The election, COVID, and markets

Hopes for more stimulus may be sustaining markets through political tumult.

  • By Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company (FMRCo),
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Key takeaways

  • The prospect that the Democrats might win the White House as well as the Senate was likely already priced into the market before the news broke about the president's COVID diagnosis.
  • For now, the market remains laser-focused on whether there will be another tranche of fiscal relief. With the liquidity impulse waning, this is a needed bridge toward economic recovery. The dramatic back-and-forth over the past few days shows how high the stakes are for the market for another fiscal bill to be passed before the election.
  • The prospect of a "blue wave" leading to an even more expansionary fiscal policy could be offsetting market concerns about potentially higher taxes and increased regulation.
  • It's possible that ongoing expansion in fiscal policy (and therefore, further debt and deficits), could be bankrolled by the Fed through continued asset purchases and very low rates.
  • That policy combination could follow the World War II playbook, during which the central bank kept interest rates well below the inflation rate while increasing its balance sheet 10-fold in order to absorb the increase in Treasury supply.

About the expert

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.

Can 2020 get any more 2020? Every time I think this bizarre year can't get any stranger, it gets even more surreal and at a speed that is hard to keep up with. The market is understandably in a state of unease as we await news on the president's health and how this might affect the upcoming election. But with only a month left before the election, the market is laser focused on fiscal policy right now, and there appears to be some positive momentum on that front.

The chart below shows that the odds of the president's re-election were already low and falling following last Tuesday's debate, as were the odds of the Republicans keeping control of the Senate. In other words, a Biden win and a blue wave, with all the potential policy implications that this implies, were likely priced in already before Friday's news.

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But we all know how wrong the polls were in 2016, and this being 2020, we should be prepared for any outcome. Perhaps the market will just float in a state of suspended animation until election day, but on the surface, it seems to be taking the odds of an election upset, a potential Democratic sweep, in stride.

As the chart shows below, while historically a blue sweep has produced below-average results for the stock market over the subsequent 2 years (presumably because of increased regulation and higher taxes), I wonder if that will hold true this time around. Perhaps today's focus on massive fiscal policy stimulus (20% of GDP this year alone) "enabled" by the Fed's ultra-accommodative monetary policy is overriding those concerns.

The current wave of COVID-related fiscal and monetary liquidity can be seen below. The chart below shows the spike in excess liquidity (M2 growth − GDP growth). (M2 is a measure of the money supply and it includes cash, checking and savings account deposits, and money market securities.) That is a massive liquidity impulse. No wonder the market's valuation is through the roof.

The bars in the bottom panel show the year-over-year growth in excess liquidity and the line shows the annualized quarter-over-quarter series. This chart shows that the liquidity impulse is waning fast. That means that unless another phase of the CARES Act comes soon, the market's former valuation tailwind could turn into a headwind. This is why the market is on pins and needles waiting for the next phase of fiscal relief.

So what will happen in a blue wave, if that is what's coming? Will an increase in taxes and regulations be offset by an ongoing expansion in fiscal policy (and therefore, further debt and deficits), "funded" by a Fed that keeps policy rates below the inflation rate while simultaneously offsetting the increase in Treasury supply with additional bond purchases?

As outlandish as this may sound (or would have sounded a few years ago), this is exactly what the Fed did during the 1940s when the US entered World War II and ran up a massive debt in the process.

Following the Great Depression of the 1930s, in 1942 the US government went into high gear to enter World War II (following the attack on Pearl Harbor), and in the process ran up a tremendous amount of government debt. Federal debt as a percent of GDP increased from 39% to 116% during the first half of the 1940s.

Not only did the Fed monetize this debt by increasing its balance sheet 10-fold, but it also repressed the entire yield curve by capping short rates at 3/8% and long rates at around 2.5%. During this period, inflation ran up, but with the Fed repressing rates at very low levels, real rates were on a steady march to increasingly negative levels. That is one way to get out of debt.

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