“The only thing we learn from new elections is that we learned nothing from the old”
Proverb
The upcoming United States presidential election will be the 10th one I have experienced since I began my career in financial services in 1982. I can’t remember a single instance throughout those years in which it wasn’t labelled as the “most important presidential election of our life,” but I will admit that given the explosion of social media in the past decade, elections certainly seem to get more amplified and polarizing each time.
Elections create uncertainty, and as we all know, markets hate uncertainty. The president of the U.S. is the Commander-in-Chief of one of the largest military operations on the planet, and the U.S. economy contains some of the biggest producers and consumers around the globe, so who’s calling the shots with policy certainly has a significant impact.
The anticipation building up to elections often brings with it questions about how financial markets will react, given who wins the presidency and the other two branches of Congress, the U.S. Senate and the U.S. House of Representatives. According to a RBC Research presentation, Elections 2020: Key issues for investors – September 2020, the following key considerations are at stake to potentially affect the markets in the 2020 U.S. presidential election:
- Corporate and individual tax rates
- The Senate filibuster rule
- A major shift for U.S. energy policy
- Health care reforms, notably Obamacare
- Infrastructure spending with different priorities
- Regulatory changes
- China and trade policies
However, it’s important to remember that the outcome of an election is only one of many inputs to the markets – and it usually has more of a short-term impact. I’ve always said that some of the biggest long-term drivers of stock prices are Federal Reserve policy (notably interest rates) and corporate earnings.
If you look at the historical returns in election years, they actually tend to be second-best, behind the third year of a presidency:
The biggest item on the election docket right now is the COVID-19 pandemic.
I think it’s wildly optimistic to assume that this pandemic will be turned off like the flip of a switch, regardless of who wins the election – instead it seems more likely to dim over time. In the meantime, the economy, particularly in certain areas, is being decimated. It goes without saying that no president wants to preside over a flagging economy. The approach that seems to have been taken by the U.S. so far can be compared to trying to hold our breath underwater – eventually, we have to come up for air. Therefore, the next four years will largely be defined by how the next president navigates this ongoing virus crisis.
Typically, recessions have not been good to incumbents:
Does it really make a difference to markets who’s in the White House? Historically, the best scenarios have been either a total Republican sweep, or Democrats with a split or Republican Congress:
In that scenario, in terms of policy reform, it could be a continuation of what we have seen the last four years. On the tax side, the Republicans have floated an unspecified tax cut for individuals. In addition, there would be a potential tax credit for moving manufacturing abroad to America, with extra emphasis on bringing manufacturing jobs from China to the U.S. These firms would potentially be able to deduct 100% of expenses to hopefully incentivize the shift stateside. Within Trump’s second-term agenda, there would be a focus on lowering prescription drug prices and attempting to reduce insurance premiums. We’d also likely see a continuation of the tough stance against illegal immigration, a refunding for police services and continued deregulation of the energy industry.
According to www.electionbettingodds.com, the flip side shows the odds of the Democrats winning the presidency, the Senate, and the House at 53.1%, 54.4%, and 83.60% respectively. This works out to a 24.15% chance of a Democrat sweep. Out of any combination, a Blue sweep currently commands the best odds. However, some sort of split control would be the most likely at over 70%, given the 24% odds and 3% odds of a Democratic and Republican sweep respectively.
The policy shift under a Blue sweep would likely be significant, since there are barriers to implementing these policies. The Biden administration would likely look to unwind most of the tax cuts under the Trump Tax Cuts and Jobs Act. For instance, Biden has proposed raising the corporate tax rate to 28% from 21% (this was lowered from 35% to 21% under Trump). In addition, Biden would look to raise taxes on the individual side and to increase the capital gains tax for high-income earners to the ordinary income rate.
Biden would also look to expand health care coverage, and like Trump, look to lower healthcare costs. The Democrats’ platform would prioritize climate change via restriction on the energy industry and expansion in terms of pro-renewable energy policy. Overall, stricter regulation is expected across most industries, with this impact being felt most acutely among financials, pharmaceuticals and perhaps even technology. A Blue wave would be less restrictive on immigration, along with dialing back the Trump administration’s travel and immigration bans, reinstating protections for “dreamers” (or children brought into the U.S. illegally by their parents) and rescinding funding for a border wall. Finally, an infrastructure spending bill would likely get passed, which appears to have bipartisan support.
