By Supriya Menon at Pictet Asset Management
The 2020 presidential campaign takes US politics into uncharted territory. Which means there’s plenty at stake for investors.
On November 3, Americans will not only be voting for whether Donald Trump or Joe Biden should be their next President. They will also be choosing the whole of the House of Representatives as well as 35 of 100 seats in the Senate. If the permutations were not complicated enough for investors, there is now an unnerving twist to this already fraught and bitterly-contested campaign. Trump’s positive test for Covid-19 32 days before the election throws US politics into uncharted territory. The range of outcomes has, to put it mildly, widened.
Before Trump’s medical predicament was revealed, prediction market Predictit offered a 48 per cent chance of a Democratic clean sweep (both Houses of Congress and the White House) and a 17 per cent chance of a Republican one.1 Both probabilities looked overstated at the time – the prospect that either Biden or Trump would face a divided Congress was under-priced. Now, the situation is far more complicated. It is unclear how Trump’s diagnosis will affect voters.
The 2020 presidential campaign takes US politics into uncharted territory. Which means there’s plenty at stake for investors.
Still, even if investors are faced with numerous permutations, the central issues remain unchanged. Two scenarios in particular are worthy of consideration and analysis: a clean sweep for either the Democrats or the Republicans. A decisive victory for either party (both houses of Congress and the White House) has the potential to bring about significant changes in policy and would thus have important market consequences.
One key difference is the parties’ approach to taxes – and thus fiscal stimulus. For Republicans, tax cuts are a supply-side fiscal tool used to stimulate the economy. Trump’s primary economic legacies from his first term were a reduction in the statutory tax rate from 35 per cent to 21 per cent and broad-based tax reform. Equity markets were disproportionately boosted by these measures, with lower effective tax rates accounting for 5.2 percentage points of 13.4 per cent total returns in the S&P 500 since January 2018, according to our calculations.
Democrats, on the other hand, see tax hikes as a means to fund demand-side measures to achieve the same result and re-distribute wealth from higher income to lower income groups.
(Click here for a detailed summary of the likely policy outlook in each scenario.)
 Data as at 20.09.2020.
02 Biden sweep
Higher corporate tax rates, higher spending to reduce inequality
Biden’s tax proposals would reverse half of Trump’s cuts, taking the statutory top rate of corporate tax up to 28 per cent, which, we calculate, would lift the effective tax rate to 23 per cent from 19 per cent. All else equal, this would depress 2021 S&P 500 earnings per share by around 5 per cent.
Other levies, such as the minimum tax on book income and windfall profit taxes, could also weigh on corporate profits. However, given the fragile state of the post-Covid economy, it is likely that the Biden administration would take a more considered approach, staggering the tax hike.
Fig. 1 – Taxing times
Effective tax rate of companies in the S&P 500
Source: Eikon, Pictet Asset Management. Data covering period 31.12.1989-30.09.2020.
In a Democratic sweep, hikes in corporate and personal taxes would be accompanied by increases in government spending, particularly on healthcare, infrastructure and education. Biden’s agenda points to a significant expansion of the welfare state, with initiatives ranging from affordable housing to pre-kindergarten education. From an economic perspective, such policies have high multipliers, meaning that the boost to the economy in general – and to purchasing power in particular – will be much greater than the size of the measure itself.
The flip side is that this programme would be funded partly through higher taxes on corporate profits, and would also incur higher labour costs. Downward pressure on profit margins would depress private investment, though this would be partially offset by government expenditure. More generally, a Biden clean sweep would further expand big government, paid for by rising deficits, with a risk that it adopts some of the more extreme measures touted by Modern Monetary Theory.
Tighter regulations, enhanced worker rights, a return to more conventional diplomacy
A Democratic sweep would also likely give rise to a tougher regulatory and antitrust regime. This could take the form of new antitrust legislation (only possible under a dominant Democrat government) or, more likely, greater scrutiny under existing laws. Then there’s the possibility of a “windfall profit tax”, which would be aimed at tech companies in particular.
