Key questions and answers
NEW: How will the U.S. election impact the U.S. dollar?
In a recent post, we argued that the main way the U.S. election had been impacting international markets was through the U.S. dollar. Indeed, this continued after Election Day as well, with a significant move down in the dollar of 1.4% in the three days after the election was held. This depreciation of the dollar is a reaction to the expected outcome of a Biden Presidency combined with split party control of Congress.
There are 3 main reasons why this downward move in the dollar makes sense:
- Uncertainty is being dialed down: Just getting through the election and getting closer to an official result represents a significant decrease in uncertainty. In addition, the outcome of a Biden Presidency is seen as a decrease in foreign policy uncertainty, as it likely leads to a return to more predictable trade and China policy. It is important to remember that from when the first tariffs on imports were introduced in January of 2018 to when the Phase I deal was signed between the U.S. and China in January of 2020, the U.S. dollar strengthened by 7.6% against developed currencies and by 16.3% against emerging ones. This is a geopolitical premium that is just starting to unwind.
- Goldilocks U.S. growth: The prospect of a divided government likely means less fiscal stimulus than would have been the case under a one party sweep – and hence more moderate nominal growth. U.S. growth that is neither too hot nor too cold is precisely the right environment for capital to flow to other countries. When U.S. growth is too boomy, capital flocks to the U.S. looking for growth. On the other hand, when U.S. growth is too shaky, capital also flows to the U.S., this time looking for safety. Moderate U.S. growth is the environment where investors need to and feel comfortable diversifying globally.
- Anchored interest rate differentials: Also, as a result of divided government and more muted fiscal stimulus, U.S. short and long-term rates are expected to be anchored at low levels. This means that U.S. interest rates are not moving higher and higher versus other developed markets – and as a result it attracts less capital looking for yield. In fact, it means capital needs to flow out of the U.S. to find income, like into emerging market local debt.
More foreign policy visibility, plus a global recovery, should push dollar down
U.S. dollar versus DM and EM currencies, Jan. 1 2008 = 100
NEW: How will the U.S. election impact international markets?
Since early September, all eyes have been on the upcoming U.S. election. Its twists and turns have not only been affecting domestic markets, but also international markets, especially via the U.S. dollar. Its impact has come from two main sources: 1) the uncertainty around the timing of the election result, and 2) the outcome of the election itself and its potential impact on international policy. Ultimately, global currencies have been reacting to whether uncertainty is being dialed up or dialed down.
On the first point, investors have become concerned about a delayed election result due to the time needed to count mail-in votes and the potential for a contested election. This possibility of a prolonged period of uncertainty has not been good for risk appetite, which tends to result in a strengthening of the U.S. dollar, especially versus riskier currencies like emerging market (EM) ones. Indeed, during the period of peak concern around a contested election (from September 18th to September 29th), the U.S. dollar strengthened by 3% versus EM currencies. It also strengthened a bit against developed market currencies by 1%. Since late September, however, Joe Biden’s lead has widened in the polls and his implied probability of victory has increased from 58% in late September to 68% on October 9th. This decreased the odds of a close election outcome and a contested election, which gave a boost to risk appetite once again, weakening the U.S. dollar by 1% against EM currencies.
Twists and turns of U.S. election have been moving the U.S. dollar
For currencies: 9/1/20 = 100, higher number = strengthening vs. USD
What are the implications of a contested election?
U.S. presidential election campaigns are always hideously long and this one has felt particularly painful, with such a deep divide between the supporters of the rival candidates. However, recently there has been increased speculation about the grim possibility of the election outcome being contested. Quite apart from the further division this would inflict upon our bruised democracy, many investors are wondering what this could mean for the economy and markets.
It is a fair question to ask for two reasons.
First, most of us remember the contested election of 2000, which helped topple the economy into recession and provided fresh fuel for an on-going bear market in stocks.
Second, the pandemic is impacting how we vote. The vast majority of Americans strongly believe in the expressed will of the people and recognize that every vote is of equal value whether it is cast by mail box, by drop box or by ballot box. However, it is clear that it will take longer to count the votes this time around because of the very large number of people requesting mail-in ballots due to the pandemic. It may well be that, as dawn breaks on November 4th, no victory has been credibly claimed, grudgingly conceded or unofficially declared.
