As the election campaign draws to a close, this Focus looks at how it has affected equity, bond, and currency markets so far and assesses how different outcomes could shift them after Election Day.
- As the election campaign draws to a close, this Focus looks at how it has affected equity, bond, and currency markets so far and assesses how different outcomes could shift them after Election Day.
- This election campaign has already had greater impact on financial markets than those in recent decades. In part, that can be explained by the wide gap between the two parties’ policy proposals, the impact of the COVID-19 pandemic and resulting slump in the US economy, and the risk of a contested election – all of which suggests that the outcome matters more than usual.
- It may also reflect the experience of 2016, when President Trump’s surprise win led to a big shift across financial markets. Back then US equities soon rose, after a brief wobble, outperforming those elsewhere; bond yields rose, also by more in the US than in other developed markets; and the dollar appreciated, especially against emerging market currencies. That reflected a combination of expectations for looser fiscal and tighter monetary policy in the US, and concerns about President Trump’s protectionist stance on trade.
- This time around investors have focused on the chance of another fiscal stimulus package in the US. Over recent weeks, equities have rallied and bond yields risen on occasions when the perceived chance of a Democratic win has gone up, and vice versa. That is probably because Democrats favour more spending than Republicans, so a win for their candidate for president, Joe Biden, combined with a ‘Blue wave’ sweep where Democrats won majorities in both the House of Representatives and the Senate, is perceived as the outcome that would deliver the largest fiscal boost and therefore the most help for risky assets.
- That appears to have outweighed the perceived downside risks to US equities from the Democrats’ intention to raise the corporate tax rate in the US, as well as their desire to reform the US healthcare system and take a stricter approach to regulation in areas such as anti trust and environmental policy.
- In our view, investors may be overly optimistic about how much stimulus a Biden administration would deliver, and how quickly it would get through Congress even with Democratic majorities in both houses. We also think that any further rise in US Treasury yields if there was a large fiscal package would not be sustained. We expect that the Fed will continue to keep yields low regardless, because it wants financial conditions to remain accommodative while the economy recovers from the COVID-19 shock.
- And, unlike Republicans in 2016, Democrats are favourites to win this election (even if their perceived chances have fallen a little this week) so investors are probably already at least partially discounting that outcome. This suggests there may be a smaller impact on markets if the polls prove right this time.
- Somewhat paradoxically, a surprise sweep for Republicans (which looks very unlikely, especially given how far behind they are in the House race) could well lead to a broadly similar market reaction as a Democratic win. They too would probably pass another stimulus package, albeit a smaller one, and continue with the generally business-friendly policies of the past four years. That said, a second term for President Trump would probably be bad news for some emerging market currencies – in particular, the Chinese renminbi – due to the risk that he may again ratchet up trade tensions again.
- If instead the election results in divided government, that may weigh on US equities and bond yields since investors would probably pare back their expectations for further fiscal stimulus. As the experience this year shows, divisions between the two parties would probably lead to continued deadlock in Congress.
- The worst outcome for investors would be if either side contested the outcome of the election. That would reduce the near-term prospects for a fiscal deal and increase uncertainty more generally. It could easily trigger a deeper setback for risky assets and a rally in safe havens, including the US dollar.
Taking stock of the risks around the US election
- This Focus considers what the implications of the upcoming US election are for financial markets. Section 1 looks at what is at stake and why this election matters more than usual for markets. Section 2 takes stock of how investors’ perceptions of the risks around the election have shifted over the course of the year. Section 3 considers the implications of different post-election scenarios for equity markets, primarily in the US. Section 4 looks at how bond and currency markets might react. Section 5 summarises.
1. This election matters more than usual
US elections usually have limited impact on financial markets. As we discussed here, there is some evidence that political uncertainty weighs on equities in the years ahead of elections. But that effect has usually been small. To the extent that in some election there has been a correlation between the stock market’s performance and the incumbent’s chance of winning, we think that mainly reflects the fact that both are driven in large part by economic conditions. (See here & here.)
