MidWay, the End, or the Beginning?

America’s midterm elections are not unlike local elections and by-elections in the UK and European elections across the EU – an often-dull event met with low turnout, but that nonetheless provides an important check on public opinion, guards against complacency by the incumbent power and helps to refresh the bloodline of politics (perhaps less so in the gerontocracy of American politics).

In this context, Republicans should bear in mind that in recent years local elections (UK) and EU polls) have proven consequential. An expected poor showing in last May’s local elections was reason enough for the Labour party to jettison Keir Starmer, while Emmanuel Macron’s foolish decision to call a general election following a weak result for his coalition in the 2024 European elections, sapped his government(s) of power and credibility.

In the US, the mid-terms have at times been fateful. In the November 5th, 1946, midterms John F Kennedy, Joe McCarthy and Richard Nixon all entered politics. In an echo of the debate on poverty in San Francisco today, and the Californian billionaire tax, the 1934 California gubernatorial election saw the Democrat Upton Sinclair (he was closer to a Democratic Socialist in today’s terms) launch a campaign entitled ‘End Poverty in California (EPIC)’. Business and landowners didn’t like this, and the movie studio bosses set against him and they spurred an attack campaign against Sinclair using fake newsreels. Upton lost to a colourless Republican in what was likely the first ‘fake news’ political attack campaign, but most certainly not the last.

In three weeks’ time, Americans will vote in a consequential midterm roster of votes. As I write, polls and prediction markets point to the potential for a Democrat upset in the Senate (65% probability). The House of Representatives already appears settled – the Democrats need three more seats for a majority but look like they might take up to ten. In the Senate, polls suggest that the Democrats will hold most of the contested ‘Blue’ states – Jon Ossoff will for example easily win Ohio. Then, it looks likely that we will see upsets in Alaska, Maine, Texas, Ohio and maybe Kansas. Since 1861 there have been 29 Republican Senators representing Kansas and only 3 Democrats, the last being in 1932.

As such, a swing to Democrats in Kansas would be emblematic of a major upset, and here there are many things at stake. The most obvious is that the midterms are a referendum of sorts on President Trump, the economic spillover of his war on Iran, growing financial polarisation and the conduct of politics. A very important consideration in the context of manifest corruption (recall that President Trump has promised USD 5,000 to Americans if his party is successful in the midterms) is the role of the democratic system as a check on executive power, and in this context a resolute vote against the President’s party and its many ill-chosen candidates, should be accepted as a sign that American democracy functions.

The midterms will also prove a steer for the next presidential election. A poor showing for the MAGA Republicans will surely dent the chances of the likes of Marco Rubio and JD Vance in 2028 and encourage the likes of Mike Pompeo and David McCormack. On the other side, if the likes of Abdul El Syed in Michigan are victorious, such a result might embolden the Democrats to present a Democratic Socialist presidential candidate in 2028 (a mistake in my view).

Into 2027, a Democrat held Senate might tilt policy in several ways. First, there may be an attempt to impeach ‘War Secretary’ Hegseth, granted the number of Republican Senators who disdain him and even, a move to impeach the President. It is likely that the Democratic Congress would seek to draw in the reins of American foreign policy, and potentially the rapid accumulation of debt by the President though it is hard to find Democrat fiscal hawks. In this regard, a potential market reaction may be a rally in Treasuries should the Democrats enjoy a successful mid-term campaign.

They are also likely to want to slow the build-out of data centres, and AI infrastructure in general, which as an economic activity is dwarfing activity in other sectors – be they manufacturing or construction, and has become a major focal point in state-level elections. Naturally, the emergence of such a policy across Congress would dent the speed of AI infrastructure build-out, which itself may not be a bad thing. But, the financial upshot is that a Democrat win in the Senate (and House) may be the catalyst to trigger a significant shift from US equities to bonds, and the President may well blame them for any resulting market volatility.

When the dust settles on the midterms, the 2028 presidential race will start.

Have a great week ahead, Mike

Ulysses, Opium and Electric Vehicles

Trade wars can have long-running, unintended consequences. The Smoot-Hawley Act of 1930, widely regarded as a catalyst to the Great Depression, contained a clause (section 305) that permitted the banning of obscene materials, a classification that (in the US) covered James Joyce’s Ulysses. Joyce’s publisher, keen to sell the book in the US, brought a test case under the Smoot Hawley Act (United States vs. One Book Called ‘Ulysses’), and the resulting verdict that the book was not ‘obscene’ made Joyce’s text a bestseller in the US and changed American obscenity laws.

