Category: Economics

I try to keep politics out of this site, except when politics has an impact on the marketplace. As long as this is the case, I’ll continue to comment about politics and this week definitely warrants some comment about it.

I’d like to preface this by explicitly outlining my level of emotional involvement in the presidential election. There is none. Whether Biden, Trump or anybody else wins the presidency, doesn’t matter much to me personally. I’m not like a spectator cheering for my preferred sports team; I’m a detached observer that is trying to predict who will win for the purposes of determining what set of policies will get implemented, and these policies will give certain sectors tailwinds that are worthy of investment, and certain sectors headwinds that you will want to steer clear. Look no further than any natural resource investment in Canada, especially post-Bill C-69, which is the incumbency protection bill for any company with an existing pipeline or natural resource project. Pipeline? Nope, unless if the government nationalizes it! Coal mine expansion? Sorry, you’re toast!

Again, winners and losers come out of any political changes in office. It is not my job to get happy or upset at any particular candidate or party, but rather to figure out what is likely to happen as a consequence and take appropriate action. My prediction of Trump winning is not out of any love for him but how I see it (although I will confess that he is ten times more entertaining to watch than Hillary Clinton or Joe Biden will ever be – it is undeniable he is a truly unique character in politics).

The point of this – some people confuse a prediction of a winner as some sort of endorsement. It is not.

Anyhow, my 2020 prediction was essentially correct. It doesn’t matter that Trump actually wins or loses the electoral votes in the states in question (the relevant ones being Arizona, Michigan, Pennsylvania, North Carolina, Georgia, Florida), the fact that Trump was polling 5-8 points behind most of these states should have made them all easy Democratic states. The real story was totally different. The public polling data was complete garbage (much more so than in a typical Canadian election) and one of the reasons for this was that the polling data was not generated for the purpose of ascertaining the voting outcome, but rather for fundraising. The other that I outlined was that they simply did not capture the composition of the actual people voting in elections.

Right now we have all the media outlets (which all are blinded by their hatred for Trump, which is ironic since the hatred amplified his political persona and elevated him to the presidency) claiming or nearly about to claim (I post this on a very late Thursday evening) that certain states have been won by Joe Biden, bringing him above the 269 electoral vote threshold, which should be sufficient for the presidency. The numbers on the electoral map will indeed show it. Half of the country will cheer thinking that Biden has won the presidency.

The reality, however, is going to be a lot more complex due to how the American electoral system works.

It is the electoral college that votes for a presidency. States approve the electors on the basis of the vote. This process is not automatic.

There will be a mountain of evidence assembled of various non-compliances of the election. This will get appealed up, and will get taken to the Supreme Court. The Supreme Court, despite being stacked with three Trump appointees, will want to wash its hands as thoroughly as possible, but they will give states some options. This is definitely a different scenario than Bush v. Gore – analogies will be made, but this analogy will be inappropriately used.

In the case of Pennsylvania, Georgia, Wisconsin, Arizona and Michigan, the state legislatures are Republican controlled. If the final reported vote margin is within a fraudulent margin provided for by evidence, it appears possible that the state can simply fail to certify the results of the vote and not choose electors. There is some precedent for this in 1864, which notably was in the middle of the civil war, which seems to be an appropriate term of what is going on in the USA right now.

If Biden was already up 300 to something, the remaining states wouldn’t have mattered. But if things are very tight (e.g. within 20 electoral votes), the closeness of the result is going to matter significantly if it is determined that one large state (e.g. Pennsylvania) is deemed to be fraudulent with their handling of mail-in ballots. With 20 electors abstaining, nobody can achieve 270 electoral college votes, and hence the vote for the president becomes a contingent election. It gets kicked to the House of Representatives, and they will have a choice of choosing the top three receivers of electoral college votes. While it is likely to be Trump, there could be a non-Biden, non-Trump elected president as long as there is a faithless elector willing to nominate a potential third person as a compromise president.

If the media claims Biden won, Biden gives his victory speech, and half the American public believes he won, and on the other side you have claims of election fraud, and also states clearing the way to (legally) not certifying the results or sending electors to Washington, DC, it amounts to a very contentious scenario which is probably to involve a lot of social unrest, especially on the Democratic side.

At one point after the election, British gambling sites were offering 15:1 odds on Trump winning the presidency given what we have seen numbers-wise. While I would not take such a bet simply because they would probably close it in Biden’s favour once the victory speech is given, I would not count Trump’s chances as being over yet. There is a very viable scenario where it becomes a contingent election, and then you’ll have to dust off the 1824 playbook, where this last occurred for presidency. This is the year 2020, and it is most certainly a year for strange things. Keep your mind open to the possibility.