In general US equities have tended to rise regardless of the political party in power. (See Chart 1.) Likewise, US elections mostly have little bearing on bond and currency markets. Overall, we take the view that broader economic trends are more important to financial markets than politics.
Chart 1: President’s Party & S&P 500 (Log Scale)
Sources: Refinitiv, Capital Economics
To some extent, however, this election appears to be an exception. Changes in the perceived odds of different election outcomes have shifted prices in core financial markets. In part that may simply reflect the fact that the surprise outcome of the 2016 election had major repercussions in equity, bond, and currency markets. Investors may be wary of getting caught napping again. More specifically, we think there are three interrelated reasons why this election matters more than usual for markets.
First, the COVID-19 pandemic has made fiscal policy more important than usual since it is key to supporting the economy through the crisis and to the speed of the recovery, and the scale of the recent and prospective stimulus is very large. The initial emergency package passed back in March enjoyed broad backing from both parties. It provided extensive support to individuals and firms affected by the pandemic, which helped the US economy hold up better than most other major advanced economies in the first half of the year and boosted its recovery over the summer. (See here.)
But differences between Democrats and Republicans as to how much and what type of further support is needed have meant a second fiscal package has not been agreed, despite lengthy negotiations over the past few months. This has weighed on equity markets, especially over the past couple of months as the economic recovery has slowed. Since Democrats have argued for a larger package of support measures than Republicans – and in general are more positive towards government spending – investors appear to believe that a Democratic sweep would lead to a larger fiscal stimulus in the near term than an outcome in which the more fiscally restrictive Republicans retain control of the Senate.
Second, the gap between the two parties’ policy positions in general is larger than in the past, and more directly relevant to equity markets. In particular, Democratic candidate Joe Biden has pledged to reverse half of the cut to the headline corporate tax rate that President Trump and Republicans passed three years ago, and close some of the loopholes that allow US firms to reduce their tax bills. That would have a direct and quantifiable impact on their post-tax earnings, and therefore their equity prices, in a way that most government policies do not. While much depends on the details of any final legislation, we estimate that Biden’s tax proposals would, other things equal, reduce the S&P 500’s earnings by about 5%. (See here.)
Democrats also favour stricter regulations in areas such as anti-trust and environmental policy, as well as major changes to US healthcare. Although it is harder to quantify the impact of these proposals, they pose a key risk to parts of the US stock market. Perhaps most significantly, a more aggressive anti-trust policy has the potential to undermine the dominant position of the ‘big tech’ firms, the five largest of which now account for almost a quarter of the S&P 500’s market capitalisation. (See here.)
Third, the polarisation of US politics, combined with the logistical challenge of holding an election during a pandemic, means that there is some risk that the election outcome remains uncertain for a period after Election Day. Unusually, President Trump has repeatedly said he might not accept the result of the election if he were to lose, and that he expects the result will ultimately be determined by the courts. It is also possible that Democrats would challenge the outcome if Trump were to win, especially if it appeared that some votes had not been counted.
A contested result, along the lines of what happened after the 2000 election, would generate significant uncertainty in the near term, and could further entrench divisions between Democrats and Republicans. One effect would probably be to delay any fiscal stimulus deal, and to reduce the chance of a bipartisan compromise next year.
In 2000, markets treated the uncertain election outcome as a risk-off event. The S&P 500 fell by around 5% in the week following the election, while Treasury yields dropped and the dollar rallied. (See Chart 2.) Much of the equity market tumble unwound once the Supreme Court’s decision effectively ended the dispute in mid-December. And in any case, the impact of the political uncertainty was much smaller than the bursting of the dotcom bubble, which had started earlier that year.
Chart 2: S&P 500, 10-yr US Treasury Yield & DXY Around 2000 Election (Election day = 100)
Sources: Refinitiv, Capital Economics
That said, the impact on market sentiment of a contested election this time could be larger, given that the economic outlook is already very uncertain due to the pandemic, and tensions between the two main parties are much higher than they were twenty years ago. Indeed, it is worth bearing in mind that in 2016, as it became clear that President Trump had won narrowly S&P 500 futures initially dropped by 5% on election night before Hillary Clinton conceded. That may, in part, have reflected fears that she might challenge the outcome in the courts, although then-President-elect Trump’s conciliatory acceptance speech also helped sooth investors’ fears about his approach to the presidency.
