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Market View

Lord Abbett investment leaders offer their insights on what the upcoming contests may signal for the economy and key asset classes.

 

In Brief

  • The U.S. midterm elections in November 2018 are being scrutinized for their potential impact on fiscal policy and the U.S. economy, and ultimately, corporate earnings.
  • Here, Lord Abbett investment leaders assess how potential changes in control of the House and Senate could influence the economy and key U.S. asset classes.
  • While electoral developments at the federal and state levels may create short-term volatility, our experts believe current market and economic fundamentals will remain in place after the election.

 

On November 6, 2018, U.S. voters will determine whether or not Republicans maintain control of both chambers of Congress.  Up for election are all 435 House seats and 35 of 100 Senate seats.  At stake for investors is the impact the midterm elections could have both on corporate earnings and on the U.S. economy overall.   

Given the particularly contentious tone of U.S. political dialogue in 2018, the months leading up to the November elections have been described by Giulio Martini, Lord Abbett partner and director of global asset allocation, as a “politically noisy environment.” Here, we will attempt to cut through the noise by offering viewpoints from five Lord Abbett investment leaders: Martini; Partner and Director of Municipal Bonds Dan Solender; Partner and Portfolio Manager Leah Traub; Partner and Portfolio Manager Kewjin Yuoh; and Equity Investment Strategist Brian Foerster.

Turbulent Times
While no two eras are directly comparable, for those of us who’ve been around the block a couple of times, the year 2018 carries echoes of the polarization of America in 1968—a year which featured a new, bloody phase of the Vietnam War; political assassinations; the Soviet invasion of Czechoslovakia; rising U.S. inflation; violence erupting at the Democratic National Convention in Chicago and in other U.S. cities; and a hotly contested U.S. presidential race that culminated in the election of Richard M. Nixon.

As headline-grabbing as the politics and policies of 1968 were, the year yielded a valuable lesson for investors: it showed that even a drastically turbulent global and U.S. environment and worsening economic conditions were not enough to prevent the U.S. stock market (as represented by the S&P 500® Index) from rising 7.7%. (See Chart 1.)

 

Chart 1. Flashback to Another Turbulent Year: The S&P 500 in 1968

Source: Bloomberg and Lord Abbett.
Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

For investors in 2018, the media’s headlines—whether it’s the potential for trade wars, the ongoing investigation by an independent counsel of a sitting U.S. president, or the controversy surrounding Supreme Court nominations—can be equally unsettling. While many U.S. investors appear nonplussed amid the steady stream of negative political headlines, some are opting for safety in their portfolios.

Once again, maybe it’s time to zero in on what really matters to the financial markets.   

Focus on the Fundamentals
Put the politics aside and “focus, instead,” says Giulio Martini, “on the economic policies and how those policies may affect the fundamentals of corporate earnings, economic growth, and inflation—each of which will influence how markets evaluate the future.” And on that, there is some good news.

“The key initiatives of President Trump’s agenda so far” Martini continues, “have been corporate tax reform, including the cut in corporate tax rates, and measures to reduce the regulatory burden on companies.  Those two initiatives alone have created a 25% increase year-over-year in U.S. corporate earnings, which, in turn, have sustained the strong stock markets into 2018, on top of the already strong recovery from mid-2016.”

While tax reform and deregulatory initiatives have had a positive impact on financial markets, other policy initiatives are, at best, questionable, according to Martini.

The administration’s immigration policies, for example, may reduce the labor supply in the United States. A lower labor supply could aggravate inflationary pressures, lowering U.S. economic growth long term. Also, if trade and tariff disagreements between the United States and other nations “are pressed further, that will certainly increase inflation in what’s already a hot economy,” Martini says.

So, “rather than focus on the number of seats the Democrats can pick up or what conclusions the Mueller investigation will reach,” Martini says, “investors should be weighing the results the election might have on the fundamental issues that affect the markets.”  So far, measures of economic policy uncertainty in the United States (see Chart 2) suggest investors remain sanguine. As the results are reported on November 8, Martini says investors will be left with one important question: ”How has the election affected the fundamentals of corporate earnings, economic growth, and inflation?’”

 

Chart 2. Amid Political Turmoil, U.S. Economic Policy Uncertainty Remains Muted
Baker, Bloom, and Davis Economic Policy Uncertainty Indexes (monthly), January 1, 1987–August 1, 2018

Source: Federal Reserve Bank of St. Louis and Economic Policy Uncertainty. Indexes depicted here measure policy-related economic uncertainty based on three types of underlying components: newspaper coverage of policy-related economic uncertainty; the number of federal tax code provisions set to expire in future years; and disagreement among economic forecasters as a proxy for uncertainty.

