October 14, 2020

The US enters the latter stages of a contentious election cycle

Rarely has an US election been as contentious and filled with hyperbolic rhetoric as the current one. The US partisan divide has widened since Donald Trump’s victory in 2016. Americans are already fatigued from COVID-19-induced shutdowns and civil unrest across the country. The political climate has only exacerbated these tensions.

 

Given the dramatic statements and posturing by both parties, it has been challenging for investors to parse the “noise” and work out the realistic economic and policy outcomes. The Democrat camp, led by Joe Biden,promises a return to civility, trade relations resembling the pre-Trump era, and government as a stabilizing force in America — albeit with higher taxes. President Trump says that if given a second term, he will finish what he started, which is an ”America First” platform of deregulation and low taxes — all focused on domestic economic growth.

Summary of our views

  • US presidents are constrained on domestic policy, due to constitutional checks and balances. This is particularly the case when at least one house of Congress is in the hands of the opposing party. There is greater potential for change if the White House and both the House of Representatives and Senate are controlled by the same party.
  • The consensus appears to be that a Trump victory would be better for equity markets. Tax policy would be favorable from the market’s perspective, but advantages arising from that may be counter-balanced by more limited fiscal stimulus and uncertainty over his trade policies.
  • A Biden victory has the potential to weigh on equity markets in light of higher income and investment taxes, a rollback of the 2017 corporate tax cut, an increased regulatory burden and more active anti-trust actions. However, the potential for more fiscal stimulus could overcome some of the economic fallout of COVID-19.
  • Perhaps the biggest risk for the market over the short term is the situation if there is no clear winner, which could result on a period of prolonged market volatility.
  • The first priority of a Biden administration would be to pass a substantial fiscal stimulus/COVID-19 relief plan. With a Democratic sweep, this could total $3 trillion. The potential stimulus would be vastly smaller if Republicans hold onto the Senate.
  • Biden has proposed partially reversing the 2017 corporate tax cut. He would also raise taxes for higher-income households, including lifting dividend and capital gains tax rates. Even if Democrats control the Senate, Biden might need tone down his proposal to some extent to get the support of more moderate Democratic senators.
  • Both candidates have indicated an intention to increase trade restrictions to protect American workers, which would be a negative for business and markets in general. Biden, however, would likely take a more multilateral and predictable approach.
  • As the 2016 election showed, the equity market can react unpredictably to political outcomes. Volatility could increase as the election approaches and the market factors in potential policy changes.
  • We believe that a typical investor should not take significant portfolio actions in advance of the election. Hedging equity exposure is an option for investors with a low risk tolerance or sensitivity to year-end valuations, but buying put options around the election is likely to be expensive.

An election attracting unprecedented attention

Following the 2016 elections, the US entered a period of above-trend economic growth, which was reflected in the financial markets. The backdrop to this was a tumultuous political environment, which still persists today.

 

Investors have enjoyed a strong stock market rally during President Trump’s four years. However, a large part of America is asking “At what cost to society?” The divide between political ideologies is significant, as the parties have moved further left and right respectively. Democrats are arguing that higher taxes and a more equitable support mechanism for the middle class and disadvantaged is necessary. 

Figure 1. Equity, bond and currency markets since President Trump took office   

Figure 2. Cost of one-year put option on the S&P500 protection beyond 20% loss

The price of a one-year put option on the S&P 500 remains elevated, as shown in Figure 2. Of course, COVID-19 plays a big role in this, but options around the election tend to price in high levels of volatility. That, in itself, is a signal of the level of market uncertainty.

 

With mail-in voting being scrutinized and possibly litigated, as well as any number of other challenges to an outcome, it is possible that the results may not be ratified until after the New Year. A challenged and drawn-out election result could lead to prolonged uncertainty. 

 

The post-election landscape

Polarization in the Houses of Congress will be a challenge for either candidate; gridlock is viewed as providing de facto stability, as contentious legislation will not get through. The president can use executive orders and regulatory agencies to sidestep Congress, but significant changes would be difficult to enact in this way.

 

Aspects of the Biden agenda could be viewed more positively by the market. Democratic control means there is the potential for more fiscal stimulus, for example, while trade policy would likely be less confrontational and more predictable. Biden would probably have to compromise on his tax proposals to get it through a Senate with only a narrow Democratic advantage, though. If Biden wins and Republicans keep the Senate, the existing tax structure could remain in place. However, there would be a higher risk of a premature end to fiscal stimulus, more so than if Trump prevails.

