Victory for the Democrats could hold back US equities - Capital Economics
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Victory for the Democrats could hold back US equities

Global Markets Focus
Written by Oliver Allen
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The odds that Joe Biden wins this year’s US presidential election, and that the Democrats also win full control of Congress, have risen recently. While we expect US equities to fare reasonably well over the next few years regardless of the result of the elections, we think that a ‘clean sweep’ for the Democrats would hold back the US stock market. That is chiefly because such an outcome would probably mean higher corporate taxes, but there are also some notable risks in a few other policy areas.

  • The odds that Joe Biden wins this year’s US presidential election, and that the Democrats also win full control of Congress, have risen recently. While we expect US equities to fare reasonably well over the next few years regardless of the result of the elections, we think that a ‘clean sweep’ for the Democrats would hold back the US stock market. That is chiefly because such an outcome would probably mean higher corporate taxes, but there are also some notable risks in a few other policy areas.
  • The combination of the coronavirus pandemic, the resulting slump in the US economy, and recent nationwide protests appears to have damaged President Trump’s standing with voters. Polls have shifted against both him and the Republican party more widely. Prediction markets now put Biden’s chances of becoming president at around 60% and give the Democrats a similar chance of taking control of the Senate too. If they won full control of the US federal government, that would give Biden a good chance to put some of the policies that he has floated on the campaign trail into practice.
  • The pricing of VIX futures contracts around election day suggests that equity investors are increasingly nervous about the outcome. While that may be partly due to uncertainties around the election itself – including the risk that Trump tries to postpone it, or refuses to accept the result – we suspect that it mainly reflects the stark difference between the policies of the two parties, especially on corporate taxes.
  • While we don’t know exactly what kind of president Biden would be if he took office, we think that some of his proposals present a risk to US equities, especially if the Democrats also win control of Congress.
  • Most important by far are Biden’s proposals to raise corporate taxes. He plans to raise the headline rate from 21% to 28%, as well as close some loopholes. We estimate that Trump’s 2017 corporate tax cut raised the level of earnings per share of by S&P 500 by around 10%. Biden’s proposals on corporate tax would presumably unwind some of that boost to earnings per share.
  • Policies favoured by the Democrats in a few other areas also have the potential to hurt US equities. Although a lot would depend on the details, some of Biden’s proposals for healthcare reform seem like bad news for healthcare stocks. Meanwhile, there is also a risk that the Democrats end up pushing for a much tougher anti-trust policy. In addition, a substantial hike to the minimum wage, and tighter regulation of the energy sector, could be another two headwinds for the US stock market.
  • The other possible outcomes of the elections probably pose less of a risk. The generally business-friendly policies of his first term, and his fondness for low taxes, suggest that a second term for Trump would provide a favourable backdrop for the stock market. Trump might also nominate a more dovish replacement for Jerome Powell when the latter’s term expires in 2022. That could benefit US equities, at least in the near term, if it meant that the Fed pursued even looser monetary policy than it might otherwise.
  • A situation where Biden won the presidency, but the Democrats failed to win control of Congress would be much less of a threat to US equities. After all, a Republican-controlled Senate would be unlikely to accept Biden’s current proposals on corporate taxes, nor on many other areas of policy. The political deadlock that has prevailed in Washington DC for much of the past decade would probably continue.
  • While politics can have a big impact on equities, history suggests broader developments in the economy often matter more. We expect an economic recovery and continued support from the Federal Reserve to mean that the outlook for US equities is fairly bright, regardless of the election result. But we think that US equities would gain less ground over the next few years if the Democrats won both the presidency and full control of Congress, even if that outcome were broadly neutral for the US economy as a whole.

Victory for the Democrats could hold back US equities

This Focus explains why we think that a ‘clean sweep’ for the Democrats – winning the presidency, the Senate, and the House of Representatives – would be a bad outcome for US equities. Section 1 examines how the race has recently shifted in the Democrats’ favour. Section 2 gives some context on how much politics have tended to matter for US equities in the past. Section 3 describes the policies that we think would present a risk to the US stock market if the Democrats won a ‘clean sweep’. Section 4 explains why we think that other election outcomes would pose less of a risk to US equities. Section 5 concludes.

1. The odds have shifted in the Democrats’ favour

Events in recent months appear to have bolstered the Democrats’ chances at this year’s elections. First and foremost, the economic slump caused by the coronavirus is bad news for the Republicans. US voters in the past have typically punished the incumbent president’s party when the economy has softened in the lead-up to an election, and this downturn is one of the deepest ever.

While Trump, like many national leaders elsewhere, initially saw his approval rating rise at the start of the pandemic, that effect has since unwound. The share of Americans who say that they disapprove of the President’s response to the virus has been gradually rising, and now stands at roughly 55%. The recent wave of nationwide protests seems to have hurt his popularity further. Trump now trails Biden by about 9% in national polls, and his personal approval rating is just 41%. If he were to win, he would be the least popular US president to win re-election since Harry Truman in 1948. (See Chart 1.)

Chart 1: Approval Ratings Prior to Election Day (%)

Sources: 538.com, Capital Economics

That said, there is a long way to go until November. Even if the economy remains weak, and his handling of the virus questionable, the polarised nature of US politics suggests that the Republicans still have a decent chance if Trump can rally his base with the same populist messages that served him well in 2016. For example, he has already resumed a tough stance on China. The electoral college system also means Trump could win the presidency even if he narrowly lost the popular vote, as he did in 2016.

Even so, the Democrats are now favoured