MSSB: Politics aside, ways to play the elections

The public policy experts who advise the Global Investment Committee give the Republicans an 80% chance of taking over the House of Representatives and a 45% chance of taking the Senate on Nov. 2. Depending on one’s political persuasion, that’s good news or bad. However, politics aside, the key investment conclusion about the midterm elections is that once political uncertainty is removed—in favor of either party—equities tend to do well. Since 1950, measuring returns from Sept. 30 in midterm election years, the forward one-year return for US equities has averaged 27%, with no negative observations (see chart below).
In addition to the upcoming election, there are two fiscal policy issues that are important for the markets. The first is what happens to the Bush-era tax cuts, set to expire on Jan. 1. While there are lots of potential outcomes, we think the most likely one will hinge on bipartisan agreement that raising taxes is a bad political and economic idea. Thus, we expect a lame-duck session of Congress will approve the extension of current tax rates, including the upper-income brackets and those on capital gains and dividends. This is not a consensus view; by extension, we doubt that it is priced into the market.
The other policy event on the calendar is the Dec. 1 release of the report of the President’s National Commission on Fiscal Responsibility & Reform that carries its recommendations for curbing the US fiscal deficit. This bipartisan commission was modeled after the Social Security Commission of the early 1980s, then chaired by Alan Greenspan before he became Fed chairman. The Greenspan Commission recommended raising the retirement age and taxing Social Security payments; both measures were ultimately approved by Congress. Generally, the political utility of presidential commissions is that they can provide political cover for politicians to do unpopular things. We expect that this commission report could do the same for the next Congress, leaving prospects for political progress on the US structural deficit not as grim as most commentators expect. As for the cyclical US deficit, progress is already underway. The Great Recession ended in the summer of 2009 and, consequently, US federal government receipts were up 13% in August versus a year earlier.
Deficits and valuation. Historically, lower deficits as a share of GDP have been associated with higher equity market price/earnings multiples, all else being equal (see Chart 4, page 6). Investors apparently take greater comfort when fiscal policy is appropriately managed. In the current cycle, as the deficit share of GDP drops cyclically (a given) and structurally (we’ll see), P/E expansion could become another propellant, alongside earnings growth, driving positive forward equity returns. Such an outcome would be better than our base case, which calls only for equity market gains in line with earnings growth.
Modest but sustained growth. Morgan Stanley and Citi economists continue to forecast decent global growth in 2010 and 2011 in the 3.0%-to-4.5% range (see Table 1, page 9). They forecast that the EM economies will grow at about 6%, and China’s 0.25% rate hike on Oct. 19 should not change that, in our view; DM economies will grow near 2%. Such an economic backdrop should be conducive to continued corporate profits growth. Citi strategists, as well as the analyst community, are looking for profit growth to exceed 30% in 2010, followed by more-normalized profit growth in 2011 (see Table 2, page 10).
Attractive valuation. US and global equities are trading at forward price/ earnings multiples near 12.5, the low end of their range during the past 20 years. What’s more, global dividend yields are attractive relative to the low yields on offer in cash or sovereign debt (see Chart 5, page 6). Likewise, corporate bonds offer above-average spreads over sovereign debt and should see more credit rating upgrades than downgrades as the profits recovery continues.
Favoring risk assets. As the global recovery evolves, we are continuously assessing whether and how to change our risk exposure. This month, yet again, we conclude that the fundamentals favor risk assets—equities, corporate and EM bonds, REITs and commodities—over safe-haven assets such as cash, sovereign debt and inflation-linked securities. As a result, our tactical asset allocation models remain positioned for a continued global expansion by overweighting global equities and alternative/absolute return investments while underweighting government bonds and cash.
Within global equities, our models are tactically overweight to emerging markets. The rationale for this positioning is that emerging markets have robust growth characteristics with potential currency appreciation. We are also overweight toward commodity-sensitive regional equity markets, specifically Canada and Asia Pacific ex Japan; the former has more exposure to energy, while the latter, which includes Australia, has more exposure to mining and raw materials. We remain underweight to DM large-cap equities in the US, Europe and Japan. Within the US, we favor growth stocks over value stocks.
Tilting toward credit. Within global fixed income, our portfolios favor highgrade and high yield corporate debt, which still offer attractive yields relative to DM government debt. US investors who can benefit from tax-free income may consider municipal bonds in lieu of corporate bonds. Our portfolios also favor the higher yields and strong credit fundamentals provided by EM debt. Given the steep yield curve, a situation whereby longer-maturity debt offers significantly higher yields than shorter maturities, we remain underweight in short-duration instruments and cash. A recovering global economy, led by economic-growth advancement in the developing countries, should spur demand for commodities. An upturn in economic fundamentals should also improve the supply/demand balance for commercial real estate. As a result, our portfolios have tactical overweight positions in two liquid, alternative/absolute return investments: commodities and REITs. Given the considerable amount of slack in developed economies, we expect inflation to remain subdued. Thus, we maintain a tactical underweight position in inflation-linked securities.

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Related Topics: Investment Gurus, Morgan Stanley Smith Barney (MSSB)