Will the Georgia Senate runoff race create some market excitement or will it be a damp squib?

As 2020 draws to a close traders should begin to cast their eyes to the Georgia Senate runoff races taking place on January 5^th. Although, betting markets such as Smarkets, PredictIt and Oddschecker all continue to heavily favour Republicans retaining control of the Senate (circa 70%) this year has taught us that anything is possible. Polls are a lot tighter with fivethirtyeight giving a slight edge to Democrat candidates and Emerson’s data moving in the Republican’s favour. Democrats have to win both seats which would then be decided by the VP in a tiebreaker vote, handing them a slim majority. In the November race between Loeffler (Republican) and Warnock, Warnock got about 33% of the vote and Loeffler 26%. However, the third candidate, who can’t compete in this runoff, was a Republican who got 20% of the vote, suggesting a Republican edge in the runoff. The other Republican candidate, Perdue nearly won his November race, with 49.7% of the vote, but he didn’t reach the required 50% to prevent a runoff. Ossoff was a close second, with 48%.

Special elections are traditionally low-turnout events, which would favour Republicans. Since 2000 there have been 3 runoffs in Georgia, in all 3 Republicans led the Election Day ballot, but still fell short of the 50%, then significantly increased their margins in low-turnout special elections. However, preliminary data already indicates that historical patterns may not hold this year with turnout nearing 1.5 million and heading for a record. Additionally, voting data compiled by GeorgiaVotes.com point to strong early turnout among Black voters, even stronger than in the November 3^rd general election. Black voters make up 32.1% of the runoff voters, compared with 27.8% in the general election, importantly they are the base of the Democratic Party in Georgia, comprising more than half of all Democratic voters. Another curveball could be a lack of Republican voter enthusiasm after feeling dejected by Trump’s loss or alternatively they could see this as their last way to block Democrat policies.

If Democrats do manage to clinch the win then we would most likely get a fiscal bazooka in the region of $2.2 trillion with spending being directed towards infrastructure, health care, education and the environment. Stimulus is never a bad thing for markets, however, it will be funded by tax increases (personal income taxes and corporate taxes) and a negative side effect of a Dem clean sweep is the risk of increased regulation – both of which would dent corporate earnings. Tax changes are the big question mark. Biden has proposed tax hikes for the highest income households and a phase-in of higher corporate taxes – 28% up from the current 21%. Democrats will likely argue that Covid exposed the stark differences between Wall Street and Main Street, and therefore health care reforms, higher minimum wages and worker protections should be implemented. Biden and many Democrats want to raise the federal minimum wage to $15/hour from the current $7.25/hour, which would have quite a substantial impact on employers’ bottom-line. Although there will be pressure from the progressive wing in the Democrat party, the party as a whole would only have a very slim majority in the Senate and more moderate Democrats could push back.

My view is that the market would have a kneejerk reaction lower on a shock Democrat win and then the narrative would switch back to one of optimism as a result of the larger stimulus and a return to normality via the vaccine (as long as the new mutation doesn’t create issues). A reflationary impulse in yields on the back of a Dem win would hurt Tech shares given they’re long duration in nature (majority of value derived from future earnings boosted by lower discount rates), and their large weighting in the S&P 500 would drag the benchmark index down too. However, they’re also defensive in nature as they’ve proved reliably profitable and immune to virus induced economic shutdowns – this is particularly relevant given Biden is pro lockdowns. On a sectoral level, Cyclicals (autos, travel, materials etc.) would benefit from a large stimulus and higher yields would help beaten down value stocks like financials as the yield curve steepens (can’t see the Fed allowing rates at the back end of the curve to blow out though – i.e. more gentle move). Equity markets will also be pricing in a lower equity risk premium as global trade tensions and policy uncertainty are eased via a less volatile and more traditional Biden presidency. So the effect of a Dem win is slightly more ambiguous for equity markets after an initial kneejerk reaction. Alternatively, if just one Republican wins then that would be a catalyst for a strong bid in equity markets and any downside hedges would be unwound. The goldilocks scenario for markets would be the current status quo.

Moving onto FX markets, a Blue Wave is the most USD negative outcome - as the loose fiscal policy would worsen the twin deficits, creating structural headwinds for the dollar. Additionally, with all the debt slushing around the system, if yields began to move upwards swiftly then the Fed would have to step in. Inflation expectations would continue to rise while yields would be supressed - combining to push real rates further into negative territory, another dollar negative. Cyclical currencies like NOK, CAD, SEK, AUD, NZD, Euro and EM will do well in a weak dollar environment. Negative real yields as a result of higher inflation should benefit the yellow shiny metal too, however, there will be outflows into equities in a strong risk-on environment.

The VIX futures curve reflects the market's estimate of the value of the VIX Index on various expiration dates in the future. The VIX, is a real-time market index that indicates the market's expectation of 30-day forward-looking volatility (price fluctuations). It is calculated from using the price of S&P 500 index options. Another name for the VIX is the fear gauge, as it provides us with an outlook on market risk and investors' sentiments. In the below chart we can see the curve kinks higher right around the 5^th of January, indicating some potential event risk and volatility for markets.