Now that I have digested the surprising results of the US election yesterday, at least as far as where we stand at the moment, I thought it would be interesting to share my thoughts on the likely effect on various markets I cover regularly in emorningcoffee.com. Before I share my brief thoughts, one non-financial observation is that President Trump and the Republican party ran a well-organised, highly effective campaign that (again) upended pollsters and will certainly cause the the Democratic party to step back and re-assess their approach and the direction of their party.
Back to economics and markets - the results of the 2020 Presidential and Congressional elections in the US remain unclear, but the scenario that currently appears most likely as I am writing this would be i) Mr Biden to eventually win the Presidency, and ii) the House (Democratic-controlled) and the Senate (Republican-controlled) to remain status quo. I could ultimately be wrong, and we might not know until the end of the week, because the Congressional make-up looks likely along these lines whilst the Presidential outcome remains far from certain. However, I am going to go with this scenario anyway. What would such an outcome mean for markets? Below I have shared my views which would be applicable once the dust settles from this election cycle, although the intervening period could be characterised by heightened volatility and uncertainty in all financial markets. And one more thing – the elephant in the room is very much the pandemic, something I have scarcely heard a word about today as the election has taken centre stage but remains perhaps the biggest unknown.
What would a Biden presidency / status quo Congress mean for individuals and companies? Clearly, this composition of a US government would be positive for individuals as the Trump tax cuts would be likely to stick because the Senate would not approve the Biden plan to raise the top marginal tax rate on high earners (income over $400,000/annum), or to increase capital gains tax rate for those making more than $1m/annum, or to roll back the inheritance tax thresholds. Leaving individual taxes as they are pursuant to the Trump tax reform plan means that investor’s disposable income will more or less be “protected.” Similarly, Biden’s proposal to increase the corporate tax rate to 28% (from 21%) will be kiboshed, a positive for companies as more income will not be siphoned off to the government. However, not increasing tax revenues will cascade through to the spending side, because they will kill off the source of funding to update infrastructure in the US (a fiscal stimulus), or perhaps (albeit unlikely) to reduce the record-high national debt achieved under the Trump Administration. As an aside, sticking with the current tax and expenditures of the U.S. Government, ignoring extraordinary spending related to CV19, the outcome is that wealth inequality in the US will continue to worsen.
So what about this election outcome and its effects on financial markets?
1. US equity markets: There is a tilt towards positive in that corporate income will not be affected by higher taxes, and retail investors – at least those with liquidity that invest in the stock market - will maintain their disposable income to invest in equities because their personal taxes will not increase. The partial offset though, as mentioned above, is that the proposed Biden infrastructure spend will not happen, and this is paramount to losing an expected fiscal stimulus. Additional (re)regulation would also be unlikely for Mr Biden to get through a divided Congress, and this would be considered business-positive. Having said this, the one caveat I would add is that – politics aside – equity markets remain very richly valued, even more so given the recent three day runup in prices, so I remain neutral at best on US equities until some froth comes out of prices, earnings catch up with prices, or a combination of both.
2. US credit markets: The main support for credit markets, i.e. principally corporate bonds, is coming from the Federal Reserve rather than any sort of fiscal action. Recall that the Federal Reserve is a buyer of both investment grade and select high yield bonds in the primary and secondary markets, providing support that far outweighs anything that could be provided as far as government action. Riskier corporate bonds, i.e. high yield bonds, are positively correlated with equities, so I would expect high yield bond prices to move more or less in tandem with equities. Having said all this, there will likely be another round of fiscal stimulus in 1Q2021 once the new President and Congress take their seats, and this will bring much-needed aid to some of the sectors that have been badly affected by CV19 (e.g. airlines). And a new package should also bring relief to many small and medium sized companies that might not have bonds outstanding (because they are too small) but might be struggling with their bank loans because of CV19.
3. US Treasuries: Since the Democratic-inspired tax-and-spend/invest “blue agenda” is off the table, this will likely cause US Treasury yields to decrease (and the yield curve to re-flatten) as investors move back into intermediate and long-term government bonds because economic growth will be slower (forgone fiscal stimulus) and the national debt will be held in check, relatively speaking. This is the perception, although the reality is that under the Trump Administration, US debt has already reached its highest absolute level ever ($27.2 trillion), as well as its highest level as a percent of GDP – even before the pandemic – since WWII. In the runup to the election, the UST market was increasingly pricing in a “blue sweep” that – regardless of whether the Democrats or Republicans win the White House – is obviously not going to happen.
4. The US Dollar: The US Dollar is considered one of the ultimate safe haven assets as a “go to” in difficult times, but of course, it also depends on what is happening with the currency on the other side of the trade. The US Dollar has been weakening since April as risk sentiment improved gradually post-pandemic and investors moved into riskier asset classes. Once there is clarity on the outcome of this presidential election, I would expect the US Dollar to continue to gradually weaken because the Federal Reserve will certainly remain accommodative for the foreseeable future (although fiscal policy is likely to be constrained). This backdrop favours risk-on assets, so I would expect the US Dollar to gradually weaken as investors continue to take on more risk (and assuming the pandemic is managed).
5. Gold: Gold is a safe-haven asset and acts as an inflation hedge (and protection against a weak / depreciating US Dollar). Government debt, which has increased substantially under President Trump, will be brought into check by a Republican-controlled Senate which has, at least most of the time over the last four years, shown much more fiscal discipline than Mr Trump. Therefore, the Federal Reserve will be the “go to” source for stimulus in the economy, and I would expect the Fed to remain accommodative throughout the next administration regardless of which party is in power. Although this might eventually prove to stoke inflationary expectations, I believe though that the price of gold will remain relatively subdued because inflation will not be a risk in the near-term with US industrial capacity at such a low utilisation rate.
In conclusion, I expect the composition of a Biden Presidency and a Republican-controlled Senate will mean not much change, as much of the “blue agenda” will not happen under this composition of the U.S. Government. I feel compelled to repeat two things. Firstly, my view is that equities remain over-valued, as they are increasingly untethered to earnings and difficult to justify even with a neutral fiscal outlook (meaning more of the same). Secondly, the big unknown remains CV19, which has been largely ignored today as the election has been the focus. The pandemic is worsening in the US, and the government’s ongoing challenge will be to navigate between the trajectory of growth of CV19 and the performance of the economy.