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Divided Government for a Divided Country?

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Investors called the US presidential election as soon as markets opened last Wednesday — days before the winner was called by cautious news outlets. A Democratic president, but without a mandate for sweeping change, looked just right for equities, which promptly shot up around the world. Adding to good cheer this Monday morning: Pfizer announced that its late-stage vaccine was more than 90 percent effective in preventing the disease. As Covid-19 cases surge again, hopes for a vaccine are crucial. On fiscal policy, it is less clear that a divided government will deliver the best outcome for the economy as a whole. As Fed Chairman Powell said again last week, more fiscal help is needed to assure a strong and broad-based recovery. Fingers crossed that the Senate now comes around to that view — perhaps even before January. Although President-Elect Biden’s most ambitious spending plans may have to be shelved — as a double win for Democrats in Georgia’s two Senate runoffs in January is unlikely — he sounded determined on Saturday to win the nation around to measures both to curb Covid-19 and get the economy back to full speed. The President-Elect is starting work today on those policy issues and the two others that he highlighted: combating climate change — a global challenge — and systemic racism — a particularly American problem. His success will both depend on and help to determine whether he can pull off the enormous task of uniting a bitterly divided nation. In the meantime, a bumpy presidential transition over the next two months may keep politics to the forefront of investors’ minds.
The Biden camp was calm and confident of victory from early morning on November 4, as it became clear that many of the still-uncounted votes in the presidential election were likely to favor their candidate. Biden succeeded in rebuilding the so-called blue wall in Wisconsin, Michigan and Pennsylvania. But only just. Tuesday night was a surprise, for Democrats, and many others in the US and elsewhere. Polls were — once again — way off in gauging the breadth of American support for President Trump. The drawn-out battle for votes kept many on the edge of their seats, and meant that it was days before the news media and others were willing to call the race for Biden. Leading Republicans have still to do so. 

They may need to do so soon — if they are not to appear grudging — including to the young people who helped Biden to win, along with his inspiring running mate, Kamala Harris. The focus on the top of the ticket meant that many around the world only paid attention to Harris for the first time this weekend. As a Black and Asian American woman, and the daughter of immigrants, Vice-President-Elect Harris will break ground in many ways when she takes office. 

The race for the White House drew the most attention. But it was only a part of the story. Strong support for Republicans running for office in state legislatures, as well as the US House and Senate, surprised both sides — as well as proving pollsters wrong again. Trump remains a commanding — as well as divisive — political figure. He may be able to wield power within the Republican party from outside the White House. But while the big initial story was the depth and strength of support for the president, down-ballot success for Republicans was perhaps more important for what comes next. Interestingly, that success included victory for a number of Republican women — almost doubling their representation in Congress.

Those candidates who now become or remain officeholders across America will be making policy in the months to come, whether deciding the size and shape of federal taxes and spending, confirming judges or influencing outcomes at state and local level, where important decisions take place, including on education, policing, regulation and health and other benefits. And some voters split their ballots, indicating dislike of the president’s norm-breaking behavior combined with support for traditional Republican policies. Pocketbook issues — jobs, incomes, healthcare — are of paramount importance to most Americans. Dignity and fair opportunity are also critical. Businesses that spoke out against racism and division and in favor of sustainable and equitable growth will need to follow through if the country is to heal as President-Elect Biden would like. And the new administration will have to be bold in addressing the wounds of voters upset by years of sub-par growth in real incomes and a scarcity of good jobs.
Observations and the takeaway for investors:
1. Jobs, jobs, jobs — and stimulus

The US economy demonstrated its strengths this year, as activity bounced back from the steepest decline in output since the post-war period. Last Friday’s job figures surprised on the upside, as private sector payrolls rose by 906,000; a drop in government employment limited the overall rise to 638,000, still above most expectations. There was a further welcome decline in unemployment, to just below 7 percent. These numbers were seized on by Senate Majority Leader Mitch McConnell as evidence that the US does not need a fiscal stimulus package as large as the $3 trillion Heroes Act passed in the House back in May. He is likely overestimating the economy’s resilience and underestimating the social costs of the unequal burden of the Coronavirus Recession. So far, low-income families, people of color and women have been hardest hit. And they will be particularly vulnerable to any new restrictions aimed at limiting the spread of Covid-19.

As always, the official numbers for unemployment only count those with no employment income who are actively looking for work. There are many more who find it difficult to make ends meet, with only part-time or very low paid jobs. New calculations from the Ludwig Institute for Shared Economic Prosperity, founded by former U.S. Comptroller of the Currency Gene Ludwig, suggest that when unemployment officially dropped to a low of just 3.6 percent in January 2020, there were as many as 23 percent of adult Americans either out of work or earning less than a living wage ($20,000 a year).

