Red is on the electoral college map and green is on the screens, but where do we go from here?
With the move higher in equities and yields this morning and leadership coming from small caps and financials, investor focus will now shift to a longer-term assessment of whether these patterns hold in the weeks and months ahead. In other words, the catalyst is in place; now, it will be about execution. Specifically, does the expected policy backdrop lead to higher earnings and/or inflation? Overall, we describe the election results and market reaction as follows: Red is a “run it hotter” economy and market with higher growth, inflation, rates, and earnings.
For bonds, the catalyst is an expectation of a bigger deficit and higher inflation, keeping yields higher for longer. A possible offset is that economic growth is likely to be higher, as is productivity. The challenge will come if rates move much higher in the coming weeks/months. We don’t expect that to happen. Historically, enthusiasm over economic growth trumps malaise over a higher deficit. A small uptick in growth has a big effect on Debt/GDP. Analysis from the Congressional Budget Office shows that +0.5% on GDP growth keeps Debt/GDP at a modest increase, while slower growth would see Debt/GDP expand significantly.
We see a favorable backdrop for equities overall, with higher confidence in stronger earnings power.
With small-cap equities, the catalyst is an expectation of more domestic activity and lighter regulation. Those themes likely have some longevity—the question is where and with what magnitude do they translate to earnings? A complicating factor is yields, as higher yields are generally detrimental to smaller companies.
An interesting question for today: Is the initial move pricing in higher earnings power, or is it a “risk-on” multiple expansion? In our view, it’s a bit of both (even with the higher rates). Why? A longer runway for the economy. Possible changes in tax and regulatory policy are both likely to extend the timeline of economic expansion. More visibility = higher multiples.
Overall
With regard to yields, and despite today’s move higher, fears over runaway rates will prove unfounded. Yields will eventually trend lower, though the process is likely to be slow, given fears over potential deficit expansion. The election results further buttress our main theme of staying slightly overweight equities vs. the benchmark. The results also support our view that the expected broadening in equity returns will likely happen. If small-cap earnings can come through in 2025, the broadening will be robust. However, tax and regulatory details are all to be determined, as is any policy favoring domestic activity. So, for now, our views shift a bit more favorably for economic growth and “risk-on” equities generically, and better odds that equity broadening continues, with a slower pace of yield declines.
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