With respect to the impact on the markets, the orgy of buying that we have seen in the past three days has been immense, but extreme caution is warranted in my opinion. This is not over at all.

I write this in the early afternoon of the Pacific Time Zone so the only true data I have to work with at present is the 16 votes for Trump and 10 votes for Biden in New Hampshire, which is not exactly representative of the national vote.

For reference, here was my November 3, 2016 presidential election prediction, where I predicted Trump 295, Clinton 243 (actual: Trump 304, Clinton 227 and 7 protest votes). The big “value-added” to that prediction, which the vast majority of others did not predict, was the breakout in Michigan.

Although all elections claim to be unique, in a sense they can be predicted to some extent given the historical correlations that various interest groups have with the red team or the blue team affiliations. Analytical minds in the major political parties try to ascertain which nudges (i.e. payouts to marginal special interests) to make to generate a winning coalition of voters. You get the numbers associated with each group, plug them into a paper napkin formula, and then build the campaign around such messaging. In 2016 it was the revival of the rust belt vs. establishment backroom politics. Trump’s team basically knew what he had to do, and aimed for a target in plain sight and got his deserved victory. Clinton’s campaign was basically “I’m not Trump”.

In 2020, times have changed. While in 2017 to early 2020 Trump was fighting the civil war in the bureaucracy (consider that a significant portion of the public service is Democratic and just because you’re the top guy in the top seat doesn’t mean that you’ll actually be able to implement policy instantaneously) and fulfilling various campaign pledges, COVID-19 completely destroyed the obvious re-election campaign pitch of “Keep America Great” to something a bit more diffuse. In this respect, COVID-19 was a net negative for Trump not because of the administration’s response to it, but because it destroyed the messaging narrative of the re-election campaign. In regards to the actual COVID-19 response, similar to Canada, the national government has limited control over the situation while provinces/states have a significant ‘say’ on what happens on the ground, which the public interprets as a national matter.

We look at the polling data. If you believe the polling data, you get an electoral map looking something like this:

In addition, congress will go Democratic, with both the House and Senate receiving Democratic majorities.

The question is – is this polling data correct? If it is, then this isn’t even going to be close. Biden wins by a mile. Indeed, in terms of the popular vote, states like California overwhelmingly will go Democratic, to the point of skewing the nation-wide popular vote by some wild margin towards the Democrats. The only reason why a Republican in California should bother up to vote is if their congressional race is in contention, or if they wish to vote in a state-wide initiative.

What polling data does not capture very well is motivation. Almost everybody you survey claims they will be voting and in reality the number is around 55-60%.  In elections where voters have the choice to not vote, it is just as important to model the cohort that vote versus those that do not.

From a more fundamental perspective, I ask what numbers of voters that voted for Donald Trump in 2016 would want to either sit this one out, or to vote Democratic – and the only people that would be in this category are the ones that believed all of the promises in 2016 (which they’d most likely turn into non-voters), or establishment Republicans that a restoration of the previous order (the Jeb Bushes, Mitt Romneys, Carly Fiorinas and the like). The first cohort is sizable; the second cohort would likely have not supported Trump in 2016.

On the flip side, there is evidence that the Republican coalition is expanding to include more of the ethnic voters (especially in the Latino/Black communities) and this has an impact in states like Florida, Arizona and Nevada. Indeed, these numbers are probably going to have a significant impact in states like Georgia, which marginally are polling Democratic this election.

Although impacted by COVID-19, you can also see that Trump has crowd-gathering abilities still, despite 4 years in office (which tend to depress voter enthusiasm, similar to how Obama’s re-election did not bring nearly the crowds that came in 2008). In fact, the crowds that still come to Trump rallies can only be described as insanely high – it is a politician’s wet dream to see such numbers coming (just imagine Trudeau trying to set something up like this).  This is contrasted with Biden, where even the most positive videos released by the Democrats don’t show that much (Bernie Sanders was much more successful in this metric).

The choice of Joe Biden is as close to a paper candidate as it gets – the whole world knows that he is not mentally functioning at a regular capacity, and that he would basically be a regent.  The VP selection did not perform very well in the campaign trail, despite hitting all of the ‘political correctness’ check-boxes.  Essentially, this renders the election as a referendum on Donald Trump – vote Democratic if you don’t like Trump, vote for Trump if you do. Are there more people upset with his presence today than they were in 2016?