Nevertheless, for investors, it is important to recognize that the odds still strongly favor the election producing a clear winner within a few days and the inauguration of that winner, on schedule, in January.
That being said, investors have good reason to worry that continued partisan bickering over basic public health practices could extend or worsen the pandemic. In addition, a contested election, even if the eventual outcome was clear enough, could distract Washington from providing further appropriate support to displaced workers, disrupted businesses and distressed state and local governments. The economic recovery already looks set to slow very sharply in the fourth quarter and political divisions could, at an extreme, lead to a double-dip recession, with negative repercussions for stocks in the months ahead.
We should emphasize that this is not our base case scenario and we don’t believe investors should delay appropriate investments until after the election. After all, almost all elections end up reducing political uncertainty rather than increasing it, and stocks tend to fare better when uncertainty falls. However, this is a good time to check portfolios to ensure that they are sufficiently diversified to weather extended election turmoil should it unfold, but also positioned to benefit from a global recovery from the pandemic in 2021 and beyond.
Addressing these issues in slightly more detail, it is important to emphasize that there is a big difference between and inconclusive election and an un-conceded one.
While the election of 2000 is often pointed to as an example of what could happen in a close race, it needs to be emphasized that 2000 was an extraordinary statistical fluke. First, it was the only election in over a century to come down to just one state. Second, within that state, according to the eventual official tally, George W. Bush beat Al Gore by just 537 votes out of almost 6 million cast - a margin of 48.85% to 48.84%.
We can say, with absolute confidence, that the result this November will not be that close and if, as is much more likely, one of the candidates is ahead by two or more states and by tens of thousands of votes in those states, then they will almost assuredly be inaugurated President. While the legislative and judicial machinery necessary to ratify the result is complicated and more partisan than it should be, it is hard to believe it is capable of denying the obvious verdict of the people in any state.
Moreover, the overall result should become relatively easy to surmise, if not on election night, then within a few days thereafter. Every state is different in its rules with regard to the counting of mail-in and early ballots and some will get to a nearly complete count pretty quickly. Comparing the results from these states and their congressional districts to the 2016 results should provide political analysts with significant information in predicting vote swings in other areas. In-person exit polls will unfortunately be useless because of an expected sharp partisan divide in use of early voting or voting by mail. However, phone or on-line surveys on how people actually voted could also help solidify forecasts of the eventual official result.
In short, while a large number of Americans will be unhappy with the result, the odds are we will know who won within a few days and that that person will become President.
On the second issue, the election drama of 2000 does appear to have contributed to the recession of 2001.
For background, it is worth remembering that the stock market peaked in March of 2000 and had already fallen 6.3% from that peak on Election Day. Despite this, the economy had continued to grow at a moderate pace throughout the year and the unemployment rate, at 3.9% in November, was basically unchanged from its April low of 3.8%. With the election uncertainty, however, consumer confidence fell sharply, with the University of Michigan index of consumer sentiment slumping from a very healthy 107.6 in November to 94.7 by February. This probably did contribute to a sharp decline in investment spending in the first quarter and a slowdown in the growth of consumer spending. Real GDP fell in the first and third quarters of 2001 and began to recover in the fourth quarter despite the trauma of 9/11. The National Bureau of Economic Research eventually announced that the recession began in March of 2001 and ended in November of the same year.
Analysts should, of course, be careful in applying the lessons of this episode to any uncertainty that could follow this November’s election. Our politics, economics and markets are all in very different places from where they were back then. That being said, this would be a particularly inopportune time for a prolonged bout of political uncertainty.
In three months’ time, Americans will join the rest of the world in saying goodbye to 2020. Never will so many have said “good riddance” with such fervor. As the dawn breaks on 2021 the election will, very likely have been long decided and we will, to that extent, face less uncertainty than today. That being said, the problems confronting our society, our economy and our markets will be formidable. The challenge for investors is to make sure they are positioned appropriately today for that more certain, but still troubled, landscape of 2021.
Which sectors perform best around an election?
As we approach Election Day, investors look to best position their portfolios for the next administration. However, looking at sector performance after each presidential election since 2000, there is little discernible pattern based on the election outcome.
