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Outlook after a blue ripple

| November 6, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The election has left a divided government and a market with good prospects for a steadily steeper yield curve, tighter risk spreads and solid performance in corporate and structured credit. It does not eliminate the pressure from low rates on banks and many insurers, or on fund managers where fees stand to become a higher share of fixed income returns. Even though many portfolios would like higher rates, it still looks like a long wait.

The election leaves a divided government

At the close of election week, Democrats look like they have won the presidency and kept the House with Republicans controlling the Senate. PredictIt.org contracts give this configuration a 69% chance. A possible January runoff election for Georgia’s two Senate seats has raised the possibility of Democratic control of that chamber, but the market gives that outcome only a 23% chance. Final tallies could still take weeks to get certified.

Exhibit 1: PredictIt.org points to a Democratic president, Republican Senate

Note: Bold indicates values taken directly from PredictIt.org contracts, other indicates inferred values. Probabilities should normally add to 100% since there can never be more than one winning outcome in any market. But since the price assigned to each potential outcome is a reflection only of the most recent trade in that contract, the sum of all prices can be higher or lower than $1, especially if prices have been changing rapidly.
Source: PredictIt.org as of 6 Nov 2020, Amherst Pierpont Securities.

The close election points to an electorate evenly split between the agendas of the major parties. That should encourage the strongest advocates on each side to dig in and discourage compromise except on the clearest bipartisan issues. The Republican majority in the Senate looks likely to be smaller by at least one seat, with a Democratic Vice President breaking any ties. This could give more leverage to moderate Republicans in the Senate and may create more occasions for bipartisanship. But divided government should rule out some of the ambitious Democratic plans for spending outlined during the campaign.

A Democratic president will be able to use executive orders to shape domestic policy and still has substantial control over foreign policy and key elements of trade. The current administration has shown these levers of power can have significant impact.

Policy expectations shift

Risk markets have understandably rallied on expectations for a range of policies positive for growth and for targeted sectors of the economy (Exhibit 2). My colleague Mary Beth Fisher has outlined the prospects for a quick stimulus bill in the lame duck Congress that convenes November 9. That could give important support to the economy through the winter—especially smaller businesses and households—and relieve some pressure on the Fed. The market had widely anticipated some form of stimulus by early 2021, so a lame duck bill just changes the magnitude and timing. Areas the market still can anticipate with a Democrat in the White House and a Republican Senate include more federal coordination of pandemic response, more international cooperation and possibly more trade, continuation of the Tax Cuts and Jobs Act of 2018 and efforts in housing, immigration, education and infrastructure that could have impact either through executive order or bipartisan legislation (Exhibit 2).

Exhibit 2: Likely policy shifts in the aftermath of US elections

Source: Amherst Pierpont Securities

Steepeners, spreads tighteners, credit overweights look better

The market still looks like it underprices likely developments in rates and risk spreads generally. In particular:

  • Steepeners. Forward rates imply the 2s10s Treasury curve will steepen less than 10 bp in the next 36 months before beginning to flatten as the Fed starts to signal higher rates. The 5s30s curve begins to flatten immediately. The combination of Fed policy, fiscal stimulus and even moderate effectiveness from federal efforts to coordinate pandemic response seems likely to lift 10-year yields above implied forwards over the next 36 months, steepening the curve beyond implied forward levels. The wildcards include a surge in the pandemic beyond even the current trajectory in the US and Europe, which would likely flatten the curve, and an effective and broadly distributed vaccine or Covid treatment before the end of 2021, which would likely steepen the curve further. A steeper 2s10s curve looks much more likely. A steeper 5s30s curve also looks more likely than the current implied flattener, assuming a Fed willing to let inflation run above target in its new flexible average inflation targeting.

Exhibit 3: Forward rates imply only slight steepening in 2s10s, flattening in 5s30s

Source: Bloomberg, Amherst Pierpont Securities

  • Spread tighteners. Fed QE has encouraged tightener risk spreads since March, and fiscal policy has helped limit the worst effects of the pandemic on fundamental credit. The election resolves significant uncertainty built into risk spreads, likely brings another round of stimulus at the very least and possibly brings new approaches to managing pandemic response. Fed QE remains the dominant factor, but stimulus and improved response should be growth and credit positives.
  • Corporate and structured credit overweights: With Democratic proposals for higher corporate taxes off the table for now, corporations should hold onto the balance sheet flexibility that came with the TCJA. Both investment grade and high yield issuers have become more leveraged through the pandemic, taking on more debt even as earnings have dropped. They will need to retain earnings over the next few years to deleverage, and the elections likely improved their chances through growth and status quo tax policy. Consumer credit also looks likely to improve with the election results of Washington can agree on some proposed changes in housing and student debt, which would lift the value of many consumers’ most valuable asset and reduce the debt burden for many younger households.

Banks, insurers and asset managers still have challenges

Even though the yield curve stands to steepen faster than forward rates imply, rates generally look set to stay at historically low levels through 2025, and that leaves heavy pressure on banks. For banks, QE should continue to feed deposits while loan demand only improves slowly. Mortgage and MBS prepayments have also put a firehose of cash back on the balance sheet. Banks have responded by adding government and agency securities at rates well below the book yield of current investment portfolios, taking on more duration, prepayment and liquidity risk to limit the yield and income damage. Bank demand for MBS in particular should help keep spreads in that market tight.

Insurers have also watched their investment portfolio yield plunge this year, and low rates should keep the pressure on. For many life insurers, annuity writers and writers of long P&C liabilities, reinvestment rates are well below those assumed in pricing significant parts of their book. Insurance portfolios have steadily added ‘BBB’ exposure in corporate and structured credit, increased exposure to private placements and added partnerships with private equity and hedge funds. Insurers should accelerate those trends.

Low rates should also keep pressure on managers of mutual funds and similar products as fees eat up a larger share of fixed income returns. Fixed income ETFs picked up impressive share of flows into fixed income funds as the market rebounded after March. Funds should be under pressure to add out-of-index exposures and find other ways to distinguish themselves from index fund and ETF competition.

Risk from pandemic resolution

One risk that few investors seemed focused on is the possibility of rapid relief from the pandemic. A faster timeline to vaccine, a faster timeline to distribution, approaches to public health management that limit economic impact all seem possibilities. Even though these possibilities seem hard to price, one or several at once could send rates up sharply. Investors reaching for yield by adding duration at current rates or adding negative convexity would all feel the impact. Many banks fall in that category. Out-of-the-money options that would pay in that scenario seems like a prudent part of any portfolio.

* * *

The view in rates

The election has largely come and gone, and the yield curve and volatility have moved largely as expected. The curve steepened on the day of the election as polls suggested a blue wave and then flattened sharply as returns from early states, including Florida, showed good prospects for Republicans. The curve re-steepened as the Democrats looked steadily more likely to capture the White House. Once election results get largely finalized, the curve should go back to focusing on the pandemic, the Fed and the economy.

Volatility also spiked ahead of the elections but has dropped sharply since. The tail of litigation that some investors worried about before the election looks unlikely at this point. Volatility should continue to decline.

The view in spreads

The prospects for tighter spreads always looked good once election uncertainty was resolved, and so it came to pass. The likely divided government set to come out of the election still offers good prospects for growth. With the Fed also pumping cash into the economy and banks and insurers trying to find yield, spreads on corporate and household should keep tightening.

The view in credit

Although small companies and the most leveraged balance sheets remain at risk, the market has largely figured out who they are at this point. Risk-reward in those names is largely priced appropriately. Leverage does need to keep coming down on corporate balance sheets. That is the key risk to watch.

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