Georgia, on my mind

Georgia, on my mind.

Here we are closing the book on the worst year of modern history, and things are starting to turn around. Vaccine readouts have been positive, and deployment is coming along, although setbacks will come. The US election came and went, but political risk never receded. Putting aside President Trumps' belabored efforts to overturn the election result, the real talk in financial markets has turned to the Georgia runoffs, which will determine the Senate's balance of power.

Why is another election happening in Georgia?

Another election is happening in Georgia because all four candidates running from the Republican and Democratic parties fell short of the required 50 percent threshold mandated in the state during the November election. The follow-up election, known as a "runoff," will be taking place on January 5th and has become particularly important for the market, given that the two seats on offer will determine the balance of power in the Senate. Although it is rare for two Senate runoffs to coincide, the anomaly this year is due to Senator Johnny Isakson's retirement last year.

What does this mean for markets?

If the Democratic Party can clinch a majority in the Senate, it will create a unified government since the Democrats already have a majority in the US House. As it relates to policy, this means that incoming President Biden will be able to pass legislation far easier than he would have with a Republican Senate, which has served as a firewall for higher taxes and increased fiscal spending. Many have dubbed the Senate "where legislation goes to die." In short, Democrats winning the Georgia runoffs will force the market to recalibrate the odds of fiscal gridlock overnight. It seems the market is leaning towards a Republican win, which means an upset could foster a market reaction.

A democratic win might lead to an unwind of those duration trades.

A Democratic win would undoubtedly turbocharge a series of blue-wave trades seen ahead of the US election. Most of these trades would be tied to the prospect of higher interest rates, and with it, higher inflation resulting from more fiscal spending. Yield curves would likely be steeper, led by higher long-end rates since short-term interest rates remain anchored by central bank forward guidance. The US 10-year would probably break sustainably above 1 percent. The composition of the increase in yields will be vital as it relates to Fed policy. A move driven by inflation expectations rather than real rates would be a welcome development for a central bank struggling to hit its inflation target.

Within equity markets, the prospect of higher rates should hurt duration sensitive sectors. Sectors that tend to have higher growth, such as technology, will likely underperform the more cyclical and value sectors. Remember that value is market jargon for companies that are oversold. That is not to say that names hit hardest by the pandemic will recovery immediately. Still, any developments that help make virus relief bills pass in more quickly will undoubtedly be a more positive development for them relative to those less affected by the pandemic.

Commodity markets will also likely recover more quickly with a Democratic Senate. The potential for more virus relief coming down the pipes will diminish any scarring fears in the labor market and business investment from prolonged shutdowns. That should translate into a faster recovery in global demand and, with it, higher commodity prices. We already see some divergence within commodity markets due to the more robust recovery in Asia relative to the rest of the world, particularly in China. To the extent that the passing of more fiscal stimulus will narrow that gap in growth is unknown but would be a step in the right direction and a net positive for commodity demand.

In the currency market, things are less clear. Everyone is a dollar bear going into the new year, primarily due to the twin deficits argument. I will elaborate more on these arguments in coming pieces, but the bottom line is that a higher fiscal and current account deficit tends to lead to a weaker currency. Although possible, it's essential to realize that the prospect of more fiscal stimulus might be the shot in the arm the US economy needs to attract more investment. This year the US dollar has depreciated due to a rebalancing of portfolios from the US into Europe. A myriad of factors drives the rebalancing flows, one of which is a potential unwind of some of the flows that came back to the US following President Trump's tax policy announcement in 2016/1017. The extent to which these flows can be unwound is not entirely clear, but positioning in currency futures points to a disproportionate short position in the US dollar. The chart below shows the positioning in currency futures relative to the US dollar.

Reading tea leaves

In terms of what to expect, early voting in Georgia has been strong.

Nearly 3 million votes were cast since early voting opened on December 14th, roughly 60 percent of the total votes cast in the November election. Polls show that the race is as near as makes no difference a toss-up. FiveThirtyEight has the Democratic Party with a negligible lead. For those interested in funding, the Democratic Party candidates raised US$ 210 million relative to the US$ 132 million of the Republican candidates. Frankly, the race is too close to call, but 2021 might start with a big shock in financial markets.

Thanks for reading,

Tiago Figueiredo