.

The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible.

Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted).

That leaves Pennsylvania as the biggest risk of a contested result. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.

We won’t know what the final court verdict on Pennsylvania will be, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges doesn’t necessarily mean they vote in his favour because they serve lifetime appointments.

Assuming North Carolina and Georgia have slipped away from Biden and that Nevada remains blue, the best-case scenario for the former vice president is a 290-electoral vote victory. That’s more than George W. Bush achieved in his two successful campaigns (271 in 2000 and 286 in 2004), but fewer than Barack Obama (365 in 2008 and 332 in 2012) and Donald Trump (304 in 2016). A win, of course, is a win. But if Biden is victorious, it will be under radically curtailed circumstances from what Democrats had assumed.

At the moment, we think a Biden win with a GOP Senate seems to have the highest probability. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and a one other states. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until December 14.

Risk-off sentiment will prevail in the interim, given the importance of the next economic stimulus package. What we know is that Republicans will very likely keep the Senate. This means gridlock is assured, which is actually positive for US stocks in the medium to long-term.

Biden Needed the Senate

The predicted ‘Blue Sweep’ didn’t materialize. That means whoever prevails in the presidential race, Mitch McConnell is likely to remain in charge of the upper chamber and that means that the American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans. In this case Biden would be the first president in 32 years to come into office without control of Congress, another dynamic that would weaken claims of a strong mandate.

The Democrats’ anti-filibuster movement and its interest in expanding the Supreme Court and the Senate, or any other process reforms to maximize a new Democratic president’s power and influence, would be placed on pause. President Biden’s agenda would be defined by his ability to win over the entire Senate Democratic caucus, from Bernie Sanders to Joe Manchin, and then as many as 10 Republicans. Ultimately, Biden would have to deal with McConnell, who would undoubtedly reprise the role he played in the Obama era when he had no incentive to help Obama rack up legislative achievements.

For markets, this is probably the best possible long-term outcome. Historically gridlock offers more upside for the S&P 500 than a single-party sweep. However, there is risk that the short-term economic stimulus will be much smaller than the market wants in the case of a Biden win with a Republican Senate. If Trump prevails, he has more leverage to force the Senate to approve a much larger economic stimulus package before the end of the year. A Trump administration will also face gridlock because of the Democratic majority in the House. In his case, the gridlock is reflationary at first (good for markets) but problematic later due to continuation and likely expansion of Trump’s trade war focus.

A Biden gridlock is deflationary at first but the best outcome for investors over the long run as it will mean that a Biden administration cannot introduce sweeping new regulations on everything from healthcare to technology companies or fracking. And it is unlikely a Republican senate will approve any tax increases. History shows that a gridlocked government tends to be positive for the economy as a whole. On top of that, a Biden administration is less likely to start a global trade war than a Trump administration. Or at least take a more considered and diplomatic approach to it. Both are positive for the global economy.

It means that a potential Biden administration will have to govern from the middle and that the progressive wing from the Democratic party will have limited influence on policy. It seems that the United States is not yet ready for a more left leaning government, despite many predictions to the contrary.

Market Impact

Now for the bad news, a contested election will lead to market uncertainty in the short-term. Mainly because it is now unclear when to expect the much-needed next economic pandemic stimulus and how big it will be.

So far, neither the election nor Ant Group’s Initial Public Offering (IPO) derailing have had a major impact on markets. All markets were up the last couple of days, basically reclaiming last week’s sell-off. We are likely to see continued uncertainty in the coming 1-2 weeks, but do not expect any major correction. Equity markets are comfortable with a Biden Presidency and a Republican Senate, so there may be some risk if recounts point the other way, but we do not expect such a move to be material enough to warrant a change in our outlook.

Over the next 12-24 months we continue to favour equities given the ongoing economic recovery, likely progress on Covid and other healthcare measures, and of course the potential for government stimulus in the US (especially now that any tax increases are likely to be constrained by the Senate).

Ant Group’s IPO 

While the US election is the biggest news globally, Ant is Asia’s leading story right now. It seems that the IPO, due to be the largest ever globally, has been put on hold by the Chinese government. Ant is already the largest non-State-Owned financial player in China and going public would put it more squarely in the private and non-government-controlled camp. This is a continuation of ongoing conflict in China between the private sector (best embodied by the outspoken and fluent in English Jack Ma) and the Communist Party (firmly controlled by Xi Jinping). 

There is lots of speculation that Jack Ma’s speech over the prior weekend about regulators holding back innovation in finance was the final straw for those in power in China. The IPO, scheduled for today in Hong Kong and Shanghai, was cancelled only two days before listing and after more than three months of reviews. This suggests the decision was made top down by Xi Jinping and the Communist Party, not by the many administrators who reviewed it in prior months. 

