Outcome of upcoming US Presidential Election more uncertain than past elections
With an ongoing Covid-19 pandemic, an escalating conflict with China across multiple fronts, and broad nationwide tensions over racial equality issues, the upcoming US Presidential Election in November 2020 is poised to be highly unusual and unpredictable as these evolving issues take centerstage in addition to the traditional topics of tax, social and energy policies.
Currently, national polls show former Vice-President Biden leading President Trump as shown in Exhibit 2, and prediction markets similarly reflect odds of a Biden win that are just shy of 60%.
President Trump, however, has been gaining ground over the last week as the infection rate of the Covid-19 pandemic begins to ease and as incoming data show that the US economy and labor market continue to improve.
President Trump has also recently ratcheted up his administration’s aggression against China with the recent banning of Chinese apps TikTok and WeChat in the US. This represents an intensification of his anti-China agenda which plays well to his base and likely also to an American public of which 73% of adults now view China unfavorably according to the Pew Research Center.
With the election three months away, a lot can change. If these trends that are favorable for President Trump continue, we could see a very close race down to the wire.
Under the scenario of a Biden win, we see the outcome of a Democrat sweep of Congress to be most likely, following which the scenario of gridlock (i.e., Republican majority in Senate, Democrat majority in House of Representatives) is the next most probable outcome.
Under the scenario of a Trump win, we believe that the status quo – which is a Republican majority in Senate and Democrat majority in House of Representatives – is the most probable outcome, followed by a less likely but possible Democrat sweep of Congress, and then followed by a Republican sweep of Congress which cannot be ruled out.
Outcome-based analysis of US Presidential Election impact
Our focus is on key scenarios and policies that have the greatest impact on financial markets and the economy, and hence we work off a framework based on three major scenarios:
a) Biden win with Democrat sweep of Congress
In the event of a Biden win with a full sweep of Congress – that is, the Democrats control both the Senate and the House of Representatives – the new President will enjoy a clear mandate to fill key positions and push through major policy changes.
We believe that the potential for tax increases under the Democrat agenda will have the largest impact on the US economy, corporate profitability, and market reaction.
Biden has proposed to increase the corporate tax rate from 21% to 28%, which will reverse about half of Trump’s cuts from 35% to 21%. He is also seeking to reduce the deductions for global intangible low-taxed income (GILTI) and to impose a 15% minimum tax on corporates with book profits above USD100 million. We estimate that the higher corporate tax alone will negatively impact the S&P500 earnings by 5% - 6%, while the higher GILTI tax and 15% minimum tax will hit earnings by another 5% - 6% and 0% - 1%, respectively. All in, we see Biden’s proposals potentially reducing the S&P500 earnings by 12% - 13%.
Biden is also proposing to increase taxes on the wealthy which would also hurt luxury retail, residential real estate and sectors exposed to high income spending. His proposal to increase the federal minimum wage to USD15 per hour will also hurt the profit margins of labor-intensive companies, although it would also drive increased consumption.
While this scenario is understandably worrying for investors and rising odds of a Democrat sweep could result in near-term volatility in the run-up to the elections, we do not see this as all bad. Despite his proposed tax increases, Biden’s overall policies represent an expansionary fiscal agenda through net spending. In addition to repealing the state and local tax (SALT) cap, Biden plans to significantly expand government spending on infrastructure, healthcare, clean energy and the environment, which will lead to a net expansion of the fiscal deficit.
Under this scenario, we expect to see less concern over the Chinese Yuan and, after a knee jerk reaction, potentially higher bond yields as Biden’s expansionary fiscal policy is taken to be reflationary which should be, over the longer term, a supportive factor for commodities and risk assets.
b) Biden win with Republican-majority Senate
The ability for President Biden to fully pursue his agenda will be curtailed if Congress is in gridlock. A Republican-majority Senate would play a key role in confirming cabinet positions, nominations to the Federal Reserve and many regulatory bodies, although a new President typically has significant leverage and the Senate will need to engage him meaningfully on his agenda, or they could face voter dissatisfaction in the 2022 midterm elections.
Under this scenario, it is probable that we see President Biden make a regulatory push on technology and net neutrality, and also see him make process in environmental and financial regulation policies. With Congress under gridlock, it will be more difficult for him to roll back Trump’s Tax Cuts and Jobs Act (TCJA) tax cuts.
In our view, this scenario could represent a benign outcome for global markets as we are likely to see a more strategic and less capricious approach towards China from President Biden which will take some pressure off the Chinese Yuan and global risk assets as US-China tensions enter a new phase. Trump’s tax cuts are not likely to be rolled back under this scenario which points to limited risk aversion and limited dollar strength. These will be favorable trends for emerging markets.
c) Trump win – broadly status quo
In the event of a Trump win, we expect a broad continuation of the status quo and no major changes in policy direction during his second term.
If we see a Democrat sweep of Congress under a Trump Presidency, Trump’s ability to push through policy changes will be further contained although his veto powers will prevent major rollbacks of his previous policies.
A much less likely scenario which cannot be ruled out is a Trump win with a Republican sweep of Congress, under which we could see an extension of key TCJA provisions under a Tax 2.0 plan, representing further fiscal expansion.
Positioning investment portfolios for volatility; rebalance from growth and momentum into cyclicals and value
The US Presidential Election typically comes to the forefront as a major market driver in the months of August, September and October. With markets now nearing new heights after a sharp four-month rally from late March, uncertainties related to the election is a potential catalyst for market volatility ahead. As shown in Exhibit 4, an analysis of the S&P 500 since 1928 show that equity volatility tends to increase 30% on average from July to November in election years.
Another risk worth highlighting is that, unique amongst incumbent Presidents, President Trump has in recent interviews refused to commit to accepting the results of the 2020 election and ensuring a peaceful transition. In the scenario of a narrow loss, a prolonged contest of the result by President Trump could be a potential cause of volatility and investor anxiety.
Taking into account the sharp rally in risk assets since late March and various uncertainties relating to the path of economic recovery and US-China tensions (see Investment Strategy: Markets at a crossroads), we recommend that investors ensure adequate diversification and incorporate hedges into their portfolios. In addition to traditional safe havens such as gold, positions in currency pairs such going long the JPY versus the AUD over H2 2020 can also be effective in hedging against volatility.
While investors will need to maintain core positions in key growth sectors, this is also an opportune time to rebalance portfolio weights in growth and momentum stocks, particularly in the US Technology and Healthcare sectors for which we see risks of regulatory pressure after the US Presidential election (see Exhibit 5), into cyclical and value names with resilient balance sheets and stable business models but should benefit alongside the long-term economic recovery. In particular, we note that cyclical sectors such as US industrials stand to broadly benefit from increased infrastructure spending in most of the potential outcomes.
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Version: July 2020