 

Martini believes that earnings growth and inflation expectations are still highly favorable for risk-asset prices, and that monetary policy is still stimulative when viewed historically, despite a series of rate hikes by the U.S. Federal Reserve (Fed). “This may mean,” he says, “that investors should, at a minimum, stick to their long-term asset allocations rather than de-risking.”   

Elections Have Consequences
Midterm elections traditionally have had short-lived to marginal impact on the markets, according to Kewjin Yuoh, but this year may be different. To provide some perspective, Yuoh weighs the potential election outcomes with those market initiatives that are important to the current administration. Noting recent polls, he looks at three separate scenarios from the most-likely to the least-likely outcome:

Democratic House, Republican Senate
The outcome with the highest likelihood is that of a Democratic House and Republican Senate. So what are the factors that investors should consider? “Tax cuts have certainly been a supportive fiscal policy,” according to Yuoh. “This potential outcome would decrease the likelihood that a second wave of tax cuts would be coming. Economic growth could slow down under this scenario, a consideration that hasn’t necessarily been priced into the market yet,” Yuoh says.  

“Trade policy, tariffs, and potential trade wars have all been significant to spread valuations and market action,” Yuoh says, “but decisions on these policies reside largely in the executive branch, so nothing significant would be expected to change in this regard. Of course, the political rhetoric would continue, contributing to market volatility.”

Consumer confidence has been high under this administration, especially among Republican voters. “We expect that indicator to remain high given the improving labor picture and generally robust growth of the U.S. economy,” Yuoh says, “no matter the election outcome.”

Republican House/Republican Senate
The outcome with the second highest probability is the Republicans maintaining the majority in both the House and the Senate.  “And really, in that scenario, you should expect more of the same,” according to Yuoh, specifically “continued U.S. economic growth, strong consumer confidence, rising interest rates, and the return of term premium in the yield curve.”

Democratic House/Democratic Senate
The outcome with the lowest probability—and the one, according to Yuoh, with the greatest potential impact on markets—is a Democratic sweep of both houses of Congress.  “What would happen in this scenario,” Yuoh says, “is that the markets would price in some uncertainty—through expectations of higher volatility—given that that would be an outcome that was not expected.”

“With higher volatility,” he continued, investment managers would “have an opportunity to invest in risk assets. Once again, Yuoh counseled focusing on fundamentals. “We believe consumer confidence will remain high, and the labor and growth picture will remain robust and that suggests a risk-taking environment.

In Any Scenario
“Historically, event risk, and specifically political event risk, generally provides short-term opportunities in the marketplace” according to Yuoh. “But as far as its impact on long-term fundamentals—that is a much slower-moving phenomenon. And so in the current environment, with fundamentals being as strong as they are, we expect the midterm elections to potentially provide some volatility and some risk-taking opportunities in the short term. But our outlook for U.S. growth and the domestic economy continue to support our position to take risk.”

Potential for Volatility
Brian Foerster agrees.  “There is a strong likelihood of heightened equity market volatility during and after this election season,” he said. “This is particularly likely should Democrats win one or both houses of Congress, with impeachment and the Mueller investigation conclusions raising uncertainty, and potentially a reason for investors to hide out in haven assets in the absence of clarity.” But even with these political scenarios affecting near-term market sentiment, Foerster expects corporate profits to be resilient, driven by “the further flow-through benefits of the 2017 U.S. tax cuts, strengthening consumer demand, unprecedented innovation, and healthy margins.”

Markets generally don’t like political upheaval, Foerster noted. He cited “a relevant comparison” to today’s events in the impeachment of President Bill Clinton in 1998—and ultimately, his acquittal in the Senate the following year—offering an analogue as to what may play out in the current environment (barring new evidence in the Mueller probe or other developments that increase legal risk for President Trump). Foerster thinks “it is very possible that as these events potentially play out, any sell-off may be followed by a strong rebound as earnings remind investors what really matters, which is what occurred with the Clinton impeachment.” Moreover, while Democrats may gain power, “they will not have a veto-proof majority, so it is unlikely that any attempt to unwind the tax cuts would survive,” he said, “thus extending the expansion and supporting many cyclical and secular growth companies.”