Putting a long story short, to answer the original question, I believe the polling is skewed because they are not sampling the right cohorts. Here’s my guess, and it is awfully similar to 2016’s electoral map and projection:

The one state I would focus on for the Latino vote is Nevada – if the vote is relatively close (it was 47.9% Democratic and 45.5% Republican in 2016) then this state could potentially flip.

Unlike 2016, I have no money directly on the result of this election. The value received is too thin (Trump is +189, Biden is -215), compared to 4 years ago where Trump was being given away at +800 after the revealing of his politically incorrect comments.

Market-wise, no matter who wins, things are going to be in extremely rough shape. There will be a limit to the borrowing power of the US Government, and there will be a day of financial reckoning which will be extremely painful. An all-Democratic congress and presidency would be the worst outcome, while a divided congress historically is the best outcome for stability, which the markets like. But don’t believe any of these pundits that believe that Biden or Trump will be the best for the stock markets – I’d be playing the safety card.

Derek asked:

Do you think negative interest rates would ever be implemented in Canada?

My opinion (and realize that the error bars are huge with this response):

Not yet.

For instance, there would be a pretty good legal case to be made that Sections 18(l), (l.1) and (l.2) of the Bank of Canada Act would have to be amended since, for example, it only authorizes the Bank of Canada to pay interest on deposits, not charge banks for such deposits. Changing the legislation requires parliamentary approval, and such a decision would likely not obtain unanimous consent. This would mean there would be at least a week of debate on the matter, assuming a majority government forced time allocation on such legislation, coupled with senate approval. Let’s just say with the current political environment in Canada, co-operation in Parliament is not too likely at the moment.

I am not a lawyer. I could be wrong. However, I have not seen this particular clause in the Bank of Canada Act mentioned by any commentators on hypothetical negative interest rates in Canada – i.e. whether the Bank of Canada actually has the authority to doing this. It is assumed by all of the media and publications they can do so, but in my eyes such an assumption should not be granted.

This is not to say that the yield curve can’t go negative – indeed, the markets can push bond yields to negative rates, or push BAX futures above 100. This is completely allowed. The question is whether the Bank of Canada can set the overnight target rate to below 0%.

The Bank of Canada has examined the matter and written about it in a small amount of detail regarding the impact of international banks when they implemented negative rates (Framework for Conducting Monetary Policy at Low Interest Rates), a November 2015 paper on The International Experience with Negative Policy Rates).

If somebody out there has a legal background and would like to chime in on this matter, it would be appreciated.

Putting it mildly, things are not going to end well. Whatever party ends up in power after the (guessing there is a good chance of this happening) November election is going to face one hell of a mess to clean up. The accumulation of debt and government entitlements will be sucking up private sector capital like a vacuum and this will result in a lowered standard of living for most in the country. It is going to be very difficult to unwind the existing entitlements, including the emergency programs, without a lot of pain. Perhaps this was the intention – to accelerate the economic collapse of the real economy (note: this is not the financial economy, which is an entirely different beast).

For instance, ask yourself why anybody at or under the $15/hour pay bracket would bother working under CERB? Working is effectively taxed at 100% of marginal income for these people. This affects the real economy, specifically the availability of low cost labour. Even middle-class labour (e.g. the $25-$30/hour bracket) has a significant marginal tax (financially, the after-tax amount one gains for spending the time is a minimal wage). The only solace is that the elements of the real economy that have been affected (restaurants, retail, tourism) are not apparently critical to the functioning of the economy.

However, this will be a “canary in the coal mine” type environment. Have any of you gone to the west coast of Newfoundland and looked at the near-ghost towns that are along the coast, most of which had their glory years decades ago when there was a thriving cod fishing industry? The first types of businesses that leave these towns are the ones that thrive on disposable surplus income. After that, other pillars go. Eventually what remains is government – hospitals, schools and city hall, but as the tax base shrinks and people emigrate, this goes as well.

The core industries that produce wealth, farming, forestry, mining (mineral and petroleum), and now to a much lesser degree, fishing, ultimately sustain the rest of it. Another major industry, the export of land titles, is also popular, but there are limitations.

The Bank of Canada confirmed on September 9 that they will be keeping rates low for a very long time, and their version of quantitative easing, $5 billion a week, which works out to a cool $260 billion/year.

QE is a conversion of long-dated maturities (held by the central bank) for short-term liquidity (held by the financial sector or whoever was the counter-party to the bond purchases). It inflates the financial economy, but it is at the expense of earning a return on investment. It also has the consequence of widening the wealth gap and this creates political problems.