 

A Biden presidency would probably offer significant domestic programs, specifically targeting social inequalities. He has also indicated he would expand financial relief and assistance to states and municipalities, which would have a stimulative effect on the economy, while also being favorable to markets.

 

Should Trump prove victorious, there is a high likelihood that Republicans will control the Senate but not the House, which will make it difficult for Trump to implement his agenda. Markets cheered the corporate tax cuts during Trump’s first term, although his stance on China and other trading partners led to periodic periods of volatility. He has stated that his “America First” platform will remain in place if re-elected.

 

As we have witnessed over the last four years, the president has far more power in international relations and trade than on domestic issues. A Trump administration could continue its movement toward protectionist policies. 

Figure 3. Potential economic and market impact of selected policies 


Political climate and polls

The probability of a Democratic sweep in November has increased since early March. Polls and betting markets give an edge to former Vice-President Biden. The House likely will remain under Democratic control, and polls suggest a rising probability of Democrats also gaining control of the Senate.

Figure 4. 2020 Presidential Winning Party PredictIt, October 11, 2020

Figure 5. 2020 Presidential Election: House and Senate Control PredictIt, October 11, 2020 House (Solid), Senate (Dotted)

If there is a Democratic sweep, markets would like the prospect of fiscal stimulus and predictability, while opposing the potential for higher taxes. However, many investors agree that a “mixed government,” where the House, Senate and Executive Branch are not controlled by a single party, would be a favorable outcome because of the inherent checks and balances against too much of a pendulum swing in either direction.

 

COVID-19 has no political affiliation

This ”once in century” pandemic has rendered 20 million[1] workers out of work in the US and another 20 million1 furloughed and potentially unemployed. Large retail bankruptcies are occurring more frequently, thousands of restaurants and small businesses have closed permanently, and many more will do the same in coming months. The US Treasury is spending upwards of $500 billion[2] monthly on various economic supports. By any measure, COVID-19 has been the most disruptive event for society and the economy since WWII. According to the Bureau of Economic Analysis, US GDP declined by an annualized 32.9% in Q2.

 

A vaccine may be necessary for the economy to recover fully. Even those businesses that have survived will likely need additional support to remain viable. Millions of families will need significant financial assistance to avoid becoming homeless. The window for a ”V-shaped recovery” has passed. When the majority of the population feels safe to patronize businesses (to the extent that they are willing), an organic rebuild of the economy can begin. Until then, deficit spending will likely be necessary to maintain the economy.

 

Current dynamic

At present, the Republican Party has the majority in the Senate while the Democrats run the House of Representatives. Continued gridlock is certainly one possible outcome. Alternatively, one party being in control of all branches of government would provide a mandate for partisan policy implementation. Figure 6 shows the possible results and policy implications following the 2020 election.

 

Based on betting markets and polling, the most probable outcome is a Democratic sweep. If Trump proves victorious, however, Democrats will most likely retain control of the House.

Figure 6. Most probable election outcomes and policy implications

Impact for investors

The election is one of many factors that could impact the direction of markets over the next few months and beyond. We believe that Investors should avoid making portfolio changes based primarily on potential election outcomes as it is difficult to predict how the market might respond.

Biden victory

  • Potential for large fiscal stimulus plans if Democrats capture control the Senate, which would increase corporate profits.
  • Higher long-term inflation risk from aggressive fiscal stimulus.
  • Negative for the dollar.
  • Higher US tax rates, which could favor non-US versus US stocks.

Trump victory

  • Lighter regulatory burden and potential for additional tax cuts with a Republican stimulus.
  • Potential for modest fiscal stimulus.  
  • Protectionist policies leading to potential trade war would be negative for global economic growth and corporate profits.
  • Stronger dollar against emerging market currencies.

COVID-19 will be an ongoing issue for society, the economy and — by extension — investors. The range of factors investors have to consider makes the future uncertain but diversification and good governance will help with the challenges. We plan to publish further thoughts over the coming weeks.

Footnotes

[1] US Department of Labor and US Bureau of Labor Statistic  September 2020
[2] Congressional Budget Office  August 2020

 

 


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Ursula Niederberger, CEFA, CAIA
Ursula Niederberger, CEFA, CAIA

Global Strategic Investment Research

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