Midterms Over, Shifting Focus onto Fed and China

By Paul Hoffmeister, Chief Economist

November 2018

One could say that the midterm elections were a split decision, and neither a “blue wave” nor “red wave” occurred.  By early indications, Democrats appeared to gain at least 26 seats (they needed 23) to regain the majority in the House, while Republicans expanded their Senate majority from 51 to 54 seats. [1] [2]

Perhaps the most important development following the election results was the tone from the leadership of both Parties. On Wednesday, President Trump congratulated Speaker Pelosi and expressed a desire to work together during the next two years. He said:

“Hopefully, we can all work together next year to continue delivering for the American people, including on economic growth, infrastructure, trade, lowering the cost of prescription drugs. These are some of things that the Democrats do want to work on, and I really believe we’ll be able to do that. I think we’re going to have a lot of reason to do it.”[3]

Nancy Pelosi sounded a similar message:

“We will strive for bipartisanship. We believe we have a responsibility to seek common ground where we can. Where we cannot, we must stand our ground. But we must try. So openness and transparency, accountability, bipartisanship, are a very important part of how we will go forward.”[4]

When asked about impeachment Tuesday evening, Pelosi told CNBC, “I don’t think there’s any impeachment unless it’s bipartisan. Our priority is to get results for the American people.”[5] And later, in an interview with PBS, Pelosi said, “For those who want impeachment, that’s not what our caucus is about.”[6]

Very quickly, concerns about a potential impeachment seemed to have been put to rest. Arguably, this is important for financial markets, which could have faced serious headwinds if they were mired in months of political uncertainty. As we explained in September, we believe the Clinton-Lewinsky scandal and impeachment prospects in 1998 were a significant factor behind a nearly 15% sell off in the S&P 500.

There also seems to be, at least for now, a real desire by both President Trump and Speaker Pelosi to legislate on issues where they can – perhaps infrastructure, prescription drug prices, and trade issues. Mr. Trump even acknowledged that he was willing to make a deal on middle-class tax cuts if Democrats proposed an idea.

With impeachment prospects seemingly eliminated and the possibility of dealmaking in Washington (within certain parameters, of course), it makes sense to us that equity markets were relieved and even optimistic last Wednesday, with the S&P 500 rallying almost 2.1%.[7]

So, what now for markets?

We believe some of the most important variables that will drive markets in the coming months will be the Fed outlook and US-China trade.

Art Laffer once said: “If regulatory policy is important by a factor of 1, then fiscal policy is important by a factor of 10, and monetary policy is important by a factor of 100.” In that vein, we believe Fed policy was a key factor behind much of the market volatility this year, and will be a critical factor behind market performance next year.

With some Fed members concerned about the so-called Philips Curve (the theory that low unemployment can spark inflation), how will the Federal Open Market Committee respond today’s historically low unemployment rate? Will it go so far as to invert the yield curve next year? If so, we expect even more criticism from the White House and classical economists. As Larry Kudlow told CNBC’s Scott Wapner last month, “…low unemployment is a good thing. Rising wages is a good thing. More people working and prospering is a good thing.”[8]

US-China relations are another major issue. The relationship seems to be changing massively, and China appears to be increasingly viewed in Washington as an economic rival and even adversary.

The New York Times reported in October that if a trade deal isn’t reached soon, the Trump trade strategy will be to reach trade deals with other countries and isolate China.[9] For example, if the United States reaches bilateral trade deals with Korea, Japan, Canada, Mexico, and the EU, this sphere of trade could comprise the majority of global commerce; and leave China on the outside.

Gary Cohn, President Trump’s former National Economic Council Director, isn’t too optimistic about a deal being reached soon. The day after the elections, he told Bloomberg’s David Rubenstein:

“I don’t think there’s a instant cure for the trade issue. I really don’t. I wish that I could sit here and say after the midterm elections, the White House, the Administration understand they’ve got to solve the trade issues. I think China would like to solve the trade issue. It really comes down to two... I would say there’s two main topics. Topic number one, for some reason, is the size of the trade deficit. The actual trade deficit with China is about $300 billion, net. And the President seems to think that number is way too large. I tend to differ with that. I tend to say that’s $300 billion worth of goods that we’re buying cheaper than we could produce ourselves. Because if we could produce them cheaper, we would be doing that. So there’s that issue. And then there is a more interesting issue that I think is more pertinent, which is the open access to Chinese markets and the enforcement of intellectual property, forced technology transfer where the Chinese have historically not allowed US companies into China and have not paid for much of the technology they have taken from the US. I think that is the bigger issue. I think the Chinese would solve the first issue and buy a lot more natural LNG, natural gas from us, and more agricultural products and bring down the trade deficit. But it doesn’t really solve the core issue, which is paying for intellectual property and respecting copyrights…”[10]

President Trump, on the other hand, struck a more optimistic tone early this month when he tweeted, “Just had a long and very good conversation with President Xi Jinping of China. We talked about many subjects, with a heavy emphasis on Trade. Those discussions are moving along nicely with meetings being scheduled at the G-20 in Argentina. Also had good discussion on North Korea!”[11]

It’s possible that the US and China will reach a partial deal and create a roadmap for further negotiations, but a complete resolution to the disagreement between both countries is highly unlikely.

In our view, there is tremendous pressure on President Xi. While the US appears to be creating its own sphere of trade that will exclude China, the CSI 300 Index is down more than 20% year-to-date and China reported the weakest manufacturing growth since July 2016.[12] [13]

But a comprehensive resolution seems impossible at the moment. The 2017 US National Security Strategy assessment concluded that China pursues six strategies of “economic aggression”, with 50 acts, policies and practices – or “tactics” – to achieve those aims.[14] In June, White House National Trade Council Director, Peter Navarro discussed these strategies and tactics at the Hudson Institute. When alluding to the negotiations with the Chinese government, he ended his speech with the following statement: “If you’re in a negotiation, and you take 25 of these off the table in a successful negotiation, you still have 25 left.”

The comment seems ominous, and suggests that President Xi will need to offer significant concessions to President Trump in their highly anticipated meeting during the G20 later this month. But, if in fact China’s economy is deeply driven by the series of trade strategies and tactics laid out by Mr. Navarro, how much can Xi concede so much without causing severe domestic disruptions?

In sum, the completion of the 2018 midterm elections and conciliatory tone of President Trump and Speaker Pelosi seemed to have caused a sigh of relief in financial markets. Now we must turn our attention to other major macrovariables, notably the Fed and US-China trade, both of which could have significantly transformative economic effects during the next year. 


Paul Hoffmeister is Chief Economist and Portfolio Manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).



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[1] “Democrats Capture Control of House; GOP Holds Senate”, by Jonathan Martin and Alexander Burns, November 6, 2018, New York Times.

[2] “How Republicans Made Gains in the Senate”, By Geoffrey Skelley, November 7, 2018, November 7, 2018.

[3] “Remarks by President Trump in Press Conference after Midterm Elections”, November 7, 2018, White House.

[4] “Nancy Pelosi Holds a Press Conference”, November 7, 2018, Fox News.

[5] “Nancy Pelosi Took Donald Trump Impeachment off the Table as Democrats Won House”, by Tim Marcin, November 7, 2018, Newsweek.

[6] Ibid.

[7] “S&P 500 and Dow Surge in Best Rally after Midterm Elections since 1982,” by Fred Imbert and Michael Sheetz, November 7, 2018, CNBC.

[8] CNBC Transcript: National Economic Council Director Larry Kudlow Speaks with CNBC’s Scott Wapner on CNBC’s ‘Fast Money Halftime Report’ Today,” October 12, 2018, CNBC.com.

[9] “The Trump Trade Strategy Is Coming into Focus. That Doesn’t Necessarily Mean It’s Going to Work,” by Neil Irwin, October 6, 2018, New York Times.

[10] “Gary Cohn Sees No Instant Cure on U.S.-China Trade Dispute,” November 7, 2018, Bloomberg.

[11] President Trump, Twitter.

[12] Bloomberg.com

[13] “China Reports Weakest Manufacturing Growth in More than Two Years,” by Huileng Tan, October 30, 2018, CNBC.

[14] Full Trasncript: White House National Trade Council Director Peter Navarro on Chinese Economic Aggression,” July 9, 2018, Hudson Institute.