For example, in the weeks following the 2016 election, cyclical sectors like financials, industrials, energy and materials outperformed the broader market. Yet, in 2000, more defensive sectors like consumer staples, health care, and utilities held up better. Both elections resulted in Republican presidents, but markets reacted differently. This is likely because markets do not like uncertainty, and regardless of the outcome, elections always reduce it—except in 2000. This created a more defensive environment compared to 2016, when results were known promptly. Additionally, elections don’t stop prevailing economic conditions from driving markets. Declines across sectors after the 2008 election were likely due to the Financial Crisis, and technology’s sharp underperformance after the 2000 election was attributable to the bursting of the Tech Bubble.
S&P sector performance after the 2016 election
Election Day to Nov. 30, 2016, Election Day = 100
How is the winner of the U.S. presidential election determined?
The presidency is determined by who wins at least 270 of the 538 Electoral College votes, not a simple majority of the popular vote. In the 2016 election, President Trump was elected with 306 pledged Electoral College votes to Hillary Clinton’s 232, but actually lost the popular vote by nearly 3 million votes.
The map below shows the number of each state’s Electoral College votes, which is roughly proportional to the state’s share of the population. In all states but two, it is winner-takes-all for Electoral College votes. Therefore, small margins of victory in individual states can have an outsized effect on the Electoral College tally. In 2016, President Trump won Michigan, Pennsylvania and Wisconsin by a spread of less than 0.8%, or about 80,000 votes across the three states, delivering him 46 Electoral College votes and the presidency.
In 2020, these three states, along with the other 5 tightest races of 2016—New Hampshire, Florida, Minnesota, Nevada, Maine, Arizona and North Carolinae—will likely determine the outcome of the election. Due to the Republicans’ structural advantage in the Electoral College, former Vice President Joe Biden must outpoll President Trump by about 3% or more to be elected.
2016 Electoral College map
What are the implications of a sweep or divided government?
As discussed in “Will there be a one-party?” the odds of a one-party sweep appear to have increased since the beginning of the year. The major implication of a one-party sweep is that that administration can more fully enact its policy agenda, while a divided government entails more compromise, or as we’ve seen in recent years, more stalemates.
From markets perspective, since 1949, equities have tended to perform better under Republican control, with average annualized returns of 11.8% on the S&P 500, vs. 9.2% under a Democratic control and 6.1% under divided government. The three major periods after WWII of Republican control and coinciding stock market climbs were the early Eisenhower years, the lead up to the Financial Crisis and President Trump’s first term at the tail-end of a record-long economic expansion.
From an economic perspective, economic growth tends to be stronger under Democratic control. Since 1945 real GDP growth averaged 4.4% annualized under Democratic control, 2.8% under Republican control and 2.5% under divided government. For Democrats, this includes the post-WWII economic expansion, as well as the healthy period of growth throughout the 1960s, as Baby Boomers began joining the workforce.
While divided governments tend not to have the optimal economic or market outcomes, it is important to keep in mind that the U.S. is governed by divided government 62% of the time, compared to 11% for Republicans and 27% for Democrats. That encapsulates most economic conditions, good and bad. If the 2020 election results in a divided government, the distribution of power will actually be as it has been for most of the last 70 years.
S&P 500 Price Index
Quarter-over-quarter % change, seasonally adjusted annualized rate
How should investors approach investing in an election year?
On average, returns have been lower and volatility has been higher during election years compared to non-election years. But what do averages really tell us? Sure, political volatility does impact markets, but let’s consider recent election years, such as 2008 and 2000. 2008 was marked by the onset of the Financial Crisis, and 2000 by the tech bubble bursting. Returns and volatility during those years were driven by prevailing market and economic conditions at the time, not the election. This year, lower returns and higher volatility will almost certainly be attributable to COVID-19.
Therefore, investors should instead continue to monitor economic fundamentals, tilt towards quality in both equity and fixed income, and maintain a well-diversified allocation. This doesn’t mean there won’t be interim volatility around the election, but that volatility is unlikely to warrant dramatic portfolio changes. Moreover, timing the market is a very difficult strategy, and no less so during an election. Recall that in the early hours of November 9, 2016, futures plummeted as election results were coming in, but markets closed positive after that day’s regular trading session. Investment time horizons extend far beyond election cycles and presidential terms, so sticking to an investment plan is more crucial than ever.