Source: Gavekal Research
In order to anticipate market swings, we must first do our best to understand current market expectations. Depending on the national poll, Biden holds anywhere from a 4% to 15% lead over Trump. Yet, important swing states are much tighter, and the electoral map is far from a slam dunk for Biden. In the Senate, the Democrats need to keep their current seats and flip three others from the GOP. Four races are seen as competitive for incumbent Republicans (North Carolina, Maine, Arizona, and Colorado). Meanwhile, the Democrats are fighting to maintain a seat from Alabama in a state where Trump won by more than 29% in 2016.
What are the most important issues (from an investment implication standpoint) the next president will face? There are many: tax reform, health care reform, more COVID-19-related regulations, a climate change agenda, infrastructure, a China policy, etc.
Other questions out there: What is the likelihood of a unified government and how will that impact future policy reform? Under a Biden presidency, how would this affect U.S. energy policy and our view towards both energy and renewable energy investments?
Many investors are counting on the presidential election to be a pivotal event for equity markets. This may be true in some areas, but as a whole, as I mentioned earlier, the effects of fiscal and monetary policy have different impacts. The stock market has returned 14.5% per year on average from 2009–2019, while over the same time period, workers’ wages have only increased 2.9%, meaning Wall Street and those who own assets (real estate, stocks, bonds, etc.) have seen a massive surge in wealth following the Great Recession, while the average worker has been left behind.
Should Trump be re-elected in November, the original “Trump trade” from four years ago will probably still remain in place. Which stocks could do well on the premise of tax cuts and deregulation? I would guess financials, energy and more broadly valued stocks should thrive.
However, a specific risk increases with a Trump re-election: the likelihood of a U.S.-China trade war.
The folks at Gavekal Research have outlined the various election outcomes, along with what they expect will do well / poorly in each possible scenario:
Source: Gavekal Research
The Biden trade, as stated above, hinges on the presumption of a Blue sweep. Biden’s proposed plan to raise corporate taxes from 21% to 28% is, and should be, one of any prudent investor’s major concerns. His policies would be bullish for publicly-traded pass-through tax entities, including REITs (which are not required to pay corporate taxes). If you examine how stocks have been moving this summer in response to odds increasing for a Biden victory, it’s telling. Relative to the market as a whole, technology, consumer discretionary, communication services and healthcare have all outperformed when the polls have favoured Biden. Meanwhile, financials, industrials and energy have all tended to move inversely. This scenario is the exact opposite of what happened after the Trump victory in November 2016, when cyclical stocks outperformed and defensive sectors (excluding tech) lagged behind. Biden’s platform contains multiple policies that could be described as business-unfriendly, such as tax increases and regulation, which can weigh on corporate profitability. However, this same approach is also likely to include additional rounds of fiscal stimulus. While there may be increased likelihood of a negative short-term impact on risk assets resulting from a Biden victory, it might also be short-lived.
Source: Gavekal Research
Regardless of which candidate wins, either will almost certainly be forced to face the reality of a growing wealth gap. One approach involves raising taxes on the wealthy, and Biden’s most recent tax plan seems to be headed in this direction. Another approach would involve antitrust regulations aimed at some of the tech giants. While the merits of antitrust regulation or higher taxes could be a separate newsletter on its own, the pursuit of either policy would likely not be welcomed news for the stock market. Further tactics to address the disparity in wealth could be an increase in the minimum wage, a universal basic income and a national infrastructure upgrade similar to Roosevelt’s WPA, or Works Progress Administration, a key part of his new deal.
Instead of focusing on who wins the election, investors are probably better to focus on how each candidate tackles the growing wealth gap, which in our view, is the real elephant in the room for markets.
I don’t currently believe the Democrats will be able to gain control of the Senate, leaving either presidential candidate with a split Congress. One bipartisan idea that will likely be implemented is a large infrastructure spending bill. From an investment perspective, this could lead us to look at cyclical companies that would benefit from such a package. Fortunately, many of these companies currently offer attractive valuations, especially relative to some of the high-flyers of the last six months.
If Biden wins the election and the Senate were to flip to the Democrats, I would anticipate a short-term market sell-off. The market would foresee higher taxes and increased regulations, which are not conducive to higher earnings. If victorious with a Blue wave tailwind, Biden will seek to increase spending on climate change mitigation, expand federal-funded healthcare and raise taxes on corporations and high-income earners. The initial investment implications of this scenario will undoubtedly focus on taxes and the negative business sentiment more regulation will bring. The longer-term scenarios to be weighed are almost certainly climate policy and energy efficiency, and the corresponding winners and losers that would be associated with changes in both.
