Reflation Revisited

US Election Results and the Prospect of Divided Government Change the Conversation in the Markets

Photo by Justus Kindermann
We're going to need more gas

As the combined consensus of polls pointed to a clean sweep by Democrats in the US federal elections, financial markets began to reflect a related set of price changes known as the "Reflation Trade", so named because it was supposed that united Democrat government would hurry to produce enormous fiscal stimulus to reflate the depressed economy and contribute to higher general price levels.


While the forecasted blue wave failed to materialize, Vice President Joseph R. Biden Jr. looks set to win the presidency of the United States, and Republicans appear to retain control of the upper chamber of Congress. Large-scale debt-financed infrastructure investments and safety-net expansions are seemingly off the table, although presumptive Senate Majority Leader McConnel indicated that there was room for a modest stimulus measure before year end.


Less infrastructure investment and safety net expansion implies less debt-financed borrowing, and accordingly, a lower stock of government debt. Prices in longer-dated maturities have risen as a result, while shorter-dated maturities have fallen. Inflation expectations, which drive the difference in price between inflation-protected securities and straight securities, fell as well, indicating that the market expects lower inflation, which is consistent with less government spending.


Another change in expectations derives from impact in expectations regarding tax policy. Democrats were expected to increase marginal tax rates, the rate of tax one pays as ones income changes, as well as the capital gains tax rate, the rate of tax one pays on the difference between acquisition and disposal prices on long-term investments. Changes in the expectations for the level of this rate impact investments whose value is driven by price change (like technology stocks,) rather than interim distributions (like fixed income or dividend-paying stocks.) And so, Big Technology saw another increase in the value of their shares, and the chasm in price-to-earnings ratios between Big Tech and the rest of the American stock market widened a bit more.


In general, stock markets like gridlock in Washington, as it is supportive of regime inertia, and inertia is a powerful non-force. We'll see how many of these changes are transitory as election returns trickle in over the next couple of days, but expect these new levels, as well as lower volatility, to be the primary indications of market sentiment over the coming days.

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