We are making our weekly note available to everyone this week in the hope that some of our free subscribers will convert to paid subscriptions, onboard us to your research platform or contact me about my advisory role with Macro Risk Advisors to gain access to our research. We have had a significant increase in interest recently and it has been some time since we put a note outside the client paywall.

It’s the Economy

Through the pandemic, our core view has been that the US economy was far more dynamic and resilient than investors, economists, and policymakers believed. The October employment report confirmed our view that the spontaneous economic order in the US cannot be stymied by a pandemic or public policy. In the four weeks from the September to the October employment surveys, continuing state jobless claims fell 4.9 million (39%), pandemic program claims fell 2.5 million (21%), and the insured unemployment rate fell 3.4% to 5.3%. Our back-to-work model accelerated as a result of continuing claims falling faster than new claims were filed and the Conference Board’s October survey showed improving job openings. These numbers were the most important inputs to our forecast that the October employment report would be much stronger in terms of job creation and unemployment than September’s and Friday’s report did resoundingly beat expectations.

Figure 1: The sectors with the highest levels of reallocation were most affected by the pandemic. This has been a theme of ours since the beginning, these workers were most accustomed to turnover and they are recovering faster. There have been very few losses at the government level.

In October, amidst a third pandemic wave and the distraction of the most controversial, but not consequential election in decades, the establishment survey reported the private sector created 906,000 seasonally adjusted jobs and 2.243 million according to the household survey. The unemployment rate dropped from 7.9% to 6.9%, well below the consensus forecast of 7.6%. In June, we questioned the efficacy of seasonal adjustment factors due to pandemic distortions, by August the Bureau of Labor Statistics (BLS) changed them for weekly jobless claims. For the month of October, seasonal adjustment factors reduced the headline payroll gain by 555,000 and household survey by 394,000 hinting that this report was even more of a blowout, thereby weakening Fed Chairman Powell’s narrative that the recovery is slowing. The employment ratio for prime age workers increased by a full percent to 76%, while the participation rate increased 0.3%, underscoring our view that ‘scaring’ is relatively contained thus far. In other words, job availability is improving. Amidst all the focus on the election and the pandemic, fourth quarter economic growth appears to be off to a strong start. It is not surprising that materials, industrials and homebuilders were at the top of the relative performance list during last week’s sharp rebound. We hope you took our suggestion last week to be greedy when others were fearful.

Figure 2: Productivity typically recovers early in a business cycle as output leads employment. It was already in an uptrend led by the service sector. The pandemic accelerated technology innovation adoption, there could certainly be some workers left behind. Thus far, the increase in discouraged workers is small to less than half of the 2010 peak.

Checks and Balances

The overarching message of the election was a rejection of statism. There was no blue wave, the Senate is unlikely to flip, Republicans likely gained a dozen House seats and at the state and local level the GOP held state houses in Texas, Iowa, Pennsylvania, Michigan and North Carolina, while both houses in New Hampshire flipped to the GOP. Karl Rove looked giddy on election night in describing the massive amount of money that was spent in Texas by Democratic Party activists hoping to turn Texas blue ahead of 2020 redistricting when Texas will likely gain 2 Congressional seats. Republicans control maps in 181 districts, while Democrats only have 76 for 2020 redistricting. The Republicans, prior the election, held 59 legislative chambers, 29 statehouses and in 21 states they held all three branches (trifectas). The Democratic party held 39 chambers, 19 state houses and 15 trifectas. Despite their efforts and spending, the Democrats failed to gain any new chambers or state houses, while the GOP won two more trifectas and expanded their majorities in North Carolina and Florida. The Biden Democratic Party nomination was itself a repudiation of statist politicians as evidenced by his underfunded, surprising comeback on Super Tuesday over candidates advocating much greater state control over economic and social affairs.

In our note titled Over? Did you say over?, we wrote that any outcome that precluded a reversal of the corporate tax reform component of the Tax Cuts & Jobs Act implied a 2021 capital spending boom and strong year for the economy and equity market. While it is likely we will have to wait until the January 5, 2021 Georgia Senate runoff elections to confirm Mitch McConnell as Senate Majority Leader, it is highly probable that the risk of corporate and capital gains tax hikes has been eliminated for at least two years. We expect a Biden presidency and recall vividly the central roles of then Vice President Biden and Senate Minority Leader McConnell in settling the 2011 debt ceiling and budget battle that led the US credit rating downgrade from AAA and largest risk-off episode of the ‘10s. Consequently, we do not expect gridlock, we expect bipartisan legislation when necessary. Under a Biden administration and cabinet approved by a Republican Senate, we expect marginal regulatory tightening, pandemic stimulus with more of a supply-side emphasis than the House Care Act, no tax hikes, and marginally more market friendly trade and immigration policy.

