US Election: “Blue Wave” Market Thoughts

• “Blue Wave” likely to unleash historic deficit spending
• What will this do to the US dollar and what sectors will benefit?
• Stocks could pullback in the near-term if no relief money next week

There are just 24 days until the US election. 

Joe Biden appears to be well ahead – pending what polls you listen to. Then again, I remember Hilary Clinton was also “ahead” by a similar margin in 2016. 

Sometimes polls get it wrong.

But if the Democrats are destined to sweep the election with a “blue wave” (as the polls suggest) – and control the House, Senate and the Presidency (as Trump did in 2016) – we should expect a wide range of new legislation at velocity. 

For example, things like higher taxes, greater regulations and so on.

All things that Biden has campaigned on.

Whilst I’m not going to debate the ideology behind what higher taxes and greater regulations could mean (I do enough of that in other posts!) – I will spend a few minutes thinking about what it means for the market.

And from there – specific sectors and stocks. 

Big Government and Big Spending

The other day I said whilst I don’t think a stimulus deal will get done before the election (mostly for political reasons) – if the Democrats sweep the House, Senate and Presidency – then look for massive deficit spending in 2021. 

Today the Democrats are asking the Republicans for around $2.2 Trillion — down from their $3.0 Trillion ask a few weeks ago. 

The Republicans are countering with something around $1.6 Trillion (based on what I have read).

But if Democrats are successful on November 3 2020 – expect a stimulus bill north of $3.0 Trillion early next year. 

In other folks – stimulus is coming.

It’s just when (not if).

For example, Biden’s Economic Plan (straight from the Keynesian playbook) is said to include (perhaps not limited to):  

• $2-$3T Trillion tax increases on companies; and individuals who earn more than US$400K per year
• $2 Trillion infrastructure spend;
• “Build” on the affordable care act; 
• $2 Trillion climate plan (i.e., warning to the fossil fuel sector)
• $15 minimum wage (i,e., likely send unemployment higher as it’s more expensive for business to hire)

Whilst we can debate the merits of the plan – it would be short-term positive for the market.

But I would stress short-term here – as stimulus plans like this are a sugar-high.

For example, to repeat the bump – another injection of the same (or more) amount is required. 

Another side note here: 

Regardless of whether the market gets the stimulus before or after the election – the market believes they are going to get it.  

For example, if we look at the betting markets (which also correctly called Brexit and Trump’s “upset” 2016 win) – they are now calling a Democrat sweep. 

For those less familiar, the federal budget deficit was $3.1 trillion for the 2020 fiscal year, the Congressional Budget Office estimated this week. 

Congressional Budget Office

As I said yesterday – this is money which is borrowed from the future – money which is owed. 

Again, if Biden is successful, then look for this to completely blow-out next year to the tune of another $3 Trillion or more. 

And with rates at zero (or negative in real-terms) and the Fed saying they are not raising them through 2023 – then we should expect massive increases in debt. 

But here’s something else to bear in mind:

With Biden’s plan to include (at least) $2 Trillion in higher taxes on both business and wealthy individuals (those who earn more than $400K) – expect (tax) receipts to plunge. 

Here’s a good economic law to remember: 

Econ 101 tells us that if you make something more expensive – you will get less of it. 

For example, make taxes more expensive (i.e. raise them) – then expect less.

In addition, make labor more expensive (raising the minimum wage) – again expect less of it. 

Therefore, we need to expect the markets to react to that. 

Greater Deficit Spending is US Dollar Bearish

If my (bold) assumption of the Democrats deficit spending being in excess of $2.0T to $3.0T+ next year is in the “ball park” (and I think it will be) — then this will most likely be US dollar bearish. 

And when I assess the weekly chart – this is what market’s are pricing in: 

US Dollar – Oct 10 2020

As I have been writing the past few months – the US dollar is bearish. 

Markets are pricing in a massive stimulus (either before or after the election) which will be dollar negative. 

We did see a short rally from oversold levels (as I indicated) – but this was hit with expected resistance around the 35-week EMA (i.e., my labelled sell zone). 

Now if my forecast of the dollar continuing to face downward pressure – we need to look at what sectors and stocks are likely to do well. 

Sectors to Benefit from Lower US Dollar

A few months ago – I talked about the likelihood of a much weaker USD and sectors likely to benefit. 

Below is the graphic I shared at the time: 

Stocks to Benefit from a Weaker USD

In summary, think materials, energy, consumer discretionary, industrials and healthcare. 

My one reservation here would be fossil fuels.

And whilst a weaker dollar will help boost the oil price (and all commodity prices) — the problem with energy is the supply / demand equation. 

