Post-midterm results support 2H rally... plus, if Republicans take Senate, even stronger Energy gains (despite conventional wisdom)

We are sending out the First Word Tuesday evening in lieu of Wednesday Morning due to Midterm Elections

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Equities have been mostly rising for the past 18 trading sessions following the abrupt reversal on the very “hot” Sept CPI (Oct 13). And markets are at an important crossroads this week — this week has two events with major implications for financial markets and the economy.

• Our overall takeaway is that the highest probable outcomes for the two events (Tues eve midterms – Republicans likely take Senate, and Thu October CPI – Core CPI likely comes below Street’s 0.5%) will support markets stronger into YE. Possibly by a wide margin:

• While the final midterm results may not be known for several weeks, betting markets (538 and others) favor Republicans taking both the House and Senate.
• If such a scenario emerges, we see inflationary pressures in the US falling for two reasons. First, future fiscal restraint means less inflationary spending. Second, we think Republicans will push back against the “climate change” agenda, and possibly support fossil fuel extension. And this means the “future oil risk premia” declines. Hence, less inflation risk.
• Since inflation “risk” is the singular issue, we see this as positive for equities. And since 1949, equities have performed best under a Democratic White House and Republican-controlled Congress (8 years 1995, 1996, 1997, 1998, 1999, 2000, 2015, 2016) since 1949. Average 12M forward returns are 16%.
• October CPI will be very important and consensus is looking for another “hot print” with some seeing YoY surging to 9%. This shows that many armchair economists simply draw lines on both growth and acceleration.
• Our best read is Oct Core +0.4% MoM or lower, which would be a major positive surprise. Especially after 2 consecutive months of Core CPI MoM >0.6%.
• This is why we see it as a “game changer” and the drivers being the Healthcare insurance, possible softening of shelter growth and core goods “payback”
• All in all, this keeps us constructive on stocks into YE. And we think this rally will rise further and last longer than the 23 trading day rally following June pivot talk.

MIDTERMS: D-R-R is good for equities

Already, many investors are talking about this. But look at the combination of market outcomes:

• since 1949
• when Dems control the White House
• Best equity returns are when Republicans control both House and Senate, which is what betting markets expect

There are multiple impacts of a Republican congress, but we think the most likely outcome is the risks of inflation upside are diminishing in the US. The reasons are simple as we noted above:

• Republicans likely change Energy agenda, especially clean energy
• Energy is the core of this global inflation story
• Republicans likely reduce financial support for the Russia-Ukraine war which also could hasten the end and that would lead to lower oil.
• Republicans will likely rein in fiscal spending, which reduces inflation risk
• This means future inflation “risk premia” should fall. Arguably, this is similar to seeing a drop in the implied Fed funds terminal rate.

And history shows inflation tends to be lower under a D-R-R split. As shown below:

• inflation under D-R-R is half at 2.3%
• vs 4.3% under D-D-D
• Is it any surprise we have high inflation?
• But we should not be surprised by lower inflation in the future

ENERGY: While investors say Dems are the best thing to happen to Energy, the Energy P/E can expand under Republicans

Many investors say Democrats are the best thing to happen to Energy stocks due to limiting production = higher prices. But there is a flip side:

• Energy stocks are 10% of S&P 500 net income
• But only 5% of the market cap
• The valuation is half the net income share
• Looks at the 1980s when Energy stocks % share of net income and market cap were the same
• We think a Republican Congress will close this valuation gap

In fact, as shown below, the 1980s and even late-2000s saw Energy market cap share far higher than the 5% today.

• investors are assigning low multiples because legislative agenda does not support sustained earnings
• and also assigns greater uncertainty to future oil price and demand
• thus, P/E are quite low for many stocks in the single digits
• but if the longevity of fossil fuels is seen, we expect multiples to expand
• this implies Energy stocks could see 1,000bp further outperformance vs S&P 500 over the next 2-3 years

STRATEGY: Equity rally is 18 days but further gains arguably ahead

We show the comparative gains of S&P 500 now versus the June 17 to August 16th rally (~20% gains).

• and this rally is tracking that one pretty closely as shown below

The VIX has fallen faster (lower chart) and the 2-year yields, massively influential on stocks, are behaving similarly:

• VIX lower means less expected volatility

Which ultimately why we see a stronger rally (vs June) ahead:

• two catalysts ahead including midterms and the October CPI
• Fed has become far more “predictable” meaning Fed is not rushing to raise, but looking around
• Financial conditions are easing and the stock market is the only “financial condition” to tighten post-FOMC
• we think this rally could exceed 20% before YE

And as Goldman Sachs noted earlier this week, the only financial condition to tighten post-FOMC is equity markets. In post-FOMC Fed talk by members, it is evident that many still see a case for pausing in early 2023. And if CPI softens as expected, this would justify a significant period of pause.

On midterms, the media in the meantime calls a D-R-R an apocalyptic event. See the headlines below.

According to the Washington Post article, if Republicans control both House and Senate:

• Stymie Biden’s agenda: not a surprise

• Hold up court vacancies: again, not a surprise

• A national abortion ban: Possible but Democrats in the Senate would filibuster it.

…CNN predicts “instability in our political system…to a combustible level”

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37 Granny Shot Ideas: We performed our quarterly rebalance on 10/19. Full stock list here –> Click here

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