Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: Wall Street’s election hopes, Treasuries hold up in volatile market, and a look at the financial impact of the Foreign Corrupt Practices Act.
Wall Street Hoping for a Blue Wave?
The conventional wisdom is that divided government is good for financial markets. When one party holds the presidency and another holds Congress, businesses don’t have to worry about dramatic policy changes — on taxes, trade, regulation, and fiscal spending — materially impacting their bottom lines.
But that may not hold in 2020. Economists and investors largely agree that the country needs another large stimulus package to cap the coronavirus recovery — a policy that both sides of the aisle appear prepared to pursue. The stimulus debate comes down to partisan disagreement as to the most effective ways in which to boost GDP growth. Democrats want more state and local aid and more federal spending on health care and unemployment insurance, while Republicans prefer to use tax cuts and direct relief to businesses to boost investment and consumer demand.
Left to their own devices, lawmakers in both parties could likely put together a half-decent stimulus bill. A negotiated package, on the other hand, is harder to pass and likely to be less ambitious than the alternative. The worst-case election scenario for the economy could therefore be a divided government in which the current stalemate between House speaker Nancy Pelosi and Treasury secretary Steven Mnuchin persists.
That’s part of why Wall Street is largely bullish about a “blue wave” in November. In a note to clients, Goldman Sachs economists wrote last week that:
In the event of a blue wave, we believe Democrats would likely pass a sizable COVID-19 relief package on the order of $2.5tn (12% of GDP) in Q1 2021, legislation to boost infrastructure by a few hundred billion dollars over the next five years, and a broad “reconciliation” bill in Q3 2021 that would provide new benefits in several areas, such as healthcare, and would probably also include tax increases to offset increased spending. We think a larger Democratic Senate majority, of around 53 or 54 seats, might also lead to the elimination of the filibuster, which would ease the passage of major legislation and increase the probability of changes to regulatory rules, anti-trust laws, and the minimum wage.
A Republican sweep, on the other hand, would lead to an extension of the portions of the Trump tax cut set to roll back after 2022, in addition to likely payroll-tax reform. But with polls putting the probability of a Republican sweep at virtually zero, Wall Street may be hoping for a blue wave for the first time in recent memory.
Treasuries Are Dead, Long Live Treasuries
I’ve written recently about concerns that U.S. Treasury securities might no longer serve as a hedge against market declines. Treasuries move in the opposite direction of stocks because they’re seen as risk free. When investors want to “de-risk”, they flee to U.S. government debt.
Some have argued that central-bank interventions in Treasury markets will change the supply and demand dynamics that make risk-free securities a haven asset. Federal Reserve purchases of Treasuries inject virtually infinite demand into the market, thereby putting a ceiling on risk-free yields. That could make price movements in U.S. government securities asymmetrical: When prices go down, the Fed buys; when prices go up, the Fed stays away. The equilibrium seems to be a continuous decline in Treasury yields — and an attendant decline in risk-off Treasury rallies.
But the fabled death of haven assets hasn’t come yet, if recent market movements are any indication. In recent weeks, as investors grew more bullish on the economy, Treasury yields notched steady increases. And today, as major stock indexes see their biggest declines in a month, Treasuries are rallying again. That’s the kind of normal price dynamic that portfolio managers rely on.
But while recent moves in Treasury yields are welcome, it remains to be seen whether Treasuries can hold as a hedge in a true risk-off event, such as a contested election. With the 10-year note currently trading at 0.80 percent (almost -1.0 percent after adjusting for inflation), yields would have to plummet into nominal negative territory in order for investors to have reasonable downside protection. With the Fed leadership arguing against negative rates, that doesn’t look likely.
Around the Web
Bad day for stocks.
Derivatives markets are preparing for the debut of water futures, which farmers, cities, and other entities that rely on water will be able to use as a hedge against price movements. As always, regulators have some concerns:
[C]ritics say the contracts may prove difficult to trade, given the highly localised nature of water pricing and regulation. Some are also uneasy with such a basic resource becoming a speculative financial-market asset, fearing that trading, which would not be restricted to industrial users, could distort water prices for everyone.
Bloomberg’s Conor Sen explains why the rally in “pandemic stocks” such as Netflix and Zoom may be coming to an end:
This is the lens through which investors should examine strength in third-quarter earnings. To the extent companies are reporting better results than they ever have, how much of that represents being winners in some post-pandemic world versus a one-off windfall as consumers shifted their behavior over the past few months?
Random Walk
As the prosecution of Goldman Sachs for bribery in connection with a Malaysian sovereign-wealth fund comes to its conclusion, it’s a good time to take a look at the Foreign Corrupt Practices Act (FCPA) under which the investment bank was prosecuted. FCPA subjects U.S. firms to prosecution in American courts for bribes paid in foreign countries. Competitors from most other OECD countries are liable only in the relevant foreign jurisdictions, which means that, in theory, FCPA puts U.S. firms at a disadvantage overseas.
A 2014 paper finds that 23 percent of U.S. firms with foreign operations engage in bribery at least once, and that charges under the FCPA materially hurt those companies’ stock prices, but only in cases where bribery charges involve financial fraud:
We develop and calibrate a model of bribery and its enforcement using data from enforcement actions initiated under the U.S. Foreign Corrupt Practices Act (FCPA) from 1978 through May 2013. We estimate that 22.9% of Compustat-listed firms with foreign sales engaged in a program of prosecutable bribery at least once during our sample period, and that the probability that a bribe-paying firm faces bribery charges is 6.4%. Bribes tend to be paid for important contracts, as the average ex ante NPV of a bribe-related contract is 2.6% of the firm’s market capitalization. The costs for firms that are prosecuted for bribery depend on whether the bribery is comingled with charges of financial fraud. Firms with comingled fraud charges face large fines, investigation costs, and reputational losses, such that the ex post NPV is negative. Bribe-paying firms without comingled fraud charges face significant fines and investigation costs, but do not, on average, lose reputation in a way that impedes future operations or profitability.
— D.T.
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