Top of the Morning: Election Watch - Unified government at a crossroads

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves Podcast Channel. For today, we will highlight the Election Watch coverage from the UBS Chief Investment Office leading up to Election Day in November.

For today, spotlighting the report from the UBS Chief Investment Office, Unified Government at a Crossroads, this report is available now up on UBS.com slash election watch. In addition to covering an update on the midterms, we will spend some time today reflecting on the recent U.S.-China summit, as well as the ongoing U.S.-Iran war. Joining me for the conversation today, glad to welcome back to Top of the Morning, Kurt Ryman, head of Fixed Income Americas from the UBS Chief Investment Office.

We have with us as well, Shane Lieberman, Senior Governmental Affairs Advisor with Governmental Affairs U.S. here at UBS. So with that, Kurt, Shane, a lot to cover, though it's great to have you back here on Top of the Morning. Thank you for dropping by and for spending some time today with our listeners and their clients.

Good to be back together with both of you. Thanks. Thanks, Dan.

Good to be with you. So as mentioned, a lot to cover, and we will spend some time on the U.S. midterm elections a bit later in the conversation, though to begin, the timing of our conversation works well to reflect on last week's highly anticipated summit in Beijing between President Trump and President Xi Jinping. A lot to unpack, though, Kurt, to begin, can you highlight for us some of the economic takeaways from the summit?

Well, Dan, I'd say first off that expectations going into the summit were pretty low. So in that sense, the fact that there were so few takeaways wasn't really a negative surprise. Really important to the administration is agreements on purchases.

And in that sense, China's commitment to purchase $17 billion of U.S. agricultural products each year through 2028 was, I think, substantial. That's small when you think about the overall U.S. agricultural output. A lot of that, of course, is domestic.

But if you think about the share of this to U.S. ag exports each year, it's pretty sizable. It's about 10%. And it also comes at a time when U.S. farmers are reeling under a cost-price squeeze from the Iran war.

I guess next I'd say there was, you know, whether there was an agreement, I guess, maybe, that are on, you know, rare earths, or whether China agreed to purchase aircraft and parts. I guess that's open to interpretation, depending on where you get your news. Both sides shared slightly different readouts from the talks.

I would say that, you know, the desire that was announced on preferring stability on bilateral trade policy is nice. It may be wishful thinking. I guess we could already say that coming into the summit, the two sides have already reached something of a stalemate or a detente on trade.

If you look at the U.S., they're conducting or have concluded multiple Section 301 investigations that could be used to target China. But then on the flip side, it's been already demonstrated that China has, it can leverage its supplies of rare earths and export controls if ever the U.S. were to ramp up or escalate. So stability is always desirable on trade, assuming it is a sustainable relationship.

They've already reached a detente. Let's see how that holds up. And then lastly, I would just say that maybe in the category of disappointments, though it's hard to say, I mean, investors may have had high hopes that there would be some agreement or that China would agree to apply pressure to end the Iran war, try to restart the free movement of ships to the Strait of Hormuz, but there was really little of substance announced that would imply a more rapid resolution.

So that would be, I think, clearly in the disappointment category. A lot there on the economic front, though Shane, as Kurt alluded to, a lot of geopolitical implications of the summit as well to be mindful of. So what are some of the geopolitical takeaways from the summit you can share with us?

Yeah, this is really interesting. For the summit, you know, there have been high tensions between China and the U.S. And so this, to borrow a word from Kurt, brought some stability to the relationship.

You know, don't forget Xi and Trump have had a regular meeting in the first term of Trump. And so they are two people who are familiar with each other. And I think they know how to work with each other.

And so this was a positive step forward. But to Kurt's point, you know, there were no huge breakthroughs. And as Kurt mentioned, you know, the takeaways were kind of different from side to side.

You know, the U.S.'s press release afterwards, you know, pointed out that, you know, China agrees that Iran should open up the Strait of Hormuz and agrees that no toll should be charged for vessels going in and out of the Strait. And so, you know, you're seeing some positioning and trying, the U.S. trying to leverage China in its greater geopolitical goals. And that focus right now would obviously be Iran.

But also I think what's notable is that Russian President Putin is going to China after Trump. So that's kind of a very interesting one-two punch, if you will. And so I think I'm going to follow the news of how the China-Russia meeting goes, because you may see some contours of Trump influence on that meeting.

We'll have to see. But, you know, I think Trump came away pleased with this visit, understanding that he's not going to get everything he wants. But this is maybe a small building block.

As Kurt noted, you know, China resuming buying U.S. beef and poultry is notable. It's been a sticking point for several years now for the U.S. and brought a lot of frustration over the years. So I think that is a small window opening that is helpful, along with, you know, the potential buying of Boeing airplanes.