A more serious case was the consequence of the Opium Wars, which ended with Hong Kong ceded to Britain, and began what China recalls as its ‘century of humiliation’, a perspective that still colours Beijing’s view of the West. In 1997, Chris Patten presided over the handover of Hong Kong to China, and in 2020 the introduction of the national security law drew Hong Kong legally, institutionally and politically back to China, with little protest from the West, and in my view, this is the defining event that marks the end of globalization as we knew it.

A key institution in the process of globalization was the World Trade Organisation (WTO), which in its early incarnation as GATT (General Agreement on Trade and Tariffs) enjoyed strong leadership under Peter Sutherand and later Pascal Lamy, but is now defunct.

Beyond its trade agreement rounds, the most consequential event for the WTO was the decision to admit China in 2001. The move was approved by President Bill Clinton at a time when there was an uneven power balance between the US and China and, at the time, Clinton described China’s economic relationship with the USA as ‘the equivalent of a one-way street’ (arguing that it was a highly attractive opportunity).

The trade, manufacturing and financial relationship between China and the West formed the basis of globalization, and it is the evolution of China from a provider of cheap labour into an economic powerhouse, together with the failure of the West to hold it to the terms of WTO, that has led to the breakdown of globalization. Indeed, many expected that the second Trump presidency would pick up where the first one left off, with a hostile trade stance on China (in 2018 Marco Rubio released a very hawkish report on China ‘The World that China Made’).

Now, Europe rather than the US, may be the one to pick a trade fight with China.

China’s growing prowess in technology, intense domestic industrial competition, coupled with large quantities of state aid for ‘champion’ firms, and the need to replace a deflating real estate sector with a manufacturing boom, have created a surplus in/of manufactured goods, which China has opportunistically dumped on the European market (known as the China shock 2.0), to the consternation of auto manufacturers, chemical producers and pharmaceutical firms in the EU.

Until very recently, the EU has permitted this to continue, for at least two reasons. The first is that EU trade policy is very product-focused in terms of its corrective measures, and the second is that there has been no strong consensus amongst the large European countries on how to deal with China. For example, in his 946 page memoir “La diplomatie n’est pas un dîner de gala’ (a play on Mao’s line that a revolution is not a dinner party) the former French ambassador to China, Claude Martin states that the lack of a coherent, watertight view on China by the EU (with policy measures to support), meant that China could divide and conquer across European capitals.

That is apparently changing. In recent weeks, commentators and industry bodies in the major countries, notably France and Germany, have been striking a bold and hawkish note on China, and this much was reflected in a major development with the issue of a letter by French and German presidents to the EC president, where they call for a much tougher stance on China.

In my view, there are three mistaken elements in the French/German stance, a lamentable view of Europe as the victim, a lack of urgency to get European industry to reform and become more competitive (notably few of the Draghi recommendations are in place), and third, the lack of an even more aggressive view on China in the sense that its economy may be even weaker than many think.

Diplomatically, the move is being presented as a ‘conversion’ by the two governments, each led by intensely unpopular figures (Macron’s ratings are at an all-time low and Merz’ is not far behind).

There are two elements to note in the letter, which aims to protect key European industries such as chemicals, pharmaceuticals and autos in particular. The first is a diversification instrument that will safeguard supply chains from over-reliance on Chinese goods and inputs, and the second powerful measure aims to exclude Chinese companies (China is not mentioned in the document but the sense is that it is very much the target) from the EU market where trade dumping produces severe and systematic distortions. The implementation of such a measure could be rapid and would need a majority of EU states to block it.

EU trade commissioner, Maros Sefcovic spent last week in China, trying to extract a commitment from Beijing to limit the flow of Chinese goods to Europe. My sense is that the polite apathy that greeted him (as I write there is talk of an agreement on are earths) means that China has little intention of striking a reliable deal, and that a trade confrontation between Europe and China in early 2027 is something European businesses need to prepare for.

