James Saft, Reuters Columnist
An election producing a split Congress and a second Barack Obama term was greeted on Wednesday with a sharp divergence in financial markets, with stocks falling and Treasuries and the dollar rallying sharply.
Since most of us in the US have spent nearly every waking hour in recent weeks being bombarded by news, advertisements, images, lies, statistics and still more lies it is no wonder that most analysis of the market is attributing the moves to the election’s implications.
The news out of Europe, where European Central Bank chief Mario Draghi was decidedly downbeat and where a key Greek vote over an austerity plan may not pass, could prove the true drivers.
To be fair, the election-market links are there. A split US Congress seems unlikely to reach a growth-friendly grand bargain on fiscal policy, making it more likely that whatever half-measures are agreed in the looming lame duck session only serve to highlight the real economic drag of the spending cuts and tax rises to come. There is a possibility that a Republican-controlled House plays hardball, potentially making the process disorderly as well as dysfunctional.
The election also does much to ensure a measure of continuity in monetary policy, with Obama likely to appoint someone in Ben Bernanke’s image if, as expected, he steps down early in 2014. That argues for a continued appetite for Treasuries by the Federal Reserve.
But except for some Senate gains, the results are pretty much exactly what betting markets and many prognosticators were predicting, so ascribing all of the moves to the election doesn’t seem likely. The prospect of higher taxes on capital gains and dividends should come as no surprise.
The strengthening of the dollar is also hard to fit into this line of thought. Continued quantitative easing and recession-inducing fiscal policy is hardly the stuff of which a stronger dollar is made.
In fact the dollar, and much of the rest of trading in financial markets, was probably driven by renewed fears over the situation in the euro zone. From a European perspective, the euro needs to weaken, both as one of the few indirect means of easing conditions for the ailing south, and, frankly, as a balm to a Germany whose economy seems to be flagging sharply.
Enter the Draghi
A weaker euro would help both issues, and obviously would be bad for profits and sales in the US, making it a strong negative for US shares. Fixed income investors are also, as they usually do, likely seeking safety in Treasuries, which will have performed very well in euro terms just recently, and which also don’t carry anywhere near the type of systemic risk associated with eurozone government bonds.
Into this situation the day after the election stepped Draghi, who was decidedly downbeat, almost like a man trying to tell you he was going to have to do something to help his economy.
“The weak overall economic situation, combined with slow money growth, means that the risks of inflation are currently very low over the medium term,” Draghi said in a speech at a conference in Frankfurt. “Germany has so far been largely insulated from some of the difficulties elsewhere in the euro area. The latest data suggest that these developments are now starting to affect the German economy.”
The ECB is not expected to lower rates when it meets on Thursday, but it would not at all be surprising if more euro-negative comments come out of Draghi’s press conference.
The risks are not all at the ECB. Greece is, amid street protests, in the process of holding a parliamentary debate ahead of a key vote on austerity measures, without which the next tranche of bailout money may not arrive, leaving the country in the embarrassing position of not being able to pay its bills.
Even if the bill, as expected, passes, this is just a foretaste of future votes and future opportunities for Greece to jeopardise its position within the single currency area.
To paraphrase former US Treasury Secretary John Connelly, the euro is their currency but a shared global problem. If the eurozone is going to hang together as currently constituted, which Draghi seems to have underwritten with his bond buying plan, then we are looking at waves of deflation and recession for at least the coming year. If it does not hold, then we’ll get one big wave, and a far more destructive one.
That argues for bonds and the dollar to rally and stocks to fall, which is exactly what is happening, and what may continue as the year heads to a close.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)