The week ahead: Midterms, China and more

As we start a new week stock markets are trapped in a narrow range. This is to be expected as this week is jam packed full of event risk. CPI reports for October will be the highlight of the economic calendar, especially US inflation that is scheduled for release on Thursday, UK Q3 GDP is also worth watching to assess how much the UK economy was impacted by September’s political and fiscal chaos. However, the markets also must navigate some choppy political waters with US Midterm elections on Tuesday 8thNovember and more uncertainty around whether China will exit its zero Covid policy. 

A Republican victory and the prospect for stocks 

While inflation reports come every month, we believe that the real risk for US and global assets right now is the US Midterms. There is concern from both sides of the political aisle: Republicans worry that if they don’t win power in both the House of Representatives and the Senate then government spending will surge to unsustainable levels, and Democrats worry that a Congress controlled by the Republicans will further enforce conservative social values on all states, and it could lead to more bipartisan gridlock in Washington. So, what would the financial markets prefer? Typically, a Republican win is good for stocks as they are seen as being more supportive of the economy. We believe that a Republican victory is positive for stocks and could lead to a weaker dollar. This is because a Republican Congress would likely limit government spending, which could help bring down inflation. Thus, a Reublican victory is seen as leading to a less hawkish Fed, something that the markets have been hoping for, without much luck, for months. 

However, we believe that the real reason why the markets would prefer a Republican victory is not because they want the Republicans in power particularly, but because it would cause bipartisan gridlock, and render President Biden a lame duck. There is nothing that investors and traders love more than stasis in Washington, when politicians from both sides are blocked from enacting policy that could upset markets. Financial markets love certainty, and sometimes certainty comes from Washington fighting amongst themselves rather than fighting with financial markets. 

A Washington Insurrection 2.0? 

However, there is a caveat to the “Republican win is good for stocks story”, even if the Dow has surged the day before the election. Right now, the polls are suggesting that the Republica s are likely to easily win the House of Representatives with the Senate still to play for, as the Republicans only hold a narrow lead. However, the big risk to this election is that we get a repeat of the outcome of the November 2020 election result, when President Trump did not accept the outcome of the election and endorsed an insurrection on Capitol Hill. If there are candidates who do not win, and do not accept the result then this could significantly lift volatility, stocks could fall, and the dollar could attract significant haven flows. The risk of an uncertain outcome should not be dismissed as a low probability event, and traders should manage their risk with caution in the next few days. In the state of Pennsylvania, where President Biden won by a narrow margin in 2020, lawmakers have already said that the outcome of the Mid-terms won’t be determined immediately, and it could take days before we get the results. 

The debt ceiling: will Congress and the White House be on a collision course? 

There is also a longer-term risk from these elections: the statutory debt ceiling. The US debt ceiling will need to be lifted at some point in Q1 2023, however the exact date is not known due to the uncertainty of tax intake and Federal spending levels. If the Republicans win the US Midterms then they could be emboldened, with some Republicans likely to demand spending cuts before they agree to lifting the debt ceiling. This could lead Congress on a collision course with the White House. While the danger of a US debt default is a tail risk right now, the stakes are high when it comes to politicians playing with the fiscal reputations of the world’s largest economies – look at what happened to the UK in September. Thus, a fight over raising the debt ceiling in the coming months could weigh on US bonds – causing yields to surge. It could also weigh on stocks, as Federal spending cuts in an economic downturn could hurt the outlook for the US, and thus global growth. 

Beijing sticks with its Zero Covid policy 

One of the biggest drivers of risk appetite as we move to the end of the year is China and whether it will lift its zero covid strategy. On Friday, unfounded rumours suggested an exit from the strategy was on the cards, which sent Chinese and global shares soaring. The Chinese currency had its biggest one day move to the upside since 2005, when it formally dropped the peg to the USD. However, on Saturday, Chinese health officials held a press conference and vowed to continue with the zero tolerance to covid outbreaks, which could limit Chinese economic growth going forward. This commitment to lockdowns is likely to lead to social problems for President Xi, and there have been reports of people growing weary of the constant lockdowns, that are enforced without notice. 

Global financial markets are desperate for any hint that Covid zero is coming to an end in China, as this could be one of the key drivers to help global stocks to recover from the current bear market. However, they seem to be cherry-picking their facts in search of any relaxation of China’s Covid rules. For example, markets had become bullish on signs that China was willing to reduce the quarantine period for travellers coming into the country and the opening of the border between Hong Kong and mainland China. Right now, it seems likely that when China does finally drop its Covid zero policy, it won’t do a mass opening like we experienced in the West. Instead, the opening of China is likely to come in stages. This could reduce the inflationary aspect of China’s emergence from Covid-zero; however, it could also delay the much-longed for rally that the market expects once China finally changes course.