In a Friday note from Goldman's FX strategy team, strategist Zach Pandl previews what is sure to be a "November to Remember" (even more so now in the aftermath of RBG's death and the SCOTUS vacancy which has profound implications for capital markets as discussed overnight), and frames in a generally optimistic note (similar to Morgan Stanley), expecting more cyclical upside despite possible near-term weakness through an eventful autumn, to wit: "despite recent risk obbles, we continue to see our central growth forecast as consistent with further strength in cyclical assets, including equities, and more depreciation for the US Dollar." Pandl dismisses the recent - and still ongoing - tech-led sell-off, saying that the latest correction was more a position adjustment than a broader fundamental shift: "significant flows into cash and options helped drive the Nasdaq to a stellar August without much fresh news, outperformance that has now largely reversed." Meanwhile, the announcement of the Fed’s framework review at Jackson Hole, though largely as expected, also resulted in an additional move in real rates and breakeven inflation whose reversal presaged the equity drops. Meanwhile, on the positive side, Pandl writes that the global growth recovery "while flattening out in places, has also been broadening."
So, the Goldman strategists concludes, the "central case is that equity markets will revisit the September high over the next couple of months, but driven this time more by an upgrade to the market’s cyclical view" with the caveat that early vaccine approval remains central to the bank's pro-cyclical outlook, while noting that "investors may be too pessimistic about risky assets under a Democratic election sweep, due to the prospect of substantial fiscal easing next year."
Echoing Morgan Stanley's latest thoughts (which we brought readers yesterday), while Goldman is optimistic, it does warn of a variety of potholes "from here to there", most of which are identical to the list presented previously by MS:
First, with the school reopening season now properly underway across much of the northern hemisphere, it will be important to watch if new economy-wide lockdowns (as has been the case in Israel) can be avoided.
Second, investor expectations from the latest round of US fiscal negotiations are already low, but it will still be a negative surprise to markets if no agreement is reached, or if partisan tensions threaten a government shutdown at the end of September.
Third, after a surprisingly unified response to the pandemic in Europe, political risks are rearing their head again. The constitutional referendum and regional elections in Italy this weekend—which may result in some losses for the governing coalition—will be a test of political stability. That said, without a new election, which seems unlikely, it is hard to see a major shift in political direction or a major selloff in BTPs. More importantly, Brexit has thrust itself back on the screen of global investors. Despite provocative legislation that would “break international law”, we think it is too early to completely dismiss the possibility of a negotiated “thin deal.”
Which brings us to the election, where Goldman focuses on the potential impact to two asset classes: equities, volatility and currencies.
Starting with stocks, Pandl writes that a Democratic sweep "would present a complicated mix for headline US equity indices" with the potential increase in corporate taxes from a Democratic sweep would be the most direct consequence for equity markets. But the prospect of larger fiscal stimulus and of more predictability in trade policy in that outcome push, at least modestly, in the other direction. While the net effect for US equity indices is probably a modest negative, Goldman notes that the uncertainty around that judgment is high, particularly since it is still unclear which policies will emerge as priorities for the possible Biden Administrations and how much has already been priced (the relative performance of “high-tax” and “low-tax equities” suggest, unsurprisingly, that the market has already shifted to some degree to price a possible Biden win).
Meanwhile, with worries about an extended delay over election results, a swift resolution in either direction may also reduce risk premia although now that we also have a SCOTUS vacancy to fill an optimistic outcome here looks unlikely. At the same time, and as in 2016, shifts in perceptions of the race around the Presidential debates may serve as a helpful barometer for the market’s initial reactions. But 2016 is also a reminder that the initial reaction may quickly reverse as the market reassesses the winner’s policy priorities. The more obvious shifts may be in relative performance, where Goldman thinks expansionary Democratic fiscal policy could support the outperformance of cyclicals over defensives, while non-US cyclical indices may benefit too (albeit less directly) from a stronger US fiscal impulse, and without facing the drag from higher US taxes.
