The US vote doesn’t matter – what matters is which story markets choose to believe

Whichever way things go, the market will create its own narrative

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The US mid-term elections are happening right now.
Here in the UK, we won’t have the full results until tomorrow morning. However, I’m not sure that the specifics are all that important.
Rather, the important thing is what the market chooses to believe about the result.
You can tell whatever story you like about the mid-term elections result
We’ve just had a bit of a correction in the markets. October was a scary month and investors are a bit less sure of themselves than they were at the end of September.
The Federal Reserve is raising interest rates. Economic data gives it no cause for pause. For now, that means rising bond yields and a rising US dollar. Can the markets take it?
There’s a point at which it will hurt. But until that point comes, markets can keep going higher. And this is where the mid-term election results come in.
There are screeds and screeds of pre-match analysis being written on this. But I’m not convinced that the details of the result are desperately important. That might sound a bit odd (and it may be wrong; we’ll find out tomorrow) but here’s my thinking.

Say the Republicans get a clean sweep (ie, they hang on to both houses of Congress). The negative spin is that Donald Trump then has nothing to stop him from doing what he wants. That, however, is also the positive spin – markets could interpret it as being a chance for more stimulus spending.
Say the Democrats sweep the board instead. The negative spin is that they might reverse Trump’s tax cuts or stop anything more from happening. Yet the positive spin is that they’d prevent global trade tensions from escalating and they’d probably be happy to spend more on infrastructure.
Or say that things stay the same. The positive spin is: “nothing to see here folks, business as usual.”
So what is genuinely interesting here is not the “fundamental” impact of the result. It’s how markets choose to interpret it.
I think that markets will use this as an excuse to set up a Santa Claus rally
On that point, my current working theory is that investors will put a positive spin on it, and use it as an excuse to put October behind us, and get set up for a Santa Claus rally up to the end of the year.
Markets will choose to believe that US growth is solid enough that it won’t be derailed by the Fed raising interest rates. Decent economic figures will increasingly be greeted with enthusiasm rather than fear.
Why do I have this as my working theory? It largely boils down to looking at the prevailing psychology, to infer what is being priced in and what is being ignored.
So what is being priced in? The mainstream concern remains that the US will be hit by recession any minute now. The fear then is that the Fed won’t be able to do much at that point, because interest rates are already so low. This is a lingering remnant of earlier fears that we were on the verge of another deflationary collapse.
Despite my own tendency to be bearish (and thus always open to listening to recession warnings) there are two main holes that I would pick in this impending recession argument.
Firstly, there’s really no sign that a recession is imminent. That might change, but most of the red flags (an inverted yield curve being one, a clear trough in the weekly US jobless claims figures being another) are absent.
Secondly, the idea that central bankers are ever powerless against a non-stagflationary slowdown or recession is demonstrably nonsense. When the main enemy is deflation, central banks can never run out of tools.
You need only look at Japan to understand the truth of this. The Japanese central bank might have given up for a while there in the mid-2000s, but when it was called upon to open the monetary floodgates by Shinzo Abe, quantitative easing (QE) definitely had an effect, as anyone who invested in Japan at the time could tell you.
I’m not saying that it’s been easy, or that it’s even been especially effective (time is often the greatest healer, and Japan has had plenty of that). But central banks have certainly not run out of experiments to try out. Once interest rates are at zero, you just start printing more money.
So this wrong-headed view that central banks are “out of ammo” (in the tediously macho parlance of financial markets) is just residual fear of the last crisis repeating itself. And the next crisis is rarely, if ever, the same as the previous one.
I do agree that the next big scare will come about partly as a result of fear of central bank powerlessness. But the scenario in which central banks are genuinely powerless to help the market is inflation, not deflation.
The only way to tackle inflation is to raise interest rates fast, and markets don’t like that. But if you don’t tackle inflation, then it gets out of hand, and markets don’t like that either.
Investors don’t yet believe that inflation is going to be a genuine problem. And they also haven’t yet let go of the idea that a recession or deflationary slump is ready to spring out of the woodwork.
As they gradually relinquish their fear of the latter, they’ll get more bullish again. And then the horrible surprise of the former will be ready to jump out and send them into a panic when they’re at their most excitable. That’s when we’ll get a proper bear market.
It’s just the way markets work. As for timeframes: for now I’d assume that 2019 is the point at which inflation will start to make itself known in a much more aggressive way than markets have been used to for a long time.
I’ll keep revising this theory as more data becomes available – but for now, let’s keep an eye on the market reaction to the US election results.

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