Parsing recent asset price movements

Business Standard, 14 November 2022

The world economy has been in unprecedentedly difficult territory, with the incomplete recovery from the pandemic and Russia's invasion of Ukraine. In February 2022, the war began and the Fed started tightening, which derailed many economies around the world. Global financial conditions have been tight, with many central banks fighting off the post-pandemic inflation. This tightening kicked off difficulties in many asset classes, such as housing, cryptocurrency and tech stocks.

In this setting, it was surprising to see global financial markets fare well in the last week. A few important developments have come together, and we in India should think about their implications for us. While this is about looking back and interpreting the forces at work in the last few days, these ideas will also be important for asset prices worldwide, including in India, on 14 and 15 November.

The key period is from the evening of the 9th to the evening of the 11th in US time. The S&P 500 is the stock market index of the most important globally diversified corporations of the world. It went up by 5.5%. The VIX is the markets' measure of the future volatility of the S&P 500. This went down from 26.1% to 22.5%. The Merrill Lynch "MOVE" is the markets's measure of the future volatility of US government bonds with maturities from 2 to 30 years. This went down from 126.33 to 111.69. These are all substantial and positive moves over a short period.

What was at work, which has created all this optimism? One part of the story is inflation in the US. The combination of Fed tightening and normalisation of production has started showing gains. From 9.1% in June, inflation in the US has moderated to 7.7% in October. This is still far from the inflation target of 2%.

There was another positive surprise in the election outcomes in the US `midterms', where results came in from 9th onwards. What was widely expected was that extremist politics would succeed, that D. Trump would get the remote control on the Senate and the House, and many state-level elections would be won by people who are committed to undermining elections. If extremists controlled the Senate and the House, they would block every plausible legislation in an environment of polarised politics. In a dark world afflicted by populism and climate change, with actors like Russia and China, it looked like the US was going to retreat into internal strife.

This is not how it worked out. The Democrats retained control of the Senate, and extremist candidates generally lost. While the Republicans are likely to win the House, it will be by just a few seats. The elections were a rebuke to the Republican platform of anti-elite grievance, nationalism and assault on institutions.

The Biden administration now has a path to carrying legislations through, as the US does not have an anti-defection law. On any one legislation, the Democrats need support of about 10 Republican members of the house, and a process of negotiation will generate the give-and-take of normal politics. The Republicans who won have seen voters favour moderates, and are emboldened to do normal politics: of negotiations across the aisle that lead to compromises in all legislation as opposed to opposition parties that block all legislation.

These outcomes were quite surprising. Simon Schama in the Financial Times wrote American democracy surprises us all again, the Economist has an article After the midterms, America and its democracy look stronger, and David Brooks wrote The fever is breaking in the New York Times.

What are the implications of these developments for the behaviour of the US government, and thus for the world economy, and for India?

These results constitute validation for the pathways that were adopted in the last two years of the Biden administration. Whether right or wrong, we will get an intensification of those approaches, doing more of the things "that worked". As an example, while the Republicans signalled a more pro-Russian approach on Ukraine, the election results will embolden the authors of the response to the invasion.

There has been a great debate around the magnitude of fiscal stimulus and acceptance of high inflation in the US. Extreme inflation is always political, particularly for older voters who are living on fixed income. The Democrats ran on the proposition that the Republic was at stake, and that helped deflect attention away from failures on inflation. How will the election outcomes impact on debates around fiscal and monetary policy?

On one hand, the election results will be read as favouring more-of-the-same. It would be argued that voters accepted high inflation, that the administration was not punished for failing on inflation and fiscal excess, therefore dovish monetary policy in coming months is preferable.

At the same time, the framing of the election as a battle for liberal democracy was a unique setting. That framing might not persuade in November 2024. This would be an argument to push harder, to get the economy into good shape, with fiscal adjustment and much lower inflation by November 2024.

The election results give the Biden administration a spring in its step in international relations, in particular on Russia's invasion of Ukraine, on Chinese threats to invade Taiwan, and on the emerging `third globalisation' doctrine. There is an opportunity for India to obtain a good position out of these developments on questions of India as a platform for global production, on military modernisation, and on financial assistance for improvements in energy policy at the sub-national level on the lines of the `JETP' for South Africa.

The US is a particularly important country in the global non-system. From 2016 onwards, unexpected behaviour by the US government on many issues was one source of surprises. This created opportunities for authoritarians, and heightened risk in global politics and economics. The midterm election results take us closer to the pre-Trump environment, with greater stability and pragmatic problem-solving.

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