2. How have markets reacted so far?
Earlier in the year investors appeared focused on the downside risks of a Democratic win. For example, during the primary campaign the share prices of healthcare stocks appeared to rise and fall with the perceived odds of left-wing candidates Bernie Sanders and Elizabeth Warren (who both advocate sweeping changes to US healthcare, as well as higher taxes and stricter regulation across the board) winning the Democratic nomination. On the day after Biden won the pivotal ‘Super Tuesday’ primaries, which made him the presumptive nominee, the S&P rallied by 4% – probably reflecting the reduced risks to equities from Biden’s more moderate policy platform.
Nonetheless, as we set out here, a Biden win, especially if accompanied by a Democratic sweep of the House and Senate, still appeared to be a downside risk to US equities. Since March, the effects of the COVID-19 pandemic and the outlook for the economic recovery from that shock have been more important considerations for investors. The Democrats’ perceived odds of winning the election rose in early summer, coinciding with a slump in the S&P 500. But it is hard to argue that one caused the other. In our view, the more important factor behind both of those developments was the resurgence of COVID-19 in the US at that time.
More recently, however, investors appear to have shifted their views about the balance of risks. Over recent weeks, equity markets have tended to rally when the perceived chance of a fiscal deal in the US have risen, and vice versa. Most strikingly, the S&P 500 rose sharply as Biden’s lead in the polls widened in the week after the first presidential debate in early October, although they have fallen sharply this week after the Senate adjourned without passing a fiscal package and COVID-19 cases surged further. (See Chart 3.) Nonetheless, their rise in the first weeks of October suggests that investors place more importance on the perceived near-term positive for equities (a better chance of a large fiscal package) than the medium-term negatives (higher corporate taxes and stricter regulation).
Chart 3: S&P 500 & 10y UST
Sources: Refinitiv, Capital Economics
At the same time, the 10-year US Treasury yield rose by about 20bp, to its highest level since June (although it has since dropped back). The shift in Treasury yields has been driven in roughly equal measures by a rise in inflation compensation and a pick-up in real yields. Meanwhile, the US dollar has generally lost ground, although it remains within its trading range since early August. That is consistent with the view that a large fiscal package would push up on Treasury yields, while an improvement in risk appetite would weigh on the dollar.
In addition, implied volatility around Election Day, rose significantly across a range of financial instruments in September. While it fell back in October, it has risen this week and remains elevated. That may be because the widening of Biden’s lead reduced fears that the outcome will be contested (since a blowout win would presumably be less likely to be challenged). That suggest that if the election passes smoothly, the reduction in uncertainty will probably give a small boost to risky assets generally. In contrast, an uncertain outcome is far from fully discounted, and the initial reaction in that event would most likely be a sell-off across risky assets and increased demand for safe havens.
3. What might come next for equity markets?
In assessing how markets might react to the election result, a key question is what investors are currently discounting. That is difficult to judge. Biden has been consistently ahead in the polls since early summer and now holds a big lead – 9-10% nationally, and 5-6% in the crucial midwestern swing states. In fact, no candidate has ever had this large a lead this close to the election and gone on to lose.
Betting markets put a roughly 65% chance on him winning the presidency. Democrats are heavily favoured to win the House (~85%) and are also seen as more likely than not to win control of the Senate (~60%). (See Chart 4.) Polling-based statistical models, such as FiveThirtyEight’s, give them even better odds of success. This suggests a Democratic win is at least partly discounted at this point.
Chart 4: Democrats’ Implied Chance Of Winning (%)
Sources: PredictIt, Capital Economics
In contrast, back in 2016 Trump’s win came as a surprise. He had been behind in the polls for most of the campaign, and betting odds gave him only a ~20% chance of winning on the eve of the election. Republicans also behind in the race for the Senate.