So I think this is a building block. But I'm very interested to see how China plays with President Putin and also how they interact with Iran. Don't forget, China purchased so much of Iran's oil that they could be a leverage in Iran.

So, you know, interesting summit that I think you can't grade it today. You have to watch the long-term changes, if there are any, and how big those changes are. So sticking with geopolitics and getting specific to the U.S.-Iran war, which is ongoing, as we're recording here on Tuesday, May 19th, Shane, it does appear that the U.S. and Iran are at a diplomatic stalemate of sorts.

So how might this all evolve in the days and weeks ahead? Yeah, about 24 hours ago, President Trump said he was going to launch a series of attacks on Iran today, Tuesday. And then, you know, yesterday afternoon, he pulled back saying, you know, the Gulf states, you know, asked for more time.

And so you see, you know, a very Trumpian way of negotiating kind of in the public and then pulling back, which he's done several times already with respect to Iran. I think you are seeing the Gulf states that surround Iran and share borders getting frustrated and are going to be pushing hard behind the scenes. And I think President Trump is giving them a little bit of leeway to try and be the facilitator here in some kind of peace agreement.

But you know, I think another day without military attacks is a positive step, although, you know, we shouldn't fool ourselves and think that there's going to be a resolution on this within hours. I think there's still some time ahead where maybe there's a verbal agreement and then, you know, another month or two just to sit down and hash all the details out. So I think you'll see maybe some patience is still this keystar hold for a little bit and hopefully that will yield.

But you know, I'm not optimistic that that happens, you know, within this week. And Kurt, as we continue to track these developments, we're of course mindful of the U.S. and global economic impacts of the conflict. Consumers have been feeling the impacts of higher energy prices at the pump.

So Kurt, to what extent has this conflict impacted U.S. economic activity as well as global? Globally, it's having the obvious effect of having a one-time increase in inflation. It's unclear whether that will lead to higher inflation expectations, whether it will pass through from broad measures of inflation into more narrow measures.

And that hinges a lot on what central banks do, if anything. The markets have repriced for central banks to get involved. And so we've had a pretty incredible move in Fed funds futures this year from expecting three cuts in 2026 to now pricing in a full hike.

Globally, central banks are now positioned for raising rates. And when you look across the yield curve, you have inflation-adjusted rates. So just take your nominal rates, subtract out inflation, and you have real yields that are positive but shrinking.

So it's interesting. The U.S. has had a different experience. The level of pain is sort of related to whether you're dependent or a net exporter of energy.

And the U.S. is a net exporter, a larger exporter. Oil prices that remain high for a while starts to incentivize increased production. And oil prices have to be expected to remain at a higher level for that production to actually take place.

So we're seeing that something of an offset. And then the tax refunds and the lower withholding rates started to kick in from the 2025 legislation right around now, you know, April, May. So a well-timed fiscal boost to somewhat offset the higher energy costs that consumers are paying.

So for now, the U.S. economy is holding up well. Net exporter of energy, timed, well-timed tax refunds to help alleviate the pressure of higher prices. But the longer this goes on, the harder it is to sustain.

It starts to become a larger drag on consumers the higher oil prices go, the greater risk that high oil prices lead to low oil prices through the destruction of demand. So really critical to this whole estimate of just how much pain is the economy facing, what will central banks do, hinges on Shane's points about timing of some sort of resolution to reopen the Strait of Hormuz, get ships moving again, get products out of the region and ships back in to start moving, because that is the, you know, that is the ultimate chokehold. And I guess I also want to point out that other areas of the economy in the U.S. that we're already generating or helping to contribute to growth, say, for example, AI infrastructure investment, that's still moving unabated.

Now economic conditions coupled with these fluid geopolitical developments could very well influence voter sentiment comes Election Day in November. The U.S. midterm elections, Shane, at this point just a few months away, and we've been monitoring redistricting efforts across many states in an attempt to deliver an outcome for both parties in November. Shane, can you share with our listeners an inventory of these redistricting efforts, including what's perhaps ahead of us?

And what outcome in November are polls pointing to today? Put another way, what is the probable outcome at this point? Yeah, it's been a rollercoaster ride on the redistricting front.

You know, there is obviously the first domino was Texas, which then got California involved. One of the biggest moves by the Democrats was the redistricting that took place in Virginia, where they probably were going to net four seats. However, the Virginia state Supreme Court overruled that.

And so they're back to the old map. And that was really a gut punch to Democrats. And you know, because Virginia's actions spurred on other states like Tennessee and gave some further fuel to Florida Republicans to push for their changes.

So a number of states have changed. I think at times it looked like Democrats were going to win the redistricting wars. Now it actually looks like Republicans are going to win the redistricting wars.

