So we have congressional gridlock, the consensus result from the US midterm elections. With that out of the way, financial markets can get back to focusing on what really worries them: Federal Reserve policy and US-China trade tension.
These two drivers of market sentiment will ultimately determine whether Wall Street and global equities can extend their recent rebound after a brutal performance in October. The election result seems likely to produce a softer dollar and steady bond yields, which will help.
One very important result from Tuesday’s split decision— with Democrats taking control of the House of Representatives and Republicans maintaining a Senate majority — is that the prospect of further fiscal stimulus dims. When early results on Tuesday night suggested Republicans might unexpectedly hold the House, opening the door to a second round of tax cuts, bond yields briefly jumped and the dollar rallied.
While infrastructure spending may well emerge in the next Congress, one key point to note is that the campaign for the 2020 presidential election now begins. It is doubtful that Democrats are going to help significantly bolster the economy from here on and help Donald Trump’s re-election prospects.
That means the US economy enters 2019 with a diminishing tailwind from tax cuts. In turn, this increases the chances that the Fed tightening cycle is nearing an end and bond yields are close to a peak.
For global markets, the most important consequence is that the dollar’s strong run looks on borrowed time. For emerging market economies, many laden with hefty dollar debts, this beckons as good news — and the early response in Asian equity markets and currencies was positive after Tuesday’s election results came in.
In terms of valuations, global equities outside the US look a lot more attractive than those on Wall Street. The first round of Trump tax cuts fueled great divergence between the US and the rest of the world in terms of economic performance. If Fed tightening slows and the global economy improves, the gap between the US and the rest of the world may narrow.
For Mr. Trump, who has frequently touted a strong stock market as a barometer of his economic policies, one interesting outcome from gridlock could be that investors rotate away from the US and seek out cheaper foreign shares.
The attention of investors now turns to the latest policy statement from the Fed coming this Thursday.
We can expect a message that US interest rates will rise in December, the same month that the European Central Bank is expected to end its official bond-buying program. The year will thus end with two major central banks retreating further from the era of easy money.
Then at the end of the month, markets will closely watch whether the US and China take a step towards defusing trade tension at the Group of 20 gathering in Buenos Aires.
Trade remains the wild card, an issue that has been flagged by many US companies during the current earnings season. A slowing Chinese economy and weakening renminbi have also hurt sentiment in global markets, notably in the export-dependent eurozone.
Mr. Trump is unlikely to retreat from his tough stance towards China. Moreover, this is an issue where he has support from many Democrats.
The US-China rivalry is likely to become far more intense — and unless we see some easing in this area, markets face signing off on 2018 with a tough couple of months, and an uncertain outlook for 2019.
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