Geopolitical Developments: Progressive Democrats And Obdurate Republicans Fuel Bearish Fantasies In The Markets

The drama in Washington concerning the Biden economic agenda is hampering markets as the twin spectre of default and debt-fueled stagflation conjure up memories of the GFC and 1970s malaise. The volatility risk premium points to a higher market over the next few days, but my technical reading of key stocks in the S&P 500 is neutral. Yesterday saw one negative factor across global asset classes: oil is pointing to stagflationary conditions. Given the political backdrop and surge in oil prices, I expect the S&P 500 to be range-bound over the next few days.

The central problem with the US economy is low productivity and a consequent over-reliance on the work ethic to maintain confidence in American growth and the political system. Low productivity is not just a manifestation of bad government statistics but a reality borne out in the declining share of labor in national income. The markets don’t believe government programs to help labor or educational reforms are effective in raising productivity, and any increase in such spending only reduces the work ethic, adds to national debt and fuels inflation worries. So markets bank on automation and technological improvements like AI to revolutionize private sector training and education and restore high productivity. In the meantime business freedom and confidence to power profit growth is key and that in turn depends on limited government and a pro-growth Fed. Biden is challenging the first and progressive Democrats are implicitly challenging the second.

The markets would like to see a coalition of conservative Democrats and liberal Republicans limit government spending, but this has yet to emerge as the GOP is united in partisanship. Not only is stymying the Democrats fun for the GOP, but playing with the debt ceiling raises worries among overseas creditors like China. So the next best hope is the Progressives cave in on the size of the infrastructure package: this looks likely but the progressives are striking back at the financial system by challenging Jerome Powell and banks to adopt ESG policies and compliance. This is a no-win situation for the markets as more regulations and government directives won’t solve the various socio-ecological problems, but instead will make banks and their corporate clients more inefficient. And deregulation is not the answer either, since banks are poorly incentivized to maintain stability in the face of a highly leveraged economy. So the markets are hoping political passions die out and little is changed in Washington, but recent cultural trends make this unlikely. The Great Resignation has signaled to Progressives that working people are tired of the work ethic and high levels of dynamism an at-will employment environment dictates. So Progressives have good reason to maintain unity and impose more regulations on the financial system, marginally hurting the economy and raising costs of doing business, at the expect of earnings. Lower margins would pull markets lower since valuations are already relatively high by historical measures.

The Progressives have a point because even though banks are already highly regulated due to changes enacted after the GFC, those regulations haven’t solved the incentive problem. Charles Goodhart and colleagues report via VoxEU that “our findings indicate that the too-big-to-fail problem remains essentially unresolved at present. Our results suggest that bail-ins under their current design are not a credible alternative to a bailouts in severe financial crises, such as the GFC, or in cases of idiosyncratic failures of the largest SIBs.”

The problem they uncover is that “contagion mechanisms could endogenously amplify shocks emanating from bail-ins, i.e. exposure loss contagion, overlapping portfolio contagion, funding contagion, bail-in debt revaluations, and bail-in debt runs originating from concerns over expected losses, uncertainty over prospective losses, or similarity to a recently failed bank...the later a bank is bailed-in (i.e. the lower the failing-likely-to-fail threshold is set), the higher the system's contagious losses are.”

Because of bank lobbying power and the deregulation mantra of the GOP, “US regulators explicitly plan to bail-in a bank late, only when it is or nearly is insolvent.” That puts the onus on banks to capitalized enough to deal with setbacks on their own and thus forestall any call for a bail-in (let alone a bail-out). But here the economists recognize another problem. “But a point that is insufficiently appreciated so far by resolution authorities, however, is that recapitalising a bank quite strongly such that it meets both its minimum capital requirements plus its combined capital buffers might still compromise stability on the order of trillions of dollars...The reason is that a bank may not be willing to use its regulatory capital buffers (Goodhart et al. 2008, Goodhart 2013, Farmer et al. 2020, Kleinnijenhuis et al. 2020), because buffer use comes with penalties in its ability to make discretionary payments such as dividends and bonuses.”

So banks are not properly capitalized to deal with major shocks and the authorities are unwilling to step in early when contagion could be limited. Armed with this knowledge the Progressives are demanding more control of the financial system, and that makes markets understandably nauseous, Thus the markets are hoping the Progressives face multiple losses and effectively diminish in influence. With the GOP playing games with the debt ceiling this looks unlikely.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), Apple (AAPL), Gibraltar Industries (ROCK), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE) and a hedged position in the S&P 500 (UPRO and SPXU).