Equally important to what investors should do is what they shouldn’t do: Don’t let how you feel about politics overrule how you think about investing. To illustrate this point, the chart below shows a poll conducted by the Pew Research Center, in which respondents rate present economic conditions as excellent, good, fair or poor. During the 8 years of the Bush Administration and since the start of the Trump Administration, those who are or lean Republican felt positively about the economy while Democrats felt less favorably. The opposite was true during the Obama Administration. But what’s most striking is how much attitudes pivot on Election Day itself, ten weeks before the new president is even inaugurated and has no direct influence over the economy yet.
One might extrapolate that investors may be under-allocated to risk assets or even pull out of the market if they feel strongly negatively about a president. However, investors would have missed out on above-average returns on the S&P 500 during the Obama Administration and the first three years of the Trump Administration if their political views governed their investment decisions.
Returns during election, non-election years
S&P 500 price index, average return, 1932-2019
S&P 500 realized volatility
S&P 500 price index, 52-week standard deviation, 1932-2019
Percentage of Republicans and Democrats who rate national economic conditions as excellent or good.
How will the U.S. approach China in the next administration?
One of the key policy items of the next administration will be the U.S. approach to China. Being tough on China appears to be one area that President Trump and former Vice President Joe Biden agree on in principle, although perhaps not in implementation. It is also an area where American voters seem to agree. According to a poll conducted by the Pew Research Center, the majority of both Republican and Democrat respondents have an unfavorable opinion of China, which has intensified over the last two years.
Thus far the current administration has proposed or implemented a number policies targeting China, including banning U.S. companies from doing business with certain large Chinese companies, restricting access to U.S. equity exchanges, revoking Hong Kong’s preferential status, and, of course, tariffs.
Although Joe Biden does not have an explicit proposal for how he would address ties with China, in his proposals to rebuild domestic supply chains, he notes he would “impose targeted restrictions on imports from nations such as China and Russia that pose national security threats.” He references China multiple times in this proposal, aiming to reduce U.S. dependency on China in supply chains and trade.
These efforts by either candidate could result in higher costs for U.S. companies and hurt corporate profitability for two reasons: import tariffs could boost input costs, and reshoring of supply chains would be expensive to relocate and maintain given higher labor costs in the U.S. On the other hand, it could also create opportunities to automate supply chains domestically and to build new domestic technologies, such as 5G. Despite a politically tough stance on China, it is still a critical market from an asset allocation standpoint. It represents 41% of the MSCI Emerging Markets index, and will continue to be a source of growth ahead.
Percentage of Republicans and Democrats who say they have an unfavorable opinion of China
How would a corporate tax hike impact the recovery?
While markets are likely to experience volatility in the lead up to and the aftermath of the election, ultimately, it’s policy, not politics, that matter most for the economy and markets in the long run. One policy proposal that has garnered the attention of most is an increase in the corporate tax rate.
From 1993-2017 the top corporate tax rate was 35%, until the 2017 Tax Cut and Jobs Act (TCJA) reduced it to 21%. Democratic nominee Joe Biden has proposed to partially reverse this cut, increasing the top corporate tax rate from 21% to 28%. This would bring it in line with the OECD GDP-weighted average of 26.53%. However, most companies do not pay this top rate, and the effective tax rate is typically below it. In 2019 it was 17.5%, and based on the relationship between top rates, effective rates and nominal GDP over time, we estimate it could be north of 21% with a partial tax hike. This could reduce S&P 500 operating earnings per share by roughly 7 USD, disrupting, but not reversing the fragile profits recovery. This compares to the 12 USD boost in operating earnings per share attributable to tax cuts in 2018, the first year the TCJA was in effect.
How might the election impact the municipal bond market?
With the presidential election just under two months away, investors are considering how individual income tax changes proposed by both candidates might affect the municipal bond market and their tax-advantage benefits.
Under a continuation of the current administration’s agenda, current individual income and estate tax changes under the Tax Cuts and Jobs Acts (TCJA) could remain in place through 2025 with the potential for the 3.8% mandatory net investment income tax to be repealed. Given this, under current law, its unlikely individual municipal bond demand would be meaningfully impacted. On the supply side, it’s reasonable to expect taxable municipal bond issuance to continue to remain robust in the years ahead given the elimination of issuers’ ability to issue advance refunding tax-exempt municipal bonds under the TCJA.
Current municipal tax equivalent yields under various individual tax schemes
Municipal bond tax equivalent yields by rating