Alibaba, Ant’s parent and major shareholder, dropped 8-9% in Hong Kong and New York on Wednesday. It is unclear how long the “regulatory” review will take and when the IPO will come back. We think that eventually the Ant IPO will go through as it is too important to be allowed to fail for both Shanghai and Hong Kong markets.

A New Wave of Covid Infections

Stocks rallied in the spring and summer on hopes that the worst of the pandemic was over and that fiscal stimulus would continue to prop up employment and spending. Now, both assumptions are being challenged. The number of coronavirus cases continues to rise worldwide. In both Europe and the US, the daily tally of confirmed new cases exceeds the March peak. The only saving grace is that the number of deaths has not risen by as much as many had feared.

While governments have understandably tightened restrictions to control the latest surge in Covid cases, they are unlikely to fully revert to the extreme measures taken in March. Back then, there was considerable uncertainty over how fatal the virus was, with estimates for the mortality rate ranging from 0.5% to over 5%. The latest research suggests that the true number is near the bottom of that range, and perhaps even below it.

Progress continues to be made on a vaccine. Close to 95% of professional forecasters surveyed by The Good Judgement Project expect a vaccine to be widely available within the next 12 months.

Ironically, the severity of this second (or third) wave of the pandemic will likely lead to even more economic stimulus than the market was expecting. Every developed country in the world has already run up deficits to finance economic stimulus. There is no politician in the world that is now going to stop spending. Especially with elections coming up in all the major countries in Europe over the next 18 months.

The combination of a vaccine and further fiscal support against a backdrop of ultra-easy monetary policy should be enough to lift global equities. While the near-term picture for stocks is uncertain, investors should remain invested in global equities.

Fixed Income Markets

A democratic Blue Sweep would have led to extensive fiscal spending the next few years. This is now much less likely to happen and that is positive for fixed income markets. Biden’s original economic plan would have likely pushed up U.S. Treasury yields.

Now that spending will be curtailed by a Republican Senate it is more likely that bond yields will remain subdued for longer. Which in turn is not only positive for bond prices in the short-term but is also positive for growth stocks as the discount rate will stay low for longer.

The U.S. Dollar

As a countercyclical currency, the US dollar is poised to weaken next year. Typically, non-US stocks outperform when global growth is strengthening, and the dollar is weakening. Moreover, a generous monetary and fiscal policy setting in the U.S. has eroded the dollar’s appeal as the country’s trade deficit widens. Furthermore, U.S. broad money growth stands far above that of other major economies. Compared with other major central banks, the Fed is more guilty of financing the public-sector’s debt binge. Debt monetization creates a real risk to a stable USD.

The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan. A strong CNY improves China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the U.S.

Portfolio Impact

Early October we rebalanced our model portfolios and believe they are well positioned to profit from the economic outlook described above. Despite any short-term market volatility we might see.

In October we added two global equity Exchange Traded Funds (ETFs), targeting Momentum and Value stocks. By adding the best performing (Momentum) and cheapest stocks (Value) at the same time, we are maintaining our overall exposure to winning technology and healthcare stocks amidst the pandemic while adding an allocation to companies likely to benefit from a gradual return to normal in the real economy, such as financials and consumer cyclicals. These companies have underperformed so far in 2020 but we anticipate a continued rotation toward recovery stocks amid further stimulus and policy clarity post the US election.

In addition, we took partial profit on our China technology and healthcare allocation (though we still maintain an overweight) and made a small allocation to global Real Estate Investment Trusts (REITs), which continue to pay out a high dividend amid lower borrowing costs and are likely to benefit as economies open up in 2021 and beyond.

Fixed Income Portfolio

Whether Biden or Trumps eventually wins, a gridlocked Congress will likely mean that bond yields won’t rise any time soon. Yields across much of the government bond universe in USD, EUR and JPY are close to 0% and are likely to stay there. As such, we are reducing our US and developed market government bond positions and have allocated to diversified sources of yield, such as US and Asia ex Japan Credit. A yield-pick up of 2%+ is worth the marginal increase in credit risk in our view.

In addition, we have added an allocation to China government bonds, which yield circa 3% vs 0.7% in the US and 0% or less in Europe and Japan. This exposure also provides a nice diversification to the U.S. dollar tilt in most fixed income portfolios.

Lastly, to leave ammunition for future market opportunities and generate yield from cash, we have added an ultra-short fixed income ETF, currently yielding 0.6% yield, materially higher than cash or T-bills.