*Figure 3: Democrats are in a weak position for the 2020 Congressional redistricting despite grassroots efforts from activists including Eric Holder.*

The Power of the Presidency

We have long believed the balance of power, described by Alex de Tocqueville in Democracy in America, is best characterized as a pendulum with the power of the executive branch ebbing and flowing over time. The Great Depression shifted power to the Presidency, at least until the Supreme Court and 1938 mid-term election rejection of FDR’s plan to pack the court, though World War II strengthened control of the executive. Harry Truman misread his surprising 1948 election as a mandate for his ‘Fair Deal’ plan to expand the 'New Deal’, his legislation was soundly defeated and Eisenhower was elected in a red wave. Supreme Allied Commander Ike surprised everyone by emasculating the military industrial complex and focusing on shrinking the national debt and budget deficit. The next peak in power was LBJ and the Great Society legislation. Nixon’s resignation damaged the Presidency until 9/11; Reagan’s two major tax bills were bipartisan, Bill Clinton and Newt Gingrich passed welfare reform and sharply reduced the national debt. Following 9/11, Congress began passing laws that acceded more power to the administrative state, the Patriot Act, Dodd/Frank, PPACA are all Examples. There was a proliferation of executive orders and wars without Congressional approval that culminated with a president whose rhetoric was often authoritarian, though his policies were mixed in terms of executive branch discretion. The Trump administration tariffs were larger than any Presidency since Congress acquiesced their Constitution mandated control over trade policy to FDR, however the deregulatory policy agenda weakened the administrative branch and the Federal government acceded authority to the states during the pandemic. Nonetheless, it appears the voters in 2020 desire balance between the executive and legislative branches and the Supreme Court is likely to further chip away at the discretion of the administrative state. The power of the presidency seems likely to be in retreat.

The Outlook for the Balance of 2020 and Beyond

Our primary sentiment model, market implied measures of equity market risk, was extremely elevated when we wrote Be Greedy When Others are Fearful a week ago. During that weekend, we sensed most investors expected equities to extend their weakness on Monday led lower by Europe due to pandemic related lockdowns. Instead, European equities recovered as the rate of change of new cases peaked like in late March for global wave one and in late June during the peak in Sunbelt cases. October manufacturing purchasing manager surveys that were better than the preliminary estimates taken two weeks earlier in Germany, France and the UK helped European equities as well. The US October ISM manufacturing survey had its fourth month of orders above 60, and while inventories broke above 50, they remain in the 30s for customers illustrating how robust inventory restocking will be in 4Q20. Strong data was evident the prior week as well, so more likely the lack of social unrest immediately surrounding the US election and lack of a blue wave outcome were the primary contributors to the collapse in volatility. The drop in volatility, normalization of the term structure, drop in correlation and premium for out of the money puts (skew) was the primary catalyst for the rally from Monday through Wednesday. By Thursday our view that reflation would be a major economic and market theme in 2021, regardless of the election outcome was again evident as Treasuries sold off, gold, copper and material stocks rallied sharply.

Figure 4: It has been quite a year for the equity volatility market. Our aggregate measures of risk reached an all-time high during the collapse of risk-parity strategies in March and failure of post-GFC regulatory policies intended to reduce risk. As the economy recovered a tremendous rally in technology stocks drove skew to 4 standard deviations above their mean. Finally, volatility collapsed after the election that was not settled immediately, but did not lead to social unrest.

For the balance of 2020, we expect positive equity market returns, however we think upside will be limited by lingering uncertainty over control of the Senate assuming a recount in Georgia does not push Senator Perdue over the 50% threshold. Industrials, materials and healthcare are our favorite sectors for the balance of 2020 and early part of 2021. Financials should benefit from the recovery in the labor market and lower expected credit costs, a steeper yield curve, and an improved regulatory outlook relative to market expectations of a blue wave. Cyclicals are likely to get a boost when US third wave case momentum peaks, an event that is likely in the near term. If we were still Barclays’ head of equity strategy we would forecast the range for the S&P 500 for the balance of the year 3300-3700, with the probability of ending the year at the high end twice the risk of settling near the low end.

Figure 5: Cases in Europe are not yet falling, however, the rate of change looks to have peaked before governments announced the latest population controls. We saw a shocking statistic this week in the Wall Street Journal; in the US there is 34.7 ICU beds for every 100,000 people, in Germany there are 29.2, Belgium 11.6, France 11.6, Spain 9.7, the UK 6.6 and the Netherlands 6.4. remember the basic economic principal, if you fix the price, the quantity supplied will fall.