It is best to think of a fiscal boost in three categories. The first is immediate support for the individuals and businesses directly hit by the Coronavirus Recession. Millions of US jobs have come back since March. But the US is still only halfway back to pre-pandemic employment levels: there were nearly 11 million fewer jobs in October than in February this year. 

The pace of recovery is now much slower than over the summer and will slow further in the absence of government support, particularly if rising Covid-19 cases dampens activity. Consumption has been held up by the tremendous fiscal support enacted in March. But — again as Chair Powell warned — American families are running out of the savings from that support, at the same time as state and local governments are curbing spending and cutting their payrolls. Think of what is needed as a relief package, to allow people to go on paying rent and food bills and businesses to keep their doors open, coupled with help for those families who may have work, but not enough income to keep out of poverty. New research suggests that an important element of any jobs package would be an increase in the Earned Income Tax Credit (EITC). Describing the EITC as “the cornerstone US anti-poverty program, typically lifting over 5 million children out of poverty every year”, economists Diane Schanzenbach and Michael Strain note that it provides a strong incentive to work. Their research shows that labor supply has increased with expansions in the program since it began in 1975. 

The second, equally urgent, fiscal need is for ramped up spending to combat the virus. Testing, contact tracing and ensuring adequate supplies of PPE for hospital and other frontline workers all require money, as well as dedication and focus, from the federal government. The first of these — if implemented properly — can also provide immediate employment and income in places across the country now hit by the virus surge.

Thirdly, as most politicians have agreed for years, America’s infrastructure needs repair and rebuilding, as well as modernization and “greening”. In addition to traditional investments, the pandemic has shown the urgent need for expansion of good internet access to cover all rural and low-income populations. This spending, as well as investment in education, training and research and development, will take time to roll out. But it should not be forgotten.

2. Covid, covid, covid

Political news has crowded out Covid-19 — but the news there is bad. New daily cases in the US soared above 120,000 last week. That was before the holiday season brings people together in circumstances where social distancing and masking will be difficult if not impossible. No surprise that Dr. Anthony Fauci has warned “All the stars are aligned in the wrong place as you go into the fall and winter season, with people congregating at home indoors.” His advice has been largely ignored by President Trump. It is likely to be taken more seriously in a new Administration. But before we get to January, there will be many more thousands of Americans infected, hospitalized and — sadly — killed by the virus. 

As Europe locks down again — and its economy weakens — attitudes on this side of the Atlantic are markedly different, at least in large swaths of the country. Economic concerns weighed more heavily for many voters than the pandemic. Analysis last week showed that Covid-19 cases are higher in counties that voted for President Trump than in those that went for Biden. That could be because Trump supporters followed the president’s lead and ignored the public health advice to wear masks and socially distance. It could also be because of financial concerns — with some continuing to work in exposed conditions to maintain their livelihood. Bartending and waiting tables are dangerous in the context of Covid-19, after all. Maybe the impact of the virus is less visible in rural areas than in crowded urban areas. 

Whatever the reason for the US acceptance of such high infection rates, we will see over the winter whether the continued spread hurts consumer and business confidence as it has elsewhere, and as many economists fear. Markets are assuming not.

3. Investor Takeaways

Equity Markets. If investors were only watching equity markets this week there would have been little to discuss! US stocks had their biggest weekly gain since April, with European equities enjoying a similarly strong upmarket and emerging market equities following suit. Cheery stock prices were despite a nail-biting US election, Covid-19 cases continuing to surge in the US, Canada and Europe and important economic data releases. 

Market strength was broad-based in US equities with the S&P 500 and NASDAQ climbing approximately 7 to 9 percent for the week. While investors may be factoring in a fiscal stimulus package being finalized soon, there were some election-related moves in certain sectors. Investments tied to renewables, financials and cyclicals lagged considerably during the week as investors rotated out of areas that may be less likely to gain momentum with a divided government. The biggest beneficiaries of US election outcomes seemed to be sectors prone to regulatory scrutiny due to dimming prospects of sweeping legislative changes. Big Tech has been in the government’s crosshairs for a while now, so no surprise that Google, Facebook and Amazon saw strong rallies and could continue to carry US equity markets as they have much of this year. Another bright spot this week — and potentially in the long term — is health care. Major drug pricing legislation looks less probable with the Senate likely not changing hands. The health care sector has been trading at close to a 25 percent discount to the S&P 500 — close to a historical low — even when taking into account the period prior to Obamacare. Given RockCreek longer-term positive views on various parts of the healthcare sector, this may be an attractive place to focus portfolios. The innovation occurring between technology and health care, the impact from the pandemic, rapid speed in development of vaccines and other glaring needs in global health care systems is an opportunity for investors.