“Our base case,” he said, “is that this era of unprecedented innovation and growth from technological advances across the economy (in areas like e-commerce, financial technology, biotechnology, and industrials) will overwhelm the short-term angst over the elections and their aftermath, leading to continued economic expansion and a resilient bull market into 2019.”

Emerging Market Impact
The U.S. midterm elections are not expected to have a direct impact on emerging markets, according to Leah Traub. The main U.S. policy that typically affects emerging markets is trade, and since trade policy is driven by the executive branch, not Congress, it is unclear what would change even if the Democrats do take over the House, which is the most likely scenario, with the Republicans keeping a slim majority in the Senate.

However, there are a number of issues that EM investors should continue to monitor, according to Traub. “On NAFTA [North American Free Trade Agreement], for example, if a revised deal can be agreed upon between the United States, Mexico, and Canada, I think any Congress would approve it,” Traub said. [Editor's Note: As this article was being prepared for publication, the United States and Canada announced an agreement to revise NAFTA, subject to Congressional approval, paving the way for a modified three-way trade pact with Mexico.]  “It is possible that if the Democrats take over both the House and the Senate, they may delay any trade deal (or any other policy), but that election outcome is unlikely. On the flip side, I think that any deal that does not include Canada will have a hard time getting through even a Republican-controlled House and Senate.”  Both parties are in favor of putting pressure on China to get a fairer trade deal with them, she said.

The more complicated issue, according to Traub, is what the outcome of the midterm elections could mean for the U.S. dollar. “The appreciation of the dollar has been an important factor in the turmoil we’ve recently witnessed in some vulnerable emerging-market currencies, such as the Argentine peso and Turkish lira,” Traub said. “Increased political uncertainly, which may arise if the Democrats take over at least one branch of Congress, has historically resulted in dollar appreciation as the ‘safe haven’ asset. And if a Democrat- controlled House of Representatives decides to engage in impeachment proceedings, the initial market reaction will be to buy the dollar and sell riskier emerging market currencies.”

Another consideration is whether a change in congressional control could lead to the reversal of any of the economic policies recently passed, such the December 2017 tax cuts. “That would be a negative for the dollar,” Traub believes, “as it would increase the probability of an economic slowdown and may cause a change in the Fed’s path for interest rates. However, she views this as a highly unlikely scenario.

Municipal-Bond Implications
What will Dan Solender and his municipal-bond investment team be watching as the election unfolds?

Solender notes that federal elections carry important ramifications for the municipal-bond market, especially in terms of fiscal policy. Should electoral shifts result in changes in tax policy and spending priorities, these developments “could have big impacts on local governments, just as we saw with the December 2017 tax bill.” For example, he noted that Republicans in Congress are trying to promote additional tax cuts, which an electoral sweep by the party in November may make possible.

Any potential changes in U.S. fiscal policy could have an impact on investor demand, and on state balance sheets, as revenues might be affected at the federal and state level, Solender said. “So that's something to watch in terms of the balance of power in the House and Senate in the election.”

At the local level, Solender notes that the expansion in U.S. economic activity in 2018 has resulted in stronger revenues for many states. Many state governments, he notes, have been “way above budget” this year. Solender and his colleagues will be watching how state governments deploy those revenues, and how confident investors are in improving local economies. At the polls, state-level referendums affecting governmental spending and bond issuance will be key, he notes, especially if expanded issuance boosts the supply of available muni bonds on the market. Further, any changes in fiscal priorities brought about by party shifts in state governorships or legislatures will be carefully examined, especially as these changes affect how states set their budgets, and how much money they use to fund pensions and infrastructure spending. Solender’s team will also be monitoring how any changes may affect spending by local governments.

Solender broke down the implications for the muni market: “There’s a lot to watch in terms of the impact on demand at the federal level, and on supply at the local level. And then, there’s the broader spending and budget impact, based on the policies expressed by the executives and legislators selected by the voters.”

Summing Up
The Lord Abbett investment professionals surveyed here all focused on different aspects of the U.S. midterm elections and their potential impact on fiscal policy, the economy, and investments. But one common theme emerged: The need to focus on fundamentals in an uncertain environment. Lord Abbett experts anticipate that the economic and market conditions that have fueled the performance of key asset classes in 2018 will remain in place for some time after the last votes are counted, and the “noise” from the 2018 U.S. midterm elections subsides.

 

MARKET VIEW PDFs


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