Fiscally, the Government of Canada is blowing out gigantic amounts of money out the door and hoping it will reignite a flurry of economic activity and keeping away food riots and other political issues that come with economic upheaval while they figure out what the heck to do. The government can afford to do this because the Bank of Canada is supporting the activity (interest rates are being held very low), in addition to the perception that Canada still has real economic output (which buoys the Canadian dollar – relative to America, we are doing quite well). Despite the Liberal government trying to destroy one of our major industries (energy), we still produce a lot of it. And hypocritically, Trans-Mountain is being constructed by the same government and Coastal Gaslink is progressing.

The short-term effect of this fiscal stimulus will be to keep things afloat. Indeed, you can see evidence of this in the vehicle market, where people are using their new-found wealth to purchase vehicles. There is evidence of other such buying elsewhere.

The issue is that this is going to be transitory. There will certainly be a “feel good” effect to injecting $300 billion into the economy, but it will not be able to last – it will break when capital allocators cannot obtain a proper return on their investments. There are a few economic scenarios that may play out, but two likely ones are we end up in a debt-ridden deflation coupled with economic stagnation for a long period of time (the only escape is significantly long periods of austerity to restore the balance sheet), or we get governments that will fund government spending directly from central banks, which in that case we get serious amounts of inflation (in addition to interest rates skyrocketing). There are other scenarios that may come out of this, but most routes are going to involve pain.

Finally, every province in the country is incurring a massive deficit. Unlike the federal government, provincial governments cannot print their own currency. Taking the inflation route is not an option – they have to go along with whatever the federal government decides.

The Liberals full well know the withdrawal pains from the binge of QE and deficit spending will be coming soon, which is why they are trying to buy themselves another year with an election. Even if the result is status-quo (plurality of seats; minority) they have bought themselves time.

The S&P has more or less been on an uphill trend for the past 3 months. The last major incursion to the prevailing market trend was in June, which shook out the people with low amounts of conviction. Since then, the people that have cashed up during Covid (“let’s wait for a vaccine”, “let’s wait for case rates to go to zero”, “let’s wait for the presidential election to conclude”), etc. have been staring at stock charts of companies like Tesla, Microsoft, Zoom, etc., all rising in price. During the three month process, the temptation to buy becomes too much (“let’s board the train”), and that also starts attracting unsophisticated retail investors (Robinhood traders) into the mix.

There is still a lot of cash on the sidelines, and there is still a lot of pessimism out there in regards to Covid and the general state of the economy, so this cash will be the ultimate backstop to the markets.

However, once in awhile, the markets need to exhibit a “shake-out”, where confidence is obviously lost, and the sentiment turns short-term negative, such as the moment we got yesterday and today – what’s happening is that equity holders with less conviction are taking gains and this creates its own stampede of people that have decided that taking gains on the past three months of performance is “good enough”.

Note I haven’t mentioned a thing about valuation in this post. Of course companies like Apple, Microsoft, etc., are trading at elevated ratios. Where else are you going to stick your capital, 30-year US treasury bonds yielding 1.4%? Of course companies like Zoom and Tesla are over-valued, but over-valuation alone is not a sufficient condition for going all negative on the S&P 500. Indeed, if the entire S&P 500 index were to collapse 25% in the next week (without a corresponding change in interest rates), you’d have the media shouting about how everything is going to hell, but privately within the halls of pension funds and institutions, would be a pretty good chance to deploy cash into equities.

The underbelly of the high profile, high-PE, high capitalization stocks still shows a market that is relatively stable and doesn’t appear excessive.

I’m guessing this hiccup will be a two week ordeal, especially when combined with presidential election antics. Panicked hands will bail, and when they’re finished, we’ll begin the slow march up against the wall of worry.

Indeed, the implied volatility of the S&P 500 has spiked, where the short term contract (mid-September expiry) is hovering around the 35% mark, while the October contract is at 40%. This massive diversion is due to the anticipated effects of the US presidential election on equity markets.

In general, I would be a seller of volatility going into the election.

Finally, this is not to say there will be economic headwinds that will cause issues in the marketplace. But this is going to be a 2021 story, not 2020. All of this nearly free money provided through quantitative easing, central bank asset purchases, and the provision of massive government fiscal deficits will have consequences. The analogy is that the shot of meth has been given to the patient and the patient has been feeling really good. But this high only lasts for so long before you either have to pump up the patient again, or let the patient sober up.