Democrats propose a rise in the Federal minimum wage to USD15 per hour from the current USD7.25 – although the impact of this is tempered by the fact that many states set their own higher minimum wages. Together with new rules making unionisation and collective bargaining easier, these policies could mark a reversal in the long-standing decline of labour’s share of the economy compared with that of capital. However, that could only be possible with the support of a Democrat-controlled Congress.
While any significant reversal of Trump’s anti-trade agenda is improbable, a Biden administration is likely to take a more diplomatic approach to foreign policy negotiations, including with China. From China’s perspective, the US will evolve into a “rational competitor” with scope for cooperation on healthcare and climate.
Environment takes centre stage
A Democrat victory would also place the US back at the heart of global efforts to limit global warming.
Biden aims to achieve a net zero carbon economy by 2050, committing USD2 trillion in new investment over four years, the most ambitious proposal put forward by any presidential candidate.
His sweeping proposals include completely decarbonising electricity generation by 2035 and doubling the rate of solar panel rollout, installing 500 million such units, in the next five years. Biden also aims to overtake China as the world leader in the electric vehicle industry by increasing Federal procurement.
Biden’s climate agenda puts the US in line with European and UK targets. Alongside China, which has recently announced its goal to become carbon neutral by 2060, Biden’s policy could reinvigorate global efforts to halt climate change and protect biodiversity.
03 Trump sweep
China remains in firing line, ‘America First’ gains strength
A win for the Republicans would be seen as vindication of Trump’s China stance, and would intensifying efforts to decouple the US from Chinese financial markets, technology and supply chains.
Allegations that China has failed to meet agreed commitments could lead to a collapse of the Phase One trade deal and trigger higher tariffs on Chinese imports. A further escalation of trade disputes may have broader repercussions. Not only might territorial disputes in the South China Sea intensify but Taiwan’s status could also become a source of Sino-US tension. From the Chinese perspective, decoupling is challenging, but also offers an opening to strengthen its own sphere of influence, particularly with other emerging markets.
The US would also further disengage from international institutions such as NATO and the World Trade Organisation. Relations with European countries would be strained by tariffs on steel exports and other security issues.
Attention turns to the taxation “cliff”
Given the landmark tax reforms in his first term, a second Trump administration would be unlikely to change the corporate tax regime further, even under a Republican-dominated Congress. However, attention would shift to the looming taxation “cliff” – a number of temporary individual tax cuts are set to expire in 2025. There is likely to be significant friction between the US and European/OECD countries over plans for global digital services taxes, which would fall disproportionately on US tech companies.
Environmental concerns to take a backseat
The rollback of the Obama-era Clean Power Plan is likely to continue. New measures could include the leasing of Federal land for exploration, relaxing rules on vehicle emissions and on permitted pollution levels from industrial companies and power plants. The energy sector would enjoy strong support in the form of direct aid and streamlining of gas exports. Arguably, progress on some of these measures could be stymied either by legal action or by states’ and local governments’ intransigence, as has been the case during Trump’s first term.
04 Where red meets blue: policy overlaps
The disproportionately low share of profits paid in taxes by large tech companies is likely to prompt action even from a Republican-dominated government. The Department of Justice’s recent antitrust inquiry against Alphabet over its anti-competitive practices shows that tech companies aren’t immune to scrutiny and censure, whatever the party in power.
A sweep for either party would also likely boost infrastructure spending – unified government would be able to agree the form, substance and details of any plan in a way that would be very difficult for a split government to achieve.
Onshoring has bipartisan support, too, through incentives such as tax credits and the Federal government’s refusal to give contracts to companies offshoring jobs to China. Both parties are likely to pursue a tough line against China, although a Biden administration is expected to be more constructive in its approach.
Pharmaceutical pricing may be targeted by either administration. Trump’s recent executive orders on drug pricing, setting caps on or limiting price increases, show that this is not just a Democrat concern. However, pharma pricing will take a backseat while vaccine development remains a priority.