Furthermore, we have the prospect of an Administration coming in who are very much anti-fossil fuels (i.e. the “$2 Trillion Climate Plan”) — this will not bode well for energy stocks. 

That said, I do think there are other commodities (like copper), metals (silver and gold), materials and industrials could stand to benefit.  

Below is the updated weekly chart for the ETF XLB (Materials Sector): 

XLB – Materials Sector ETF – Oct 10 2020

Over the past few months – this chart has been the inverse of the US dollar. 

For example, within weeks of the US dollar turning bearish, the ETF took off to the upside (and continues to accelerate). 

I like this ETF whenever it pulls back towards the 35-week EMA. 

Let’s now take look at the Industrials ETF (XLI) 

XLI – Industrial Sector ETF – Oct 10 2020

The story is not as strong for the Industrial ETF – however directionally it’s similar. 

Note – you will see from the ETF sector graphic shared in my preface that the XLI does not typically perform as well as materials with a weaker dollar. 

Nonetheless – this is an ETF I would lean towards on a pullback – given the dollar is set to weaken. 

Two “Blue Wave” Stock Picks

First I will look at the metals and commodities space and then a possible transports play. 

1. FCX – Freeport-McMoRan Copper and Gold

Let’s start with the weekly chart to assess the trend: 

FCX – Oct 10 2020

Freeport-McMoRan has typically risen and fallen with the price of copper – however it’s gold operations should not be overlooked.

According to their latest report – FCX gets a $70 million boost to EBITDA with every $50 increase in gold.

A move from $1,400/oz to $2,000/oz provides an $840 million boost to EBITDA.

In the course of the last year, the copper miner has seen a huge benefit from the higher gold prices. The company now provides estimates of EBITDA reaching $7 billion in 2021/22 based on gold at $1,800/oz with copper at $3/lb

So let’s connect some of the dots: 

With the Democrats likely to win the election and blow-out fiscal spending – undermined by QE and zero-percent interest rates – I do think gold will find strong support at $1,850 and trade north of $2,000 in 2021. 

This amount adds as much as $840M+ to their annual EBITDA . 

And then add to that the likelihood of a higher copper price (again due to the low USD) – this would also boost their EBITDA by a further $700M plus. 

Look at FCX between $15 and $16. It has a lot of upside. 

2. Kansas City Southern (KSU) – Takeover Target

My second “blue wave” pick is a railway stock – and one that is reportedly a target for Blackstone Group and Global Infrastructure Partners. 

Kansas City Southern’s stock has been a tear lately – alongside other rail stocks.

KSU – Oct 10 2020

But before I look at KSU – it should be noted that the Dow Transports hit a new all-time high this week. However, “transports” fall into three buckets: (i) air; (ii) trucks; and (iii) rail 

I’m not a fan of the airline stocks (for obvious reasons) – but I do see potential upside for railway stocks. 

For example, September 2020 was the fourth best inter-modal month in history for U.S. railroads, as retailers and others restocked their inventories and prepared for the holiday season,” says AAR Senior Vice President John T. Gray

On a weekly basis, U.S. railroads recorded a marginal increase of 0.8% YoY to 518,761 carloads and inter-modal units for the week ending Oct. 3, 2020. 

Let’s talk a bit to KSU – and specifically the alleged takeover bid:

First up, management is said to have rejected a $20 billion, $208 stock price, takeover bid from Blackstone Group and Global Infrastructure Partners.

KSU stock is currently trading at $186 – which would represent a 12% increase on the current price.

What’s interesting about this bid is it offers a “template” on how the market evaluates railroads. 

For example, KSU’s trailing PE ratio appears high at 31x with a dividend yield of just 0.88%.

But here’s the thing: 

This is a zero rate environment. Therefore, your traditional benchmarks of say 15-18x PEs and higher yields of 2-3% are out the window. 

But second (and more importantly) the best way to evaluate this stock (and most established stocks for that matter) is its free cash flow. 

KSU’s operating cash flows have been around $1 billion over the last three years while the capital investments were constantly at around $600 million — which leaves $400 million in free cash flow

But looking ahead – that cash flow is likely to improve by about $200M. 

For example – based on its latest annual report – it’s not spending on new locomotives in the near-term and the restructuring program is already showing its benefits.

It forecasts its capex is likely to be around $400 million – which will allow for stable dividends and more buybacks. 

Net-net – this will allow KSU to buy back more of its stock – in turn boosting the share price. 

For example, let’s say they reduced their stock on issue by 10M units (from 94M to just 84M) – this would push the price north of $230 for a takeover (assuming Blakstone kept its bid at $19.5B)

In summary – keep an eye on this play as a trade on higher rail stocks.