1. What's your latest outlook for the midterm elections?
Dan Clifton, Partner and Head of Washington Office for Strategas
The consensus view is that the Democrats will win the House and the Republicans will keep the Senate majority, with roughly a 70% chance of both. Historically, there has never been a midterm where the House flipped and the Senate didn't. Markets are anticipating the gridlock scenario, so the reaction would likely be muted.
A Democratic sweep is more likely than a Republican sweep. A Democratic majority in both the House and Senate would be the least favorable for the markets and have the potential for the most significant policy change. There would be a better chance for an infrastructure deal as well as Medicaid expansion, but there could also be pressure to repeal some of the tax cuts in return for raising the debt ceiling. A Republican sweep would be the biggest surprise to the markets, but the most favorable scenario for equity markets and the economy, as it would allow President Trump to continue pursuing his pro-growth policy agenda.
2. Despite all of the trade headlines, volatility has subsided over the last several months. What is your take on low volatility?
Sinead Colton, Head of Investment Strategy at Mellon Capital
Markets have been calm. The last 1% move in the S&P 500 index occurred in late June. Although this may suggest there is little to worry about, there are significant risks out there, including politics — both in the U.S. and abroad — and trade. I'm cautiously optimistic on equities in light of solid earnings and economic growth projections, but prefer non-U.S. equities to U.S. markets given the strong performance of domestic equities and more attractive valuations outside the U.S.
We do expect volatility to move higher in the next 12 to 18 months, but view it as an opportunity to take advantage of mispricings in the market. Investors who are concerned about volatility can adjust exposure based on their goals.
3. How would you describe valuations in the private market and would an uptick in volatility have an impact?
Paul Vittone, Managing Director, Head of Private Equity Investments at BNY Mellon Wealth Management
Private equity valuations are high, having risen this year to just over a 10-times multiple. We are seeing a meaningful difference for pricing in the smaller end of the market (sub $200 million deals) of around six- to eight times earnings before interest, taxes, depreciation and amortization (EBITDA). We are seeing more opportunities in the lower end of the market as there is a more potential to drive growth while also capitalizing on multiple expansion. A pick up in volatility shouldn't have a big impact on private market valuations, which are being supported by relatively low interest rates, a strong credit market and a significant supply of capital moving into private market investing.
4. What's your outlook on the trade front?
Progress has been made with our North America trading partners, with Canada agreeing to a deal to replace NAFTA after a preliminary deal was reached with Mexico in late August. The new deal has been deemed the United States-Mexico-Canada Agreement. The European Union and the U.S. are at the table, and it's less likely that the U.S. will impose tariffs on EU automobile imports.
A U.S-China trade deal is more challenging, as President Trump is looking for structural reforms: lowering tariffs and ending intellectual property theft. China likely won't resume negotiations until after the midterms, when Trump could potentially be negotiating from a weaker position.
Historically, tariffs have hurt the growth rate for the countries involved but the benefits to the U.S. economy from fiscal stimulus dwarf the cost of tariffs. The worst case scenario is that all tariffs will cost approximately $120 to 240 billion dollars, compared to the $800 billion in tax receipts as a result of tax reform. However, the benefit of fiscal stimulus will fade over time while the cost of tariffs will increase if no resolution is reached.
Markets don't like trade wars or uncertainty because, in aggregate, it would negatively impact economic growth globally. The trade rhetoric may also impact the pace of Fed tightening and the strength of the dollar. Other central banks are largely on hold, so the dollar strength will likely persist.
5. What is the downside of a trade war with China?
Although the market appears willing to give the president more leeway with China for now, there is the potential for downside impact. These tariffs will result in higher taxes on consumers, create a lack of confidence from a business decision-making/investment perspective and disrupt supply chains.
The impact of tariffs may be much larger than what companies are expecting and the lack of clarity on the supply chain side may result in either lower profits or companies passing along increased costs to consumers.
China has been an area of growth in private equity, with managers investing in companies that target or benefit from an increasing consumer-driven economy. Because there has been a shift away from export-driven businesses, I would expect private equity investments to be less impacted by trade policies. However, a full-blown trade war could have broader implications, benefiting smaller, fast-growing Chinese companies that would face less competition from U.S. companies but also hindering those China-based companies that seek an exit path through the U.S. markets, both through M&A and IPOs.
6. Are you worried about the 2020 fiscal cliff and the increasing federal budget deficit?
Under current law, the aggregate amount of U.S. fiscal policy declines from 2.06% of GDP in 2019 to 1.4% in 2020. However, investors are likely too pessimistic about the fiscal drag given that most of the drag comes from federal spending.
Because the Bipartisan Budget Act only provides for a two-year (2018 and 2019) increase in the spending caps from the 2011 Budget Control Act, Congress will need to pass a budget for 2020. It is unlikely that Congress lets the budget collapse — even if the Democrats sweep both houses — because of the pressure of reelection. Also, we expect that the fiscal drag will not be far less significant than currently expected in light tax changes for corporations which should lead to higher investment. The growing federal budget deficit is a concern over the long term. We're five years away from the debt-to-GDP ratio reaching 100% and only at that point does it become a big issue.
Politics and trade tensions may have raised the level of uncertainty near term, but investors should not make any investment decisions based on political polls. Instead, they should take a longer-term view. The global economy is growing (led by the U.S.), corporate profits are robust and inflation remains contained.
Eventually, this long economic expansion and bull market will end, but we are not yet seeing signs of a recession. We continue to keep a watchful eye on trade developments, changes in the policy agenda as a result of midterms or an unexpected surge in inflation that could cause the Federal Reserve deviate from its gradual pace of tightening. But overall, we continue to believe that fundamentals are quite strong and that investors will benefit from a globally diversified portfolio that favors equities and a tilt towards domestic equities.
Incorporating a diversified mix of fixed income and lower-correlated investments as well as customized hedging solutions are also prudent to help buffer volatility, which inevitably will return.