Analyzing Treasury Yields and Market Reactions Ahead of Elections

On the eve of a competitive US election, our CIO and Chief US Equity Strategist joins our head of Corporate Credit Research and Chief Fixed Income Strategist to asses how investors are preparing for each possible outcome of the race.

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Mike Wilson: Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist.

Andrew Sheets: I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley.

Vishy Tirupattur: And I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist.

Mike Wilson: Today on the show, the day before the US election, we're going to do a conversation with my colleagues about what we're watching out for in the markets.

It's Monday, November 4th, at 1130am in New York.

So let's get after it.

Andrew Sheets: Well, Mike, like you said, it's the day before the US election. The campaign is going down to the wire and the polling looks very close. Which means both it could be a while before we know the results and a lot of different potential outcomes are still in play. So it would be great to just start with a high-level overview of how you're thinking about the different outcomes.

So, first Mike, to you, as you think across some of the broad different scenarios that we could see post election, what do you think are some of the most important takeaways for how markets might react?

Mike Wilson: Yeah, thanks, Andrew. I mean, it's hard to, you know, consider oneself as an expert in these types of events, which are extremely hard to predict. And there's a lot of permutations, by the way. There's obviously the presidential election, but then of course there's congressional elections. And it's the combination of all those that then feed into policy, which could be immediate or longer lasting.

So, the other thing to just keep in mind is that, you know, markets tend to pre-trade events like this. I mean, this is a known date, right? A known kind of event. It's not a surprise. And the outcome is a surprise. So people are making investments based on how they think the outcome is going to come. So that's the way we think about it now.

Clearly, you know, treasury markets have sold off. Some of that's better economic data, as our strategists in fixed income have told us. But I think it's also this view that, you know, Trump presidency, particularly Republican sweep, may lead to more spending or bigger budget deficits. And so, term premium has widened out a bit, so that’s been an area; here I think you could get some reversion if Harris were to win.

And that has impact on the equity markets -- whether that's some maybe small cap stocks or financials; some of the, you know, names that are levered to industrial spending that they want to do from a traditional energy standpoint.

And then, of course, on the negative side, you know, a lot of consumer-oriented stocks have suffered because of fears about tariffs increasing along with renewables. Because of the view that, you know, the IRA would be pared back or even repealed.

And I think there's still follow through particularly in financials. So, if Trump were to win, with a Republican Congress, I think, you know, financials could see some follow through. I think you could see some more strength in small caps because of perhaps animal spirits increasing a little further; a bit of a blow off move, perhaps, in the indices.

And then, of course, if Harris wins, I would expect, perhaps, bonds to rally. I think you might see some of these, you know, micro trades like in financials give back some along with small caps. And then you'd see a big rally in the renewables. And some of the tariff losers that have suffered recently. So, there's a lot, there's a lot of opportunity, depending on the outcome tomorrow.

Andrew Sheets: And Vishy, as you think about these outcomes for fixed income, what really stands out to you?

Vishy Tirupattur: I think what is important, Andrew, is really to think about what's happening today in the macro context, related to what was happening in 2016. So, if you look at 2016; and people are too quick to turn to the 2016 playbook and look at, you know, what a potential Trump, win would mean to the rates markets.

I think we should keep in mind that going into the polls in 2016, the market was expecting a 30 basis points of rate hikes over the next 12 months. And that rate hike expectation transitioned into something like a 125 place basis points over the following 12 months. And where we are today is very different.

We are looking at a[n] expectation of a 130-135 basis points of rate cuts over the next 12 months. So what that means to me is underlying macroeconomic conditions in where the economy is, where monetary policy is very, very different. So, we should not expect the same reaction in the markets, whether it's a micro or macro -- similar to what happened in 2016.

So that's the first point. The second thing I want to; I'm really focused on is – if it is a Harris win, it's more of a policy continuity. And if it's a Trump win, there is going to be significant policy changes. But in thinking about those policy changes, you know, before we leap into deficit expansion, et cetera, we need to think in terms of the sequencing of the policy and what is really doable.

