Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about understanding market dynamics against the backdrop of US elections.
It's Monday, Oct 28th at 1 pm in New York.
The outcome of US elections, now just over a week away, has been at the center of every discussion I have had in the last several days. There have been significant moves, not so much in the opinion polls – but in prediction markets. In the opinion polls, the presidential race remains tight and neck-to-neck in key swing states with poll numbers well within the margin of error. But some prediction markets have shifted meaningfully toward Republicans in the contests for both the presidency and control of the Congress.
Financial markets have also moved a lot. Stocks exposed to a Republican win outcome have risen a fair bit.
To understand the potential policy changes that can have an impact on markets, I think it’s crucial to understand the sequencing of those policy changes.
Given the moves in the prediction markets, let us first frame a Trump win scenario. It seems reasonable to bucket possible policy shifts into three categories – fiscal policy, immigration controls, and tariffs.
Meaningful changes in fiscal policy require control of both houses of Congress; and even in a Republican sweep scenario, legislation would still be time-consuming and likely come last. We don’t really have many details on how changes to immigration policy would be implemented and so their timing remains very unclear. On the other hand, given broad presidential discretion on trade policy, Trump’s expressed intentions in his campaign messaging, and the precedent of his first term, tariff changes would likely come first.
Our economists have looked at the potential impact of tariffs on the economy. They concluded that broad tariffs imply downside risks to growth through declines in consumption, investment spending, payrolls, and labor income, and upside risks to inflation. Their estimates suggest that imposing all the tariffs currently under discussion could result in a delayed drag of -1.4 percent on real GDP growth and a more rapid boost of 0.9 percent inflation.
How do we reconcile the equity market’s reaction to the increasing odds of a Trump win in some prediction markets with the idea that there will be a drag on GDP growth and boost to inflation that our economists assess?
Two explanations. Markets could be counting on the prospect that all tariffs would not be imposed, or, at least, would be sequenced over an extended period, with some coming much later than others. Also, markets could be putting greater emphasis on the revival of “animal spirits” driven by expectations of regulatory easing, which is hard to define or quantify.
Let’s look at some other markets.
In the bond markets, treasury yields have risen notably in the last month. Many investors see the Republican sweep outcome as most bearish for US Treasuries, based on the experience of the 2016 election. As Matt Hornbach, our global head of macro strategy has noted, there are meaningful differences between the Fed’s monetary policy expectations today and the pre-election period in 2016, suggesting that any rise in Treasury yields would be more contained this time, even in a Republican sweep outcome.
In 2016, markets were pricing in about 30 basis points of rate hikes over the next 12 months. Contrast that to the current market expectation of 135 basis points in rate cuts over the next 12 months. Also, in the year after the 2016 election, expectations for the Fed Funds Rate rose nearly 125 basis points. A similar rise in expectations for Fed policy now would require market participants to expect the Fed to stop cutting immediately; and refrain from further cuts through 2025. This seems like a remote possibility – even under a Republican sweep elections scenario.
Given the recent moves across markets and the expectations they are pricing in, markets may now be somewhat offside should Harris win, as they would have to reverse the course.
Elections are a known unknown. Based on opinion polls, this race remains extremely tight, and multiple combinations of presidential and congressional outcomes are very much in play. We must also contend with the prospect that the determination of the outcome may take much longer this time.
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