By Libby Cantrill and Scott Mather, Pimco
While divided governments have generally been decent for markets, we think a defensive portfolio posture is prudent.
The U.S. midterm elections played out much as expected, with Democrats picking up the 23 seats (and more) needed to retake the majority in the House of Representatives and Republicans easily defending their majority in the Senate. While divided governments have generally been decent for markets, we see greater policy risks than in past elections, including infrastructure on the upside and potential for government shutdowns, investigations and impeachment on the downside – not to mention trade policy risk, which is likely to continue unabated. These risks point to increased volatility and underscore our more defensive investment posture.
Congressional Republicans are more “Trumpian.” With moderates in the Senate (such as Bob Corker and Jeff Flake) gone, the Senate majority expanded by at least two seats, and pro-Trump Republicans left in the House, we could see more support for efforts like a border wall and greater potential for shutdowns – and a more partisan Congress.
Democrats’ bet on women largely paid off; progressives, not so much. The House will see a record number of women in the next Congress, sending at least 100 (only 23%, but still historic), including many of the Democratic freshmen. At the same time, some of the more high-profile progressive Democrats did not do particularly well. Both will be lessons for 2020.
Protectionist trade policy helped more than hurt, on both sides. The president did well among farmers (e.g., North Dakota), where some had thought his tough stance on trade would hurt. Similarly, the more protectionist-leaning Democratic Senator Sherrod Brown won easily in Ohio. Expect a fight over NAFTA 2.0 (the United States-Mexico-Canada Agreement, or USMCA), as Democrats will want to leave their imprint, which could also mean the president threatens withdrawal. As we have said before, expect trade policy risk to persist: Trade is one of the levers for which the president does not need Congress, so we could see a doubling-down on trade policies.
Infrastructure and investigation headlines will dominate. Democrats want to show they can govern and will likely focus on areas of agreement, including infrastructure, criminal justice reform and drug pricing. Chances for an infrastructure deal will depend on how Democrats propose to pay for it: If it includes rolling back tax cuts, it would be dead-on-arrival in the Senate. We believe the window for getting a deal done on infrastructure is even tighter with Attorney General Jeff Sessions out and House Democrats likely to begin investigations sooner, enabled by subpoena power – if a deal hasn’t happened by late spring/summer 2019, it’s less likely to happen at all.
Impeachment risk declines if Nancy Pelosi is Speaker of the House. Leadership elections in the House will be in early December for Democrats, with the House Speaker vote in January. Pelosi is pitching the idea of a “transitional” speakership until 2020 before stepping down. If this works, expect her to fend off impeachment moves against the president with the hopes of winning back the White House for Democrats in 2020.
A “redder” Senate makes it easier for Trump to confirm appointees. Expect a Cabinet shuffle as a result, with Sessions the first Cabinet official to go, and a more Republican-leaning judiciary.
While the prevailing view is that gridlock is good for financial assets, we think a defensive portfolio posture is prudent against a “growing but slowing” economic backdrop marked by stretched valuations and potential for increased risk premia. Market volatility is likely to be a more regular feature of markets going forward after years of central-bank-fostered relative calm.
We do not expect President Trump’s comments critical of the Federal Reserve to change the Fed’s reaction function and continue to believe the Fed will raise rates in December and two more times in 2019. This would put the policy rate on the tighter side of neutral, and tighter policy next year is one reason why we expect slower growth.
In terms of positioning, in U.S. fixed income, we appear close to fair value in high quality and shorter-maturity assets. We are cautious on corporate credit, instead favoring housing-related assets, including high quality agency mortgages (which we view as on the cheaper side of fair value) and non-agency mortgage-backed securities (MBS). Volatility may also create tactical opportunities in currencies, though we don’t think the U.S. dollar will lead these moves.
All told, we believe now is not the time to bet on the outperformance of risk assets more broadly, and focus more on attractive bottom-up alpha opportunities.