You know, we're thinking three buckets. I think in terms of changes to immigration policy, changes to tariff policy, and changes to tax code. Of these things, the thing that requires no congressional approval is the changes to tariff policy, and the tariffs are probably are going to be much more front loaded compared to immigration. Or certainly the tax policy [is] going to take a quite a bit of time for it to work out – even under the Republican sweep scenario.

So, the sequencing of even the tariff policy, the effect of the tariffs really depends upon the sequencing of tariffs itself. Do we get to the 60 per cent China tariffs off the bat? Or will that be built over time? Are we looking at across the board, 10 per cent tariffs? Or are we looking at it in much more sequential terms? So, I would be careful not to jump into any knee-jerk reaction to any outcome.

Andrew Sheets: So, Mike, the next question I wanted to ask you is – you've been obviously having a lot of conversations with investors around this topic. And so, is there a piece of kind of conventional wisdom around the election or how markets will react to the election that you find yourself disagreeing with the most?

Mike Wilson: Well, I don't think there's any standard reaction function because, as Vishy said -- depending on when the election's occurring, it's a very different setup. And I will go back to what he was saying on 2016. I remember in 2016, thinking after Trump won, which was a surprise to the markets, that was a reflationary trade that we were very bullish on because there was so much slack in the economy.

We had borrowing capabilities and we hadn't done any tax cuts yet. So, there was just; there was a lot of running room to kind of push that envelope.

If we start pushing the envelope further on spending or reflationary type policies, all of a sudden the Fed probably can't cut. And that changes the dynamics in the bond market. It changes the dynamics in the stock market from a valuation standpoint, for sure. We've really priced in this like, kind of glide path now on, on Fed policy, which will be kind of turned upside down if we try to reflate things.

Andrew Sheets: So Vishy, that's a great point because, you know, I imagine something that investors do ask a lot about towards the bond market is, you know, we see these yields rising. Are they rising for kind of good reasons because the economy is better? Are they rising for less good reasons, maybe because inflation's higher or the deficit's widening too much? How do you think about that issue of the rise in bond yields? At what point is it rising for kind of less healthy reasons?

Vishy Tirupattur: So Andrew, if you look back to the last 30 days or so, the reaction the Treasury yields is mostly on account of stronger data. Not to say that the expectation changes about the presidential election outcomes haven't played a role. They have. But we've had really strong data. You know, we can ignore the data from last Friday – because the employment data that we got last Friday was affected by hurricanes and strikes, etc. But take that out of the picture. The data has been very strong. So, it's really a reflection of both of them. But we think stronger data have played a bigger role in yield rise than electoral outcome expectation changes.

Andrew Sheets: Mike, maybe to take that question and throw it back to you, as you think about this issue of the rise in yields – and at what point they're a problem for the equity market. How are you thinking about that?

Mike Wilson: Well, I think there's two ways to think about it. Number one, if it really is about the data getting better, then all of a sudden, you know, maybe the multiple expansion we've seen is right. And that, it's sort of foretelling of an earnings growth picture next year that's, you know, much faster than what, the consensus is modeling.

However, I'd push back on that because the consensus already is modeling a pretty good growth trajectory of about 12 per cent earnings growth. And that's, you know, quite healthy. I think, you know, it's probably more mixed. I mean, the term premium has gone up by 50 basis points, so some of this is about fiscal sustainability – no matter who wins, by the way. I wouldn't say either party has done a very good stewardship of, you know, monitoring the fiscal deficits; and I think some of it is definitely part of that. And then, look, I mean, this is what happened last year where, you know, we get financial conditions loosened up so much that inflation comes back. And then the Fed can't cut.

So to me, you know, we're right there and we've written about this extensively. We're right around the 200-day moving average for 10-year yields. The term premium now is up about 50 basis points. There's not a lot of wiggle room now. Stock market did trade poorly last week as we went through those levels. So, I think if rates go up another 10 or 20 basis points post the election, no matter who wins and it's driven at least half by term premium, I think the equity market's not gonna like that.

