Pricing In the Likely Republican Sweep

With the Republican party poised to clinch control of the White House and Congress, our CIO and Chief US Equity Strategist says markets are readying for a lighter regulatory environment, supportive tax policy and a possible rebound in investor enthusiasm.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Today on the podcast I'll be talking about the results of last week’s election and its impact on equity markets.

It's Monday, Nov 11th at 11:30am in New York.

So let’s get after it.

Our work leading up to the election showed that stocks likely to benefit from a Republican sweep did not actually see material outperformance up and through November 5th. In other words, this political outcome was not fully priced. As a result, this allowed for significant outperformance of Financials, Industrials, and other cyclicals last week. We see further follow through to the upside in quality cyclicals as prospects for a lighter regulatory environment, supportive tax policy and a potential rebound in animal spirits should rise following the election outcome. These developments came on the back of a macro backdrop that was already becoming more supportive of cyclical outperformance – and why we upgraded this cohort to overweight in early October. We continue to be sellers though of tariff-exposed consumer stocks and renewable energy stocks.

Our upgrade to Financials in early October was rooted in our view that expectations were low going into earnings season while positioning remained light. Our work since then showed that the majority of the group's outperformance into the election could be explained by strong earnings revisions as opposed to rising odds of a Trump win in prediction markets. Now that we have the election results in hand, it appears that expectations for de-regulation are also driving performance upside in addition to improving fundamentals.

While the 2016 playbook would suggest small caps and lower quality equities could see a period of outperformance following the election, there are a couple of important differences worth considering. First, several of these areas of the market are exhibiting a negative correlation to interest rates today whereas they were showing a positive correlation in 2016. In other words, in today's later cycle environment, these cohorts' adverse sensitivity to rising rates is greater than it was in that period. Should rates see more upside post the election, there is likely less upside this time for small caps and lower quality cyclicals. Furthermore, relative earnings revisions breadth for small cap cyclicals is negative today, whereas it was positive in 2016. Finally, even with the increase in animal spirits following the 2016 election, small caps' relative performance peaked in early December of that year, just one month after the election.

While the momentum remains to the upside for US equity markets led by quality cyclicals, it's worth considering the potential risks. The first one is a material move higher in interest rates driven by a rising term premium. The 50 basis point rise in term premium so far has not been enough to worry equity investors yet. However, should the term premium accelerate materially from here driven by fiscal sustainability concerns, equity valuations would likely face headwinds. Second, one of the more popular views in the macro community is for a stronger dollar. If such strength continues into year-end, it could provide a headwind to multinationals' Earnings growth for 2024 and 2025.

A final risk to the positive price momentum is simply price itself. Over the past several months, the price change of the S&P 500 has distanced itself from the fundamentals. More specifically, the year-over-year change in the S&P has rarely been this disconnected from earnings revision breadth and business confidence surveys. However, given the positive reaction to the election so far in markets and from many business leaders, perhaps animal spirits can take earnings guidance higher – which is necessary to maintain the current trajectory in equity markets, especially since that is now expected by stock prices.

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