05 Investment implications
Over the past half a century, most presidential elections have had – at most – only a transient impact on markets. That’s the picture that emerges when comparing equity market moves in the three-month lead-up to the vote with their behaviour in the three months that follow (see Fig. 2). The main exceptions have been Ronald Reagan’s election victory 1980, which saw a recession precipitated by the combination of an oil shock and steep interest rate hikes, and, of course, Trump’s victorious campaign in 2016, when a sharp sell-off going into the ballot was reversed by the tax-cut rally.
Fig. 2 – Consequences of politics
US elections’ impact on stock market
Source: Eikon, Pictet Asset Management.
A clean sweep in either direction would have a much greater impact.
If a Democratic sweep looks likely, it could plausibly lead to a 5-10 per cent sell-off in the US stock market in the run up to the vote – and thus a 1-2 point compression in price-to-earnings (P/E) ratios. Arguably, we are already starting to see this in the latest market moves.
That would be similar to what we saw before the 2016 election. Such a move would reflect the impact of potential tax hikes on corporate profits – estimated as a hit of 5-10 per cent relative to consensus 2021 EPS.
Higher taxes on higher earners would hit consumer discretionary stocks, while higher capital gains taxes could reduce the appeal of equities more broadly, thus pushing up the equity risk premium – the extra return investors demand for the risk of holding stock over bonds. Small cap stocks, domestic equities and infrastructure sectors should do particularly well, with a likely sector and style rotation into value-cyclical laggards.
On the corporate taxation front, utilities and communications are likely to be the most affected, and tech companies could also be targeted. Buybacks would be curtailed – they constituted the largest use of the cash windfall from the Trump tax cuts and are likely to face tougher regulatory obstacles.
ACA and Medicare will probably be expanded, leading to increased access to drugs and thus greater revenues for pharma companies, even if it doesn’t boost profitability.
The US dollar is likely to strengthen as capital is drawn inwards into the US, especially if growth overseas does not pick up on a relative basis. Gold, in contrast, could weaken. Pro-cyclical fiscal spending should lead to an increase in the supply of US government bonds. Long-term Treasury bonds would suffer from a steepening of the yield curve and higher breakeven inflation rates, but the steepening would likely be modest given Fed support and ongoing QE.
A Republican sweep, meanwhile, would serve to reinforce current corporate earnings expectations. Equity multiples could receive a boost from regulatory relief. Share buybacks could continue unabated. However, the unpredictability of Trump administration’s trade policies and an intensification of ‘America first’ measures such as re-shoring would weight on equity risk premia. We could thus see an initial sharp market rally, which may not be sustained.
Republican policies on balance favour domestically-focused stocks over multi- nationals in strategic industries with global supply chains and revenue bases.
Traditional energy companies and telecoms would benefit from a less stringent regulatory framework, while defence and infrastructure-related sectors would gain from fiscal expansion. Healthcare stocks’ outperformance could be short-lived as the government hones in on pharmaceutical pricing.
The dollar’s fate is less clear. While Trump has a stated policy favouring a weak currency, on-shoring supply chains and fiscal stimulus would be tailwinds for the greenback. Continued geopolitical tension would benefit gold, although the impact would be modest in the face of higher real rates (similar to what occurred in 2017-18).
The outlook for emerging markets would be negative, although over the medium term China could see an opportunity to build its capital markets and tech infrastructure, as well as strategic clout among other emerging market countries.
Fig. 3 – Trade opportunities
Source: PredictIt.org, Pictet Asset Management *As of 20 September 2020. Calculated from PredictIt odds. Both split congress scenarios = D House R Senate.
Beware of disputes
Arguably the worst scenario for markets in the near term would be a disputed election. A higher reliance on voting by mail could lead to delays in obtaining results in key states. In addition, either candidate could contest the election if the outcome is a very close one. If it happens, it would further delay any post-election skinny stimulus and, in a worst case scenario it could lead to public unrest.
The closest parallel we have is the 2000 election between George W. Bush and Al Gore where markets fell by 8 per cent from election day to the trough in markets over the one-month period it took to pass the final judgment. However, we believe this time any such sell-offs (even over a longer period of election impasse) should prove short-lived as the eventual outcome would likely be a market-friendly divided government.