Markets discount electoral uncertainty
Prolonged uncertainty about exactly who will be the next US president has been a big issue for the stock and bond markets. But not the biggest, say strategists.
Weak corporate profit reports have added to concerns about the slowing national economy. And with the US Federal Reserve apparently still in tightening mode, many in the market are worried about the possibility of seeing an even worse set of earnings reports next time around.
“Certainly the election has put a big question-mark over market performance, although that uncertainty is abating,” says Lorenzo Codogno, senior economist at Bank of America in London. “The market is focusing on the underlying trend of the economy. Whether it is Bush or Gore who wins, this should change the outlook for fiscal policy. But the overall impact of fiscal easing will be the same.” However, if the legal battle over the election result dragged on into early next year, this would clearly be a big problem for the markets, he adds.
The lack of a clear election winner between the Republicans and the Democrats has left Congress balanced, and this is likely to result in difficulty getting legislation through, says Jeff Davis, chief investment strategist at State Street Global Advisors in Boston.
But political gridlock has advantages for some businesses. “The beneficiaries of this are the healthcare stocks, and we have seen that already,” he says. Proposed pharmaceutical price controls are unlikely to be implemented in the near future.
When the final result of the presidential election is known, the impact on the market will be relatively small, except for the inevitable rally as the market sighs with relief that the waiting is over, says Davis.
In general, Davis says State Street is more bullish than most managers about the market’s potential into the first half of 2001. “When people start looking at the slowdown in profits... inflation doesn’t seem to be an issue,” he says. In any case, Fed chairman Alan Greenspan has said a slowdown in the US economy was more or less essential.
The only real disappointment for stocks in the US has been the pace of economic development in Europe and Japan, says Davis. The much-heralded economic recovery in Japan is not living up to expectations, he says, and more attention is now being paid to the “triple dip theorists”.
Davis sees the Dow Jones Industrial Average putting on around 10% over the next six months. But the spectre of a recession still looms. Much depends on the behaviour of US consumers, and the level of capital expenditure on computers and other technology, says Davis. “The US consumer is still at the core,” he says.
But Codogno sees equities becoming more fragile as time moves on, and says he would not rule a sharp fall in prices in the next six months. “The market is increasingly worried about tightening credit conditions, and widening credit spreads,” he says.
The US economy is very highly leveraged, he says, and this is a frightening fact for many in the market. There is plenty of room for both fiscal and monetary policy to respond to this situation, says Codogno.
Though there had been signs that monetary policy was shifting into neutral, the most recent statement from the Fed was very cautious, he says. This was taken as signalling that the central bank is keeping policy on hold and not likely to lift the tightening bias yet.
The markets are still busy debating how quickly the Fed will look at data, which testifies to the economic slowdown and cut rates, says Ifty Islam, fixed income strategist at Deutsche Bank in New York. But despite economic signals, inflationary pressures still lurk in some corners. “The continued resilience of oil prices is pushing inflation higher,” he points out.
However, for Treasuries, the environment is increasingly positive, says Codogno. “Worries in Latin America and downgrades by the ratings agencies... That can only be positive for the US bond market,” he says.
Islam says the fiscal outlook is still uncertain as the presidential election result hangs in the balance, with Bush seen as the candidate likely to opt for the more expansionary policy.
Despite the closeness of the Senate, he says most congressmen will be under pressure to push for more aggressive fiscal easing, which will give the US yield curve a steepening bias.
The market is now awaiting a potential upwards revision to the budget surplus. Forecasts have been in the region of 2.7%, and any more than this could give bonds at the shorter end a boost.
Next year will be interesting for US bonds, says Islam. “Growth will be slowing, but we may not see a rally at the back end of the yield curve... a general slowdown will be beneficial to five-year bonds.”
With the slowdown on one hand, and the buy-back scenario on the other, the current fixed income environment is a difficult one for fund managers to take a view in, he says.