So, a Democratic win next week would come as less of a bombshell than the 2016 outcome. That suggests that while equity markets may well rise further if the expectation of a Democratic win is confirmed, the market reaction may be smaller than in 2016. On the other hand, if the outcome is divided government (either a Biden presidency with a Republican Senate, or Trump win with a Democratic House) that would come as a surprise this time, and may well lead to a near-term fall in equities, since it would reduce the perceived chance of a large fiscal stimulus. A Republican-controlled Senate could well take a very restrictive approach to further fiscal stimulus, as it did during the Obama administration after the 2010 mid-term election.
That said, deadlock in Congress would also diminish the chance of tax hikes. And if equity markets did fall significantly, that would increase the pressure on both parties to reach a compromise deal – as happened back in March this year (and in 2008-09 during the Global Financial Crisis).
Meanwhile, if President Trump and the Republicans pull off another surprise sweep, that may be the most positive outcome for equities. It would probably lead to another stimulus package (albeit a smaller one than in the event of a Democratic sweep) and a continuation of their generally business-friendly policies.
If either side contested the outcome, we think that would be the worst outcome for equities. It would reduce the near-term prospects for a fiscal deal and increase uncertainty more generally. Combined with a renewed rise in COVID-19 cases in the US and the ongoing second wave in Europe, it would increase the danger of a deeper setback for risky assets. That said, even a prolonged dispute would probably not do long-lasting damage to US equities – once the issue was resolved, the uncertainty would lift.
The other key consideration is to what extent investors are right in assuming that a Democratic win would help US equities. In our view, while the chance of a large fiscal stimulus is plainly higher in the event of a Democratic sweep than in the other scenarios, investors may be overly optimistic about how quickly such a package would materialise and how much stimulus it would provide.
As we set out here, even with a majority in both chambers of Congress, there are limits to what a Biden administration could do without the support of at least a handful of Republican senators. This might result in either a smaller compromise fiscal deal, or that it would take several months for Democrats to put together a comprehensive fiscal package that included both near-term stimulus measures and longer term tax hikes and changes to government spending. Since increased spending would be partly offset by tax hikes, the overall effect might provide less of a boost to the economy than many anticipate.
In addition, other aspects of the Democrats’ agenda would weigh on US equities. Stricter environmental regulation, healthcare reform, and bolder anti-trust measures are all part of the Democratic policy platform, even if they may not be the initial focus of an incoming Biden administration. So, while the initial reaction to a Democratic sweep might be positive for US equities, it might not last long.
One implication of that, in our view, is that equities in the rest of the world might fare better than those in the US. After all, they would benefit to the extent that growth in the US picked up and drove a global recovery but would not suffer the negative effects of higher corporate taxes or increased regulation.
Another implication is that the relative performance of different sectors within the US stock market might change. As we set out here, there are several reasons why the policies proposed by the Democrats might lead to at least a partial reversal of the outperformance of the ‘growth’ stocks – most notably ‘big tech’ and healthcare – that have been the best performers in the US over the past few years.
4. What about bond and currency markets?
Until this week, when hopes of a fiscal deal before the election were finally extinguished, US bond yields (both nominal and real) had risen, and the dollar generally been on the backfoot. That suggests that – despite the resurgence of COVID-19 in Europe and the US, which threatens to slow down the recovery of the global economy – investors were becoming more optimistic about the economic outlook. To a significant extent, that appears to reflect expectations that further fiscal stimulus will lead to a stronger recovery and a generally reflationary environment.
In some ways, that is similar to what happened after the 2016 election. Then, the Republican win created an expectation that a generally more expansionary fiscal stance would lead to a pick-up in US growth and inflation, and in turn to tighter monetary policy from the Fed. That prompted a jump in US bond yields (and, to a lesser extent, those elsewhere too) and an appreciation of the US dollar. Emerging market currencies were particularly hard hit, with the Mexican peso suffering the sharpest fall due to fears that Trump would disrupt trade relations between the US and Mexico (although those never materialised). While those moves partially unwound in 2017, when Republicans tried to pass healthcare reforms and delayed their tax cut legislation, they were ultimately validated in 2018. (See Chart 5)
Chart 5: 10-yr US Treasury Yields (%) & DXY
Sources: Refinitiv, Capital Economics
As set out in the previous section, we doubt that fiscal stimulus would materialise as quickly as appears to be expected in the event of a Democratic sweep. That is one reason why we think that even if bond yields were to rise after the election on expectations of more stimulus, that move would fade if we are right that getting a package through Congress could prove difficult even if the Democrats win majorities in both houses.