2021 Capital Investment Boom

There is a considerable amount of academic research concluding that election year uncertainty impairs capital investment. One particularly interesting paper, The Real Effects of Political Uncertainty: Elections and Investment Sensitivity to Stock Prices, concluded that investment is 40% less sensitive to stock prices during election years. TCJA significantly reduced the after-tax cost of structures investment, improved corporate cash flow from the lower tax rate boosted software spending and the R&D tax credit contributed to the strongest growth in that category of nonresidential fixed investment in decades until the pandemic. Equipment and structures investment fell sharply during the US/China trade war along with business confidence, the price of oil, global manufacturing and trade volume. In 2021, there will not be an election, increased tariffs and nontariff barriers are unlikely, pandemic effects should diminish, TCJA is unlikely to be reversed, trade is recovering and the evolution to ‘just-in-case’ supply chain management should broaden from industrial companies to healthcare, consumer products and technology companies. Our measure of manufacturing capital spending plans derived from regional Federal Reserve Bank manufacturing surveys is back to February levels and likely to continue towards multi-decade highs reached following the passage of TCJA in early 2018. This implies upside to corporate margins, productivity growth, and a strong year for the equity market.

*Figure 6: Information processing equipment rebounded ahead of schedule and is much stronger than our model suggests it should be after underperforming our model’s forecast throughout the trade war.*

Final Thoughts

Political pollsters’ underestimation of social desirability bias and inability to reach the growing unaffiliated center of the voting population was similar to credit rating agencies flaws before the financial crisis. Unsubscribe to 538, bookmark The Trafalgar Group and follow John Cahaly on Twitter. Nonetheless, we expect social desirability bias to fall sharply in the 2024 election because we believe the worst of the political storm has passed. This country is not coming apart, social media is amplifying extremist views and the center right political views of the country were abundantly clear in Congressional and state elections. The noise may persist for a short period as the vote counting and legal challenges continue, we doubt extremists heard the message from the voters, but the storm did not damage the republic beyond repair. Meanwhile, the public is going about their lives figuring out how to deal with the pandemic and their dynamism, resilience and progress is unmistakable. Stay long cyclical stocks, short Treasuries, and long gold. The federal government is going to borrow more money and in 2021, they will begin the process of inflating their way out of the pandemic debt.

Figure 7: Despite the policy uncertainty index at extreme levels due to the still unsettled election results', volatility fell in all asset classes last week. Our aggregate measure is quite close to its lowest pandemic reading from mid-October. Equities fell from 2.43 standard deviations above the longer-run mean to 0.72, which was a major catalyst for the 6.89% rally in the S&P 500 last week.

Figure 8: The equity risk premium contracted from 5% last week to 4.8%, very close to the longer-run average of 4.82%. Expected 2020 S&P 500 earnings increased from 137.46 to 138.80 this week and 131.63 before earnings reporting season began. Real 10-year yields fell 4bps this week, but after a sharp election related drop, nominal 10s are above resistance at 0.82% and we remain convinced they are on their way to 1.3%.

Barry C. Knapp

Managing Partner

Director of Research

Ironsides Macroeconomics LLC

908-821-7584

bcknapp@ironsidesmacro.com

https://ironsidesmacro.substack.com

https://www.linkedin.com/in/barry-c-knapp/

@barryknapp

Reading List

Latest Book: “A History of the Federal Reserve, Volume 2, Book 1, 1951-1969”, Allan H. Meltzer

Next Book: “Human Action, The Scholar’s Edition”, Ludwig von Mises

“Trade Wars Are Class Wars”, Matthew C. Klein & Michael Pettis

“Showdown at Gucci Gulch, Lawmakers, Lobbyists, and the Unlikely Triumph of Tax Reform”, Jeffrey H. Birnbaum and Alan S. Murray

“A Great Leap Forward, 1930s Depression and US Economic Growth”, Alexander J. Field

“1493, Uncovering the New World Columbus Created”, Charles C. Mann

“Great Society, A New History”, Amity Shlaes

“The Second Machine Age”, Erik Brynjolofsson, Andrew McAfee

“Grand Pursuit, the Story of Economic Genius”, Sylvia Nasar

“The Rise and Fall of the Great Powers”, Paul Kennedy

“Capitalism in America, A History”, Alan Greenspan & Adrian Woolridge

“Diversity Explosion, How New Racial Demographics are Remaking America”, William H. Frey

“Clashing Over Commerce, A History of US Trade Policy”, Douglas A. Irwin

“Destined for War, Can America and China Escape Thucydides’s Trap”, Graham Allison

“The Constitution of Liberty”, F.A. Hayek

“Judgement in Moscow, Soviet Crimes and Western Complicity”, Vladimir Bukovsky

“1931, Debt, Crisis and the Rise of Hitler”, Tobias Straumann

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