Jean Alphonse Karr’s epigram "plus ça change, plus c'est la même chose" or "the more things change, the more they stay the same" is a satirical description of the status quo. Essentially, the net result of even what appears to be a large change is often minimal. Last week we did in fact have change – a big change – as the Republican Party swept the mid-term U.S. elections, giving the GOP its largest majority since World War II.
The last time that the GOP had control over both the House and the Senate with a sitting Democrat President was after the ’94 elections. The Republican Party swept the mid-terms, dealing U.S. President Bill Clinton a significant loss. Riding the wave of the victory, the Republicans, via their Contract with America, embarked on an ambitious political agenda that was designed to bring quick legislative change during the first 100 days of the 104th Congress.
In the end the Contract proved to be too aggressive, and true to the epigram the political situation in Washington largely remained the same, despite the large shift in Congress. Yet it’s worth noting what happened in the markets. Equities had a brief pause and then the bull market began its run, which saw a 250% increase over the next five years. The fixed-income market saw rates drop by 300 plus basis points and the unemployment rate fell from 5.6% to under 4% during the same period. The political stalemate proved fruitful for the capital markets.
The big question tied to last week’s election results is “Will history repeat itself?” Most likely it will not. The current environment is very different and the issues facing the market are both more macro and structural than in 1994. Additionally, market valuations are not as cheap, with current S&P 500 price earnings multiple (P/E) based on trailing twelve months sitting at 19.55, vs. just under 15. Further, the effects of the last recession continue to linger and the FOMC’s historically unprecedented stimulus program has dramatically altered the rate environment. Even with last week’s shift in Congressional control we are likely to get more of the same in regard to the markets.
The October payroll data from the BLS showed a 214K gain. Since expectations were 235K, the data was largely viewed as being status quo. The revision in the September figure resulted in a 256K print, which was a slight improvement over the previously reported 248K level. For context this stretch of monthly job gains, which began in October 2010, is the longest running stretch in history. Also, the unemployment rate fell to 5.8%, down from 5.9%, which is the lowest level since July 2008.
On the European front, the ECB left rates unchanged with the main refinancing facility remaining at 0.05%, the rate on the marginal lending facility at 0.30%, and the rate on the depository facility at -0.20%. The official statement from the meeting was largely lackluster but Draghi’s comments during the press conference proved more interesting. During his comments Draghi discussed the potential size of the ECB’s stimulus program, framing it in terms of what the ECB’s balance sheet looked like in the beginning of 2012. This would suggest that the latest round of ECB stimulus would be roughly 1 trillion Euros.
The Asian markets saw a resurgence of volatility as Japanese equities experienced a “flash crash” during trading on Thursday. The plunge saw the Nikkei drop 325 points in roughly 20 minutes. While there were attempts to explain away the drop by attributing profit taking the instability of the Yen is a more logical explanation. The Yen dropped to new lows vs. the dollar at 115.52, hitting the lowest levels since November 2007. Many currency traders are watching the 120 level as the next target.
Global sovereign rates pushed lower last week as most markets saw rates fall by 2 to 5 basis points. German Bunds rallied by 3.5 basis points as yields dropped but the largest drop in yields was seen in Greek debt, where rates fell by 17 basis points. Draghi’s sizing of the ECB’s stimulus program clearly benefited the peripheral sovereigns in Europe. The spread between Bunds and Treasuries finished the week at 150 basis points – unchanged on the week.
U.S. rates fell by as much as 1 to 2 basis points on the long end of the curve as the 10-year hit a high of 2.39% mid-week before falling to 2.315% on Friday. Volatility last week was muted, with most of the week’s activity taking place in a 7 basis point range. We had highlighted the fact that much of the curve was pushing into resistance levels so the rally on Friday made sense. Additionally, the record short in 10-year Treasury futures will likely mitigate any dramatic increases. In framing the 10-year, the range looks to be 2.20% to 2.40% and the path of least resistance appears lower toward the bottom of the range.
The curve finished on Friday with most relationships flattening. The spread between 2-year and 10-year Treasuries dropped by 3 basis points, finishing the week at 181 basis points. With the recent move we have the potential to see some steepening over the next several weeks. The upper end of the range looks to be 190 bps and this is a likely target.
As we close the week, the markets remain mixed and stimulus still seems to drive investor sentiment. The slightly better U.S. employment picture and the drop in energy prices are promising. History suggests we could see positive benefits tied to a politically split government but there are enough differences where this time could be different. However, valuations and risk are entirely different than they were in 1994. True to Karr’s epigram we are likely to experience more of the same even with the historic shifts that occurred last week.
Sean Fallon, CFA, is Senior Vice President of Stephens Inc. He joined Stephens in July 2012 to head the Municipal Taxable efforts and to trade CMBS, Agency CMBS, and ABS. He has 19 years of experience managing and trading fixed income assets.