And they're still not done. You know, states like Louisiana may still try and redistrict. I think Missouri was just polishing off their changes.

So a number of states are involved here. And I think, you know, when you add it all up, it appears that Republicans are on track to net six to 10 seats from redistricting. However, does that mean that they will necessarily hold power in the House?

No, I think that the dynamics of the election are still in Democrats' favor. So you know, this may stem the bleeding from Republicans and may help prevent a landslide election. But I think the way things are still shaping up, you know, with the Iran war and rising prices and affordability being a real buzzword for voters, I think, you know, Democrats are still in favor to win the House, even though redistricting at this moment looks like a Republican's one knack out.

Kurt, mindful of the probable outcome as it stands today of the midterm elections, what could be the policy and market implications of that outcome? Well, there's a lot and we don't have time for everything. But I will say that we've done some pretty robust work historically trying to look at all sorts of different trends, how markets perform in the various years of a presidential election cycle, carving up the constellation of power within D.C. between united government or a united versus divided Congress, divided government, and just to try to see what happens in financial markets.

Are there any observations that we can make? And there are some of them I would maybe, you know, I would pour some cold water on, take with a grain of salt. Others maybe provide a bit more signal.

You know, year two in an election cycle tends to be one of the weaker, still positive, but one of the weaker years for stocks. The year two, though, if we go back to, you know, 2022, 2018, you know, the Fed was raising interest rates. We had tariff noise unsettling the markets back in 2018. 2022, the air was still coming out of the dotcom bubble.

So a lot of times you can find macro considerations that happen to be driving markets during that year two, independent of the political cycle of year one, year two, year three and so forth. We do see that in a large number of observations that stocks do better under united government, which cuts against that old adage of gridlock is good. This idea that policy continuity is better for stocks.

Actually, during divided government, stocks perform generally in line with long run averages, but they don't do as well when you see when you compare it to when there's united government, like under the past couple of years. So this this shift that Shane is mentioned is important. We we have to think about it.

So, you know, one one idea, though, that we've been that we've been noodling on is this idea that next year the debt limit reappears. So that was that was back in the twenty twenty five legislation. They they raised the debt limit.

We're now going to revisit that and it'll be in play for, you know, for a tool or a cudgel to get, you know, some to extract some sort of a concession. It seems pretty likely that if the Democrats take one or both chambers, we could see an effort to either delay or postpone or or outright, you know, remove most likely delay. But these spending cuts that that were driving towards Medicaid and supplemental nutritional assistance programs and others.

So delaying those, pushing that down the road in exchange for, let's say, higher defense spending may mean that we don't have the expected fiscal drag next year and into twenty twenty eight. So good news for the economy, bad news for fiscal discipline, bad news for deficits. Potentially some volatility around, you know, around the debt ceiling, volatility around passing a budget, maybe another series of government shutdowns.

But ultimately supportive in the short run for the economy. And then when you mirror that with or mix that with some of the other positives that that matter, you know, we've we've been we just came out of a tremendously good earning season. If that continues, earnings hold up.

AI investment, the productivity cycle still good for stocks. I would say on the bond side, you know, we've had some already repricing of higher yields around the risk of higher inflation, you know, shorter term yields look really good here in our view, especially if the Fed cuts instead of raises rates. And then we would just be mindful still, you know, of the risk that you take of moving out the yield curve just on some of these issues of fiscal sustainability, inflation expectations, all that we've talked about on today's call.

You know, ultimately, I'd say that the fundamentals really are what drive financial market outcomes. But there's this dance between fundamentals and policy. They matter for one another.

They communicate back and forth. And I would say on that point, you know, here we're talking about AI being at least the investment angle and the productivity benefits being supportive for stocks. We should expect that in this midterm, but especially in 2028, AI is going to feature much more prominently on the policy front.

Something that, you know, both sides of the aisle have a certain degree of fear about the future. And so that's likely to, you know, be a big part of the future. And I think that's going to rally at least some interest in how is it managed.

So to be continued, something to definitely follow closely. Well, Kurt, Shane, thank you both for dropping by top of the morning. Very productive conversation as we covered a lot of ground for our listeners and our clients.

And I do look forward to continuing the conversation with you both in the months ahead leading up to Election Day in November. I thank you again for dropping by. Thank you, Dan.

Again, today, we've been joined by Kurt Reiman, head of Fixed Income Americas from the UBS Chief Investment Office, as well as Shane Lieberman, senior governmental affairs advisor with Governmental Affairs U.S. here at UBS. And again, I do want to point you, our listeners, to the ongoing Election Watch series leading up to Election Day in November. Today, we highlighted the first report, Unified Government at a Crossroads, which again is available for you at UBS.com slash election watch from UBS Studios on Dan Cassidy.

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