More importantly, we do not think that the Fed would respond in the same way as it did after the 2016 election. Then, it had already started a tightening cycle, and continued to raise interest rates and reduce the size of its balance sheet. It raised its policy rate in December 2016, three times in 2017, and four times in 2018, after Congress passed the Republican tax cuts, taking the Fed Funds target from 0.25-0.5% to 2.25-2.5%.
But now it has made clear that policy is set to remain ultra-loose while the economy recovers from the pandemic shock. Indeed, its new average inflation-targeting framework combined with its current inflation projections suggests it will keep interest rates at their current levels for at least the next three years, if not longer. We think that if Treasury yields were to rise significantly, the Fed would respond, perhaps by strengthening its forward guidance and, if necessary, increasing its asset purchases to avoid financial conditions tightening.
In contrast, if the election results in split government, bond yields may well fall a bit if expectations for further fiscal stimulus are pared back. And if the outcome is contested, bond yields may fall sharply as safe-haven demand picks up.
In any case, our view is that government bond yields in the US (and other developed markets) are set to remain not far from their current levels over the next couple of years as central banks continue to keep policy accommodative while the global economy recovers from the pandemic shock. (See here.)
When it comes to the dollar, its rise in 2016 was mainly down to two factors: the shift in expected growth and interest rate differentials in favour of the US, and concerns that President Trump’s protectionist trade policy would result in a trade war with one or more of the US’ trading partners (as indeed transpired in 2018). The same two factors are key to the post-election outlook this year.
While the greenback is still in the range it has traded within since early August, it has generally weakened when Biden’s perceived chance of winning has risen. One factor behind that is probably that that Biden appears likely to take a less aggressive stance on trade issues than Trump. That is particularly important for the Chinese renminbi and other Asian currencies, which bore the brunt of the 2018-19 US-China trade war. While we think that US-China relations will deteriorate regardless of who is president, Biden may place less emphasis on tariffs than Trump has. (See here.) On the other hand, Biden may take a tougher stance towards Turkey and Russia, which appears to have contributed to the recent weakness of the lira and the ruble. (See here.)
More broadly though, investors’ view of the dollar appears to be driven by expectations about the fiscal deal and the outlook for the global economy. Their logic appears to be that another large fiscal boost in the US would speed up the recovery, which would probably lead to a weaker dollar. After all, the greenback generally tends to fall when the global economy is in a recovery phase, and riskier currencies to benefit the most.
Given our view that the Fed and other central banks are set to keep policy rates at or near their lower bounds for several years as the global economy recovers from the COVID-19, we expect that nominal interest differentials will not move much, regardless of the election outcome. And because we expect inflation expectations to pick up by more in the US than in Europe and Japan (where low inflation was already entrenched before COVID-19 hit), we think that real rate differentials will move a bit further against the dollar over the next couple of years.
The election could easily become a catalyst for a major shift over the next couple of months. The largest shift would probably come if the election outcome is contested: the uncertainty that would generate could well lead to a sell-off across risky assets and an increase in safe-haven demand. If the result is a divided government, that may also weigh on equities and bond yields, although not by as much.
A sweep for the Republicans – which looks very unlikely based on current polls – might well be the best outcome for US equities, although it would probably weigh on EM currencies. The most likely outcome appears to be a clean sweep for the Democrats. Even if it is partly discounted in markets, that result would probably lead to a continuation of the ‘reflation trade’ that appeared underway for much October: stronger equity markets, higher bond yields, and a weaker dollar.
Jonas Goltermann, Senior Markets Economist, firstname.lastname@example.org