Focus on the US Presidential Election

July 27, 2020

The market’s attention, which has been consumed by the coronavirus pandemic, is gradually shifting to the US Presidential elections. Recalling the impact that Trump’s election in 2016 had on markets, investors want to assess what potential results could mean for their investment strategies, seeking to minimize event risk in their portfolios. However, three months lie between now and the November 3rd showdown. Until then, a lot of ink will be spilled on predictions and associated narratives.

At first we need to be transparent. When writing on political perspectives, our personal and political biases are probably omnipresent. But whatever our preferences, we believe that investors should not let politics be a determining factor in their investments. Morgan Housel perfectly described the idea: “most dumb money decisions are made when we tie our emotions to our money. And few things stir up emotions like politics. Just leave it to politics to turn a pleasant conversation into a heated shouting match between people who are otherwise civilized and respect each other”.

This isn’t to say that politics doesn’t matter. But when it comes to managing, saving, and investing, we should avoid letting the political winds shift our approach.

Historically, incumbent presidents have been re-elected unless there was a recession during their term. But the historic polling failure of 2016 shows that nothing can be taken for granted, and this is especially true in the current context with developments on the pandemic front strongly influencing voting intentions.

Who is more likely to win? This is not a done deal

Using the major opinion polls, we should expect a landslide victory for Joe Biden, the Democrat candidate whose popularity has shot up significantly over the last few months. But we should not forget that the US President is not elected on overall popularity.

Democrat Donkey and Republican Elephant. Source: Getty

Even pro-Democrats get the picture right when observing that Biden is leading many polls “by-default”. Much of Biden’s support comes from a coalition of voters united far more by their disdain for Trump than their affinity for Biden. A lot of voters don’t know much about Joe Biden aside from him being Obama’s vice president.

Opinion polls matter but the popular vote does not determine the President and Vice-President. To win the election, a candidate must receive a majority of electoral votes from the Electoral College. The Electoral College consists of 538 electors, and an absolute majority of at least 270 electoral votes is required to win the election.

Using the Economist’s model [1], Joe Biden is very likely to beat Donald Trump in the electoral college.

According to most political commentators, four leading issues are at play for this election: the economy, China, the handling of the coronavirus and race relations. According to opinion polls [2], Trump seems to be favoured on the economy (best policies), but addressing the pandemic has become one of the top issues for voters.

As such, the elephant in the room on the US election is probably not the Republican one but the coronavirus, a key driver of approval ratings. Trump’s handling of the crisis has been questionable and for months, he has insisted that the show must go on. But the ‘showman-in-chief’ recently announced that celebrations around the 2020 National Republican Convention were cancelled due to health concerns.

Most Americans believe they should continue to social distance for as long as is needed to curb the spread of coronavirus, even if it means continued damage to the economy. In this context, no one should be surprised that an economic gauge is currently less relevant in the election perspective.

Up to election day, the voting public’s perception of how well both the virus is contained, and the economy is recovering could be critical in determining the election outcome. Furthermore, no one knows as of now, if the pandemic could also disrupt the ability to vote.

United or Divided?

There is more than ‘just’ a single race. The composition of Congress will also influence how the next administration will function. Whether the government is unified or divided will be a critical distinction, creating potential for gridlock in Washington.

Democrats have held a majority in the US House of Representatives since the 2018 elections, while Republicans have held control of the US Senate since the 2014 elections.

All 435 voting seats in the United States House of Representatives will be up for election; 218 seats are necessary for a majority.

At least 35 of the 100 seats in the Senate will be up for election. Republicans currently hold 53 Senate seats, while Democrats hold 45 seats, and independents hold two seats. Barring further vacancies or party switching, 21 Republican-held seats, along with 12 Democratic-held seats, will be up for election.

Democrats already control the House of Representatives and are likely to hold onto this through 2021. The focus therefore falls on the Republicans’ ability to hold a majority in the Senate, if they are to obstruct certain elements off the Democratic Presidential agenda, in the event that the White House is lost.

A divided government in the US occurs when one party controls the executive branch while another party controls one or both houses of the legislative branch. The degree to which the President of the United States has control of Congress often determines his political strength – such as the ability to pass sponsored legislation, ratify treaties, and have Cabinet members and judges approved.

Since the 1970s divided governments have become increasingly common. The election of many Presidents produced what is known as a coattail effect, in which the success of a presidential candidate also leads to electoral success for other members of his or her party. In fact, all newly elected presidents except Zachary Taylor, Richard Nixon, and George H. W. Bush were accompanied by control of at least one house of Congress.

Some political commentators argue that a divided government is positive as “it encourages more policing of those in power by the opposition, as well as limiting spending and the expansion of undesirable laws”, while other commentators just claim the opposite, arguing that “divided governments become lethargic, leading to many gridlocks.” [3] 

What does Wall Street make of that?