If rates kind of stay right around in here and we see term premium stabilize, or even come down because people get more excited about growth -- well then, we can probably rally a bit. So it's much a reason of why rates are going up as much as how much they're going up for the impact on equity multiples.

Vishy Tirupattur: Andrew, how are you thinking about credit markets against this background?

Andrew Sheets: Yeah, so I think a few things are important for credit. So first is I do think credit is a[n] asset class that likes moderation. And so, I think outcomes that are likely to deliver much larger changes in economic, domestic, foreign policy are worse for credit. I mean, I think that the current status quo is quite helpful to credit given we're trading at some of the tightest spreads in the last 20 years. So, I think the less that changes around that for the macro backdrop for credit, the better.

I think secondly, you know, if I -- and Mike correct me, if you think I'm phrasing this wrong. But I think kind of some of the upside case that people make, that investors make for equities in the Republican sweep scenario is some version of kind of an animal spirits case; that you'll see lower taxes, less regulation, more corporate risk taking higher corporate confidence. That might be good for the equity market, but usually greater animal spirits are not good for the credit market. That higher level of risk taking is often not as good for the lenders. So, there are scenarios that you could get outcomes that might be, you know, positive for equities that would not be positive for credit.

And then I think conversely, in say the event of a democratic sweep or in the scenarios where Harris wins, I do think the market would probably see those as potentially, you know, the lower vol events – as they're probably most similar to the status quo. And again, I think that vol suppression that might be helpful to credit; that might be helpful for things like mortgages that credit is compared to. And so, I think that's also kind of important for how we're thinking about it.

To both Mike and Vishy, to round out the episode, as we mentioned, the race is close. We might not know the outcome immediately. As you're going to be looking at the news and the markets over Tuesday evening, into Wednesday morning. What's your process? How closely do you follow the events? What are you going to be focused on and what are kind of the pitfalls that you're trying to avoid?

Maybe Vishy, I'll start with you.

Vishy Tirupattur: I think the first thing I'd like to avoid is – do not make any market conclusions based on the first initial set of data. This is going to be a somewhat drawn out; maybe not as drawn out as last time around in 2020. But it is probably unlikely, but we will know the outcome on Tuesday night as we did in 2016.

So, hurry up and wait as my colleague, Michael Zezas puts it.

Mike Wilson: And I'm going to take the view, which I think most clients have taken over the last, you know, really several months, which is -- price is your best analyst, sadly. And I think a lot of people are going to do the same thing, right? So, we're all going to watch price to see kind of, ‘Okay, well, how was the market adjusting to the results that we know and to the results that we don't know?’

Because that's how you trade it, right? I mean, if you get big price swings in certain things that look like they're out of bounds because of positioning, you gotta take advantage of that. And vice versa. If you think that the price movement is kind of correct with it, there's probably maybe more momentum if in fact, the market's getting it right.

So this is what makes this so tricky – is that, you know, markets move not just based on the outcome of events or earnings or whatever it might be; but how positioning is. And so, the first two or three days – you know, it's a clearing event. You know, volatility is probably going to come down as we learn the results, no matter who wins. And then you're going to have to figure out, okay, where are things priced correctly? And where are things priced incorrectly? And then I can look at my analysis as to what I actually want to own, as opposed to trade

Andrew Sheets: That's great. And if I could just maybe add one, one thing for my side, you know, Mike – which you mentioned about volatility coming down. I do think that makes a lot of sense. That's something, you know, we're going to be watching on the credit side. If that does not happen, kind of as expected, that would be notable. And I also think what you mentioned about that interplay between, you know, higher yields and higher equities on some sort of initial move – especially if it was, a Republican sweep scenario where I think kind of the consensus view is that might be a 'stocks up yields up' type of type of environment. I think that will be very interesting to watch in terms of do we start to see a different interaction between stocks and yields as we break through some key levels. And I think for the credit market that interaction could certainly matter.

It's great to catch up. Hopefully we'll know a lot more about how this all turned out pretty soon.

Vishy Tirupattur: It's great chatting with both of you, Mike and Andrew.

Mike Wilson: Thanks for listening. If you enjoy the show, leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.