Next, the Goldman strategist looks at volatility, writing that while it remains sticky, it is "vulnerable beyond the big events" as the election and vaccine events have important implications for the pricing of volatility and options risk:
For a broad range of assets, it is true both that implied volatility is unusually high relative to realized volatility and the slope of implied volatility between 1 and 3 months is unusually steep (in part because of the election “bump”). Both of these features are potentially important. Because the distribution of potential outcomes around the mix of vaccine and elections remains quite wide, options markets need to reflect that even if the day-to-day volatility is lower. But the experience around prior elections of the last few years and events like the 2016 Brexit referendum illustrates that resolution in any direction often leads to stickiness in implied volatility until that point and a sharp drop in implied volatility as one or other path is confirmed.
If Goldman is right that we will know the outcomes of both the vaccine and the election by December - even assuming the “risk-negative” versions - there is a good chance that the VIX may be significantly lower than forward pricing assumes by year-end, according to Pandl: "Given the potential for both some vaccine news as Phase III trials progress and potential shifts in election views through the debates, we think that horizon presents potentially interesting opportunities to position for core themes." (which likely means Goldman prop is buying long vol from its clients).
Which brings us to the punchline, especially since this report is written by Goldman's FX team. According to them, a Biden win should accelerate Dollar weakness. As Pandl explains, Goldman continues to see "a good case for sustained US Dollar weakness, reflecting the greenback’s high valuation, deeply negative real interest rates in the US, and a recovering global economy (which tends to weigh on the currency’s because of its unique global role)." A Democrat sweep in the US elections would likely accelerate this trend:
- First, Biden’s proposals to raise the US corporate tax rate would make domestic stocks less attractive compared to international markets, all else equal, which could result in Dollar selling if US equities underperform. Regulatory changes, especially anything targeting the technology sector, could have similar effects.
- Second, a large fiscal stimulus would also likely weaken the Dollar, due to the Fed’s commitment to keep rates low. Normally currencies appreciate after fiscal stimulus, because it lifts rates, and higher rates in turn attract portfolio inflows from abroad. But academic research finds that currencies depreciate after fiscal expansions when unemployment is high and/or central bank policy rates are stuck at their effective lower bound.
- Third, a more multilateral approach to foreign affairs should reduce risk premium in certain currencies, especially the Chinese Yuan. Goldman recently lowered its 12m target for USD/CNH to 6.50 for this reason: a Biden Administration would likely imply lower trade war risks, and therefore should allow the Chinese currency to gain alongside broad Dollar weakness.
That said, other election outcomes would likely imply less Dollar weakness and affect the performance of certain crosses, according to Goldman. For example, if Democrats were to take the White House but Republicans maintain control of the Senate, the US policy approach toward China would likely change, but fiscal stimulus would become much less likely. This could result in Yuan outperformance vs the more risk-sensitive EM and G10 currencies. Alternatively, a Trump win plus Republican control of the Senate would likely benefit the Dollar, especially vs the Euro and Yuan.
Finally, as discussed yesterday in Tug Of War Across Markets Hides "Trade Of A Lifetime", Goldman agrees that "a potentially potent mix of vaccine approval and fiscal expansion" could lead to a rip-roaring value/cyclical/reflationary rally. Goldman explains:
Implied probabilities for early vaccine approval and a Biden win in the US election—e.g. probabilities provided by Good Judgment Inc and FiveThirtyEIght, respectively—have been hovering around the 65%-70% mark. As these probabilities have consolidated, there have already been some signs of markets moving to price the most likely outcomes: cyclical stocks have held onto most of their August outperformance even with the Nasdaq selloff and EM high-yielding currencies (with the telling exception of the Russian Ruble) have displayed remarkable resilience. In the event that such procyclical probabilities inch higher, "markets should move further towards pricing the modal outcomes: a move higher in cyclical exposures in equities, higher breakeven inflation, and a broadening in the outperformance versus a weaker Dollar to include EM."
As Pandl concludes, "These remain our core cross-asset recommendations ahead of a very busy autumn. To state the obvious, the more the market moves to price either vaccine or election results with greater certainty, the worse risk/reward we would see in these expressions, and the greater the need to consider hedges."