Have a great week ahead, Mike

Reincarnation

In the coming weeks we will likely hear James Carville’s name more often. Carville earned his fame as political adviser to the Democrats (his wife Mary Matalin was an equally famous Republican adviser), and is known for his pithy advice, having told the Clinton Democrats that ‘It’s the economy, stupid!’, and recently counselled them to ‘play dead’, whilst the Trump Republicans continue to make mistakes.

It might be expected that Carville will become sought after for his views on the forthcoming mid-terms, but it is more likely we will hear him quoted in relation to the bond market. In the context of mostly dull economists, journalists in need of a good bond market quote turn to Carville who stated that ‘’I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

He said it in 1994, when US bond yields had pushed out to 8%, forcing Treasury Secretary Robert Rubin into a four-year deficit reduction programme – built on a rare moment of constructive bipartisanship – that halved bond yields and eventually produced a budget surplus. That kind of policy foresight, bipartisanship and political leadership is rare today; what endures is the bond market’s reputation as a powerful, intimidating beast.

Today, the bond market is back, and it is intimidating investors, governments and soon, the public. For all too long, bond buying by central banks had a soporific effect on bond prices, dulling them to the rising fiscal risks that have now enveloped most of the major economies. A couple of years ago we compared the effect of central bank liquidity to the storyline in the Danish film ‘Druk’ (which I recommend) where a group of teachers experiment with a permanent state of tipsiness. Central banks are now withdrawing liquidity, bond markets are sober and alive to the world and are pointing out various truths.

The first of these is that the ‘debt purgatory’ has commenced, precisely when the US Treasury Secretary made a series of failed interventions in currency and bond markets, demonstrating – in the spirit of Carville’s quote – that the bond market is more powerful than the government. In that respect, a threshold has been crossed where finance ministers may no longer be able to run near record deficits (in the context of economic expansion) and gargantuan debt levels. Scott Bessent, who has displayed a fetish for controlling market prices, may soon need either to start trimming spending, or to raise taxes (unlikely).

In France, the debate on the budget starts in earnest next week, in the context of the highest spread between French and German bond yields since 2012, and the woeful performance of the CAC 40 (in the past three years the Spanish and Italian stock markets have outperformed it by close to 90% and 75% respectively). To that end, debt, deficits and bond markets will dominate politics. For example, a recent Institute of International Finance (IIF) shows that the US spends more on interest payments (4% of GDP) than at any point in the last thirty years. In that context, it is likely that bond markets may only be calmed when governments make a serious effort to mend their finances, and when central banks enact further rate increases. This will prove to be a tough run into and beyond Christmas.

The second germane element of the rise in bond yields (which are only returning to their 150 year averages), is reflexivity, a word coined by George Soros to describe the ways in which moves in asset prices can cause effects in the real economy (and in other asset prices).

Higher bond yields should curb risk appetite and slow the economy. In previous economic cycles the thinking was that higher bond yields led to higher mortgage rates and thus a sluggish property market. The difference today is that many of the ‘Baby-Boomer’ generation have paid off their mortgages, or locked in mortgage rates at low levels, and the US middle-class has never been wealthier, and less rate sensitive (for example a new book ‘The Everywhere Millionaire’ by Owen Zidar and Eric Zwick traces the origins of the wealth of the 3 million Americans with over USD 25 million in wealth each and this effect is evident through the rest of the US wealth pyramid).

In other areas, the reflexive effect of bond yields may just be beginning and is already manifesting itself in the very riskier reaches of the corporate bond market (high yield/CCC rated bond yields are rising) and may soon take its toll on cyclical commodity prices (copper and oil).

The puzzle, optically at least, is that US equities have not registered the rise on bond yields. However, within the equity market, the many stocks have been weak over the past month (for example household ‘names’ Goldman Sachs and Boeing have fallen close to 20% since mid July) but headline indices have been kept higher by the small number of mega-cap AI related stocks (Intel, NVIDIA). Unlike US households who have in general been deleveraging, the AI complex is busy piling on debt. A sign of this is that UBS recently initiated a new publication, the ‘AI Debt Financing Monitor’. Experience tells me that the initiation of publications that herald the arrival of new asset classes is always a warning sign. To that end, the time to buy bonds is when yields rise to levels that brings hyperscaler debt raises to a halt.

Have a great week ahead, Mike