Covid-19 cases continue to be a worry in Europe, yet equity markets were supported by strong quarterly earnings and additional UK stimulus on top of the upbeat tone coming from US markets. Technology stocks outperformed as they did in the US, but the breadth of the rally extended into more cyclical industries including autos and chemicals — a large part of the European market. While renewable energy names like Vesta Wind Systems and Siemens Gamesa saw a temporary move down in the middle of the week, they quickly recovered. International stocks are well placed to benefit from a Biden administration that is expected to be more predictable on trade.

While the developed markets were focused on elections, earnings and economic data, in emerging markets the big news was the abrupt suspension of the world’s largest IPO — a big shock to the market. The Ant Group IPO suspension and the new micro-lending regulations not only cast doubts on the company itself but also tainted the internet finance, online wealth management and mobile payments sectors. Payment companies in China are increasingly viewed as “public goods,” meaning firms like Ant may be regulated more like a commercial bank, while banks, which are already under strict regulation, may receive some buying interest. In the meantime, liquidity that had been made available for the IPO rotated back into many of our high conviction names in China. Despite cautious sentiment at the start of the week, both Hong Kong and mainland China markets experienced a sound rally, as global risk appetite rose on increasing odds of a Biden win. Flows into Asian emerging market countries have now been positive for nine consecutive weeks as investors take advantage of the region’s handling of the pandemic, improving economic conditions and attractive valuations. 

Overall as we go into the end of the year, it is a healthy environment for fundamental investors globally. Despite election uncertainty and society’s ongoing struggles with Covid-19, stock prices have been responding to underlying data points. This week, Qualcomm reported strong Q3 revenues and earnings while raising guidance on expectations of a surge in sales of 5G-capable devices and the stock was up 14 percent in premarket trading. Hanesbrands reported weaker than expected revenues and earnings as the pandemic disrupted its business and the stock tumbled 14 percent in pre-market trading. This type of price action explains why active investors are having their day in the sun again.

Fixed Income. It was a wild ride for US treasuries this week as yields on the 10yr note swung between 0.72 percent and 0.94 percent before settling at 0.82 percent on Friday. Although yields started the week rising in anticipation of large fiscal spending, markets quickly adjusted to an economy that would have to lean more heavily on the Fed for economic support. The FOMC decision on Thursday also seemed to have little impact on rates with little change in the Fed’s statement and outlook. 10yr yields were higher by the end of the week as jobs data was stronger than expected. The medium term outlook remains for a flatter curve as markets now expect a less significant expansionary fiscal policy. Inflation expectations will likely remain subdued and open market operations by the Fed will persist, which could continue to weigh on the dollar. 

Emerging market fixed income and FX markets have also been opportunistic investments for investors looking to diversify outside the G7 markets. Mexico’s longer-dated sovereign dollar bonds jumped more than 5 cents reaching multi-month highs. Likewise, in FX, emerging markets currencies broadly appreciated against the US Dollar, surprisingly led by the Russian Ruble. This is probably a temporary relief rally as the worsening public health picture in Russia coupled with little to no room for additional fiscal stimulus means the Russian Central Bank will likely have to cut rates. While the current uptick in food inflation may prove a near-term obstacle to easing at the December meeting, market consensus is for a 50 bps rate cut in February 2021.
Credit. Beyond the positive reaction from credit markets since election day, we believe corporate spreads will continue to have room to tighten further — especially in non-Covid-19 impacted sectors. We are likely to see broad-based spread compression in the near term, especially as rates are likely to stay lower and investors begin to reach for yield. While a divided government would result in a smaller fiscal stimulus package, the deficit impact will likely be balanced by the absence of the significant increase in corporate tax that was expected with a blue wave. Credit performance of cyclically exposed sectors will be more constrained in the near term and more linked to the progress and release of a vaccine. Despite the worsening situation for many cyclical companies, we believe default rates will continue to fall given that ample balance sheet liquidity has been raised and open capital markets continue. Outside of corporate credit, the one segment that could see more stress and defaults is the high yield municipal sector. High yield municipal issuers continue to face enormous macro-pressure due to the expectation that revenues will stay well below pre-pandemic levels and the unlikelihood of a generous federal aid package for support. This may be a sector to watch closely for anomalies or opportunistic trades.
RockCreek Update
The RockCreek team continues to work seamlessly and productively remotely, with some team members coming into the office. Our team has been staying connected with morning coffee sessions, town halls, guided meditations and more.

At RockCreek, November 3 was a holiday for the 2020 Election given the uncertainties created by the pandemic so team members could vote and participate as volunteers. Plans were made for team members with market-related positions to have time to vote.

Team RockCreek

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