Interestingly, as Biden’s polls improve, markets continue to rise. Markets usually respond to personal and corporate taxes, both of which would likely increase under a Biden administration, including taxes on capital gains and dividends, which directly impact investing in markets. If that were to include some financial transaction taxes, I can’t believe that would be a positive for markets. Those have the potential to hurt liquidity, which could hurt the transfer of risk in markets.
Here are the sectors of the economy that could benefit from a Biden win, according to RBC Capital Markets’ analysis in [Elections 2020: Key issues for investors]:
And here are the sectors that RBC Capital Markets notes may not benefit from a Biden win:
Source: RBC Capital Markets
In regards to potential tax changes, this chart from our friends at Fidelity Investments indicates that the stock market has oftentimes been able to see past tax increases thanks to many other economic factors. To wit, macro variables such as gross domestic product (GDP) growth, fiscal and monetary policy settings, inflation, bond yields, corporate profit trends and valuations have historically overwhelmed the influence of tax increases. According to Fidelity’s, Jurrien Timmer (presentation – October 5th, 2020):
“Taxes break down into 3 basic baskets: corporate, personal, and capital gains. Big increases are rare, only happening about 10% of the time over 70 years, amounting to just 23 instances among the 3 types. The last time all 3 kinds of taxes increased at the same time was 1993, followed by an increase in personal taxes and capital gains taxes in 2013.
“In the 13 previous instances of tax increases since 1950, the S&P 500 has shown higher average returns, and higher odds of an advance, in times when taxes are increasing.”
Source: Fidelity Investments
I began this MNS edition by saying that markets hate uncertainty. Presidential elections create a lot of uncertainty. But this time around, it really could ramp up. One of the most common concerns which could create the most uncertainty is if this election becomes contested, and there isn’t a clear winner on election day.
The expected surge in mail-in ballots due to COVID-19 restrictions and related health concerns has increased the possibility that election results could be delayed. For example, states like Wisconsin and North Carolina, two states considered to be “swing” states, are allowing mail-in ballots to be accepted up to six and nine days (respectively) after the Nov. 3 election day, as long as the ballots are verified by postmarks. This may happen in other states as well, where court challenges are taking place as I type. A closely contested race could create a lot of recounts, or worse, litigation. This election could make the 2000 election between George Bush and Al Gore and the “hanging chads” in Florida (which found its way to the U.S. Supreme Court) look like a cake walk. This is another reason why getting the empty seat on the highest court in the land filled (or not) is important to both sides of the aisle.
By the way, the uncertainty that came out of the contested results in 2000? The S&P 500 fell 12% from election day (Nov. 7) to the market bottom (Dec. 20), which occurred a week after Gore officially conceded. That contested election in 2000 was on no one’s radar prior to the event, so it blindsided markets. Whereas now, we hear a lot of talk about a contested election – so maybe markets will brace for it and it will be less of a surprise, should it happen?
Here is what the S&P 500 performance looked like amid the contested 2000 election:
This election comes at one of the more turbulent times that America and, indeed, the world has seen in decades. Volatility is very high, the highest since the Great Recession of 2008-09. It’s partly driven by COVID-19 and partly by the election. The ongoing pandemic, social unrest and bipartisanship are concerns in our view, but given the fact that an unprecedented number of Americans are expected to vote by mail, there is a material risk that any election result is contested. That sort of chaos, the probability of which is increasing daily, could likely cause a market selloff like in 2000.
Some people think Trump winning will be worse for markets, some think Biden will be will be worse. I don’t think it really matters right off the mark, but what markets don’t like is uncertainty. And after Nov. 3, or shortly thereafter, a lot of that uncertainty will be eliminated, so markets won’t have the election to worry about anymore.
If Trump wins and Republicans keep the Senate, we expect to see:
- Stimulus pass
- Further economic stimulus
- The virus gets contained sometime in 2021
- U.S. economy rebounds smartly
- U.S. taxes get cut further
- Inflation risk rises
- Investors remain “risk on”
If Biden wins and Democrats take the Senate, we expect to see:
- Stimlus pass
- White House focuses on more stimlus
- The virus gets contained sometime in 2021
- U.S. economy rebounds smartly
- Raise of capital gains taxes (leading to selling of “winners” / tech stocks)
- Inflation risk rises
- Investors remain “risk on”
Regardless of which way the election goes, we will remain diligent in the management of our client’s portfolios and adjust accordingly where we see a need.
Stay tuned,
Vito Finucci
Vice-President & Director, Portfolio Manager