At first, we would like to make it clear that empirical statistics on past elections are basically irrelevant. Since 1928, 23 observations give us a sample size that is simply not significant (# of presidential elections). The human condition, and its associated cognitive biases and short-term orientation, make it tempting to seek meaning from these samples, but indeed ‘small samples of market conditions are full of surprises, while larger samples generate results that are closer to predictions’.

This is valid both ways. Not only is the media full of headlines using presidential election cycle theory (trying to gauge which year of the presidential tenor is the best vintage for stock returns), or historical observations of either a Democrat or Republican president and associated equity returns, we also observed a large number of models predicting who is going to win based on the current state of the US economy.

Yes, economic strength could be a necessary condition, but it is for sure not a sufficient one. A strong economy or solid economic growth does not necessarily assure an incumbent’s re-election.

Such analyses give investors a false sense of comfort. This is a fallacy. The ubiquitously small sample size should immediately ring some alarm bells and generate questions about statistical validity.

Forecasting the impact of US elections on financial markets is more of an art than a science. If daily stock prices follow a random walk (with a positive drift earned by long-term investors), predicting the US election outcomes on financial markets is, by essence, a hazardous exercise. Investor sentiment is the main unknown: should we fear the madness of crowds or enjoy the wisdom of it?

Our main take-away is that investors should not make the mistake of conflating candidates’ policy positions with their future policy path.

Everyone still remembers the 2016 election for which investors assumed a Trump win would usher in risk-off conditions. If you had perceived a Trump victory and shorted the equity market, you would have succeeded for 2 hours before going bankrupt or going out of a job thereafter. The missing link at that time was the fact that Trump’s agenda was friendly to the macro outlook in the short-term, bringing tax cuts without the classically-associated spending austerity. As commented by Morgan Stanley, this was the only “plausible political path” to get agreement between a slim majority control of Congress.

As of now, the agendas of Biden and Trump strongly diverge on taxes, climate & green initiatives, as well as on trade agreements (multilateral vs. bilateral) … There are nevertheless some similarities as well: both have stressed the need for an hawkish and firm attitude towards China. President Trump campaigned on “America First” while Biden is shouting “Buy American”.

In a nutshell,  the differences between the two candidates’ can be summarized as:

  • Trump supports further tax cuts, deregulation and protectionism: “Trumponomics” are supportive for stock markets (though his protectionist rhetoric is not) and prior to the crisis, he presided over an equity market that skipped from new high to new high and a 50-year low in the unemployment rate.
  • Biden supports higher taxes and higher public spending. The consensus view is that a Democrat victory in November will be negative for both equity and bond markets, as well as for the US dollar.

But this view is extremely simplistic and both candidates could bring a blend of pros and cons for markets. Remembering that political scientist Anthony Downs once noted that “politicians don’t get elected to formulate policy; they formulate policy to get elected”, investors should not conflate the candidates’ positions with the policies that can, actually, be implemented. In other words, investors should avoiding misreading the outcome.

In his first term, Trump was quick to slide the knife through corporate tax rates, giving Wall Street and earnings results a significant boost. Under his Tax Cut and Jobs Act (TCJA), the effective tax rate fell sharply from 35% to c.21%. Biden’s proposed tax plan involves a partial reversal of the 2017 Trump tax cuts, from 21% to 28% and a new minimum corporate tax rate of 15%. Whether these plans can come to fruition is another thing: This could be seen as rubbing salt on corporate wounds amidst a deep recession and/or the plans may be blocked in Congress: Biden’s freedom to operate will largely depend upon who holds the Senate majority. Furthermore, we should bear in mind that tax increases could be phased in over time while higher government spending may exceed the level of tax increases.

President Trump is likely to seek lower taxes in a second term, or to make certain provisions of the Tax Cuts and Jobs Act that are scheduled to expire in December 2025 permanent. This comes on top of the major tax cuts that were included in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed by Congress. Indeed, tax cuts would ease the financial burden on corporations in order to stimulate economic growth, but some commentators argue that this is an ill-fitting policy response to the current crisis. Perhaps, more targeted support for households is required if demand is to recover. Demand could be coaxed upwards under Biden’s plans to increase the minimum wage. While this can initially be viewed as an additional cost for firms, on the other side of the coin, it could result in higher spending.

When it comes to foreign policy, Biden could in fact prove to be more market friendly, as he is likely to adopt a less bellicose rhetoric, especially on trade. In 2019, the US-China trade war was a major headwind for global growth and before the coronavirus pandemic stole the show, markets were held hostage to US trade policy (often communicated bluntly via the Trump Twitter feed), resulting in elevated volatility. With Biden installed in the White House, frictions with China – especially with regard to technology and intellectual property – are unlikely to go away: Opinion polls show that both Republican and Democratic voters support a tough stance on China. However, it is expected that Biden will adopt a less impulsive communication policy.

If you believe, as we do, that the American society is facing significant polarisation, the outcome of the election should not be a revolution. It will not be a game changer with regard to the capacity to find compromises between Republicans and Democrats in a divided legislature. Legislative gridlock is a more reasonable expectation. Even if a unified government is elected, consensus in between ‘fractions’ will be needed. As such, some moderation is to be expected versus campaign slogans and platforms.

Winners and losers from the 2020 Election

US interest rates are more likely to rise if the result is a united government. If the opposite plays out, they are more likely to stay range-bound or fall. Fiscal policy should be the largest factor behind the move. Fiscal expansion (tax cuts for Republicans, Infrastructure spending for Democrats) and a reflationary impulse will affect expectations about government bond supply. But here again, how markets respond is likely to come from both the perception of these policies before the election and the reality of these policies after the election.

For equity markets, the picture is more complex. A Republican victory should support corporate confidence (lower taxes or at least no risk of higher taxes) and their willingness to resume investment. A Democrat success should support wealth redistribution (from tax redistribution, but also minimum wage), supporting consumption of the most fragile but also the highest propensity to consume cohorts. In this case, there is a clear risk that market participants price in some degradation of corporate confidence at the start. Any potential rollback of the TCJA is at the top of investors’ minds given the immediate impact on corporate margins.

The most predominant source of uncertainty in equity markets should probably come from the regulatory agenda and the associated impacts on some sectors. Infrastructure spending is likely to be an outsized facet of both candidates’ manifestos, especially in the wake of Covid-19. Biden is floating a 2-trillion-dollar green deal which would focus on decarbonising America. Higher infrastructure spending would of course bring benefits in terms of employment and wages with Industrials and Materials poised to benefit.

Healthcare

This is traditionally the first sector on investor minds when discussing political repercussions. The Republicans’ repeal of the Affordable Care Act (ACA, better known as Obama-care) is presumably off the table with the Covid-19 outbreak. From the Democrats, J. Biden actively campaigned against Medicare for All [4], but an extension of ACA or Medicare to a particular segments of the population could be expected with potential impact on Healthcare Services companies.

For pharmaceutical companies, the political rhetoric related to drug pricing will probably be less relevant in the current context and for as long as the majority of the population is not vaccinated against Covid-19. Pressure for repatriation of drug manufacturing onto US soil (diagnosed as an issue of national security) is already ongoing and should continue. This will be negative for margins, but is currently perceived as immaterial (potentially subsidized).

Finally, MedTech remains largely insulated to regulatory and pricing risk versus the broader sector.

Information Technology

This sector is exposed to headline risk on Big Tech regulation and breakups from both parties. Criticism about privacy, misinformation and monopolies is abound but this is not the solel risk. Tighter regulation on China could also hurt supply-chains for hardware companies. The status of ‘Gig economy workers’ [5] could also make headlines in case of success for the Democrats.

Energy

Energy is another sector which will see prominent headline risk. Medium to longer-term implications from an administration focused on the country’s decarbonization path (vs. the status quo) are significant. This could be a catalyst to unlock significant capex opportunities towards renewables and carbon capture. A Republican failure could also mean stringent regulations on fracking.

CONCLUSIONS

For some of us this US presidential election is reminiscent of the “good old days” of the Muppet Show, with Statler and Waldorf at their balcony seats. In a battle of septuagenarians, the Trump campaign has long tried to paint Biden as having lost some of his mental sharpness. It seems some kind of karma is at play with Trump now misstepping with regard to his own cognitive test.

In the end, no matter who is President, saving the economy will come first and foremost and policy will be fine-tuned in order to achieve this. At the same time, virus headlines and the race to a vaccine, as well is stimulus will ultimately drive sentiment. No matter who is President of the USA, our approach to money remains the same: spend less than you earn, grow your savings and investments, diversify and plan for the long term. One should also keep an eye firmly focused on societal changes. The oil & gas sector’s transition towards clean energy is a necessity, regardless of who is elected as the President of the USA.

The best way to sum-up is probably to use two traditional British quotes:

  1. The devil is in the details: a divided vs. united legislative landscape is probably more important for investors.
  2. The proof is in the pudding: neither party would set out explicitly on budgetary expansion but both will go that way.

 Take your seats and enjoy the meal.

References

[1] https://projects.economist.com/us-2020-forecast/president

[2] Gallup: survey on most important problem https://news.gallup.com/poll/1675/most-important-problem.aspx

[3] https://en.wikipedia.org/wiki/Divided_government_in_the_United_States

[4] This proposal, spearheaded by Sen. Bernie Sanders, would radically change the way Americans are covered, shifting control to the federal government and essentially eliminating the private insurance industry. Under Sanders’ plan, Americans would be enrolled in a national health insurance program, also known as a “single-payer” system, which many other developed countries have. The federal government would run the program, and taxpayers — would pay the bills.

[5] From Wikipedia: “Gig workers are independent contractors, online platform workers, contract firm workers, on-call workers and temporary workers. Gig workers enter into formal agreements with on-demand companies to provide services to the company’s clients. I.e. workers for Uber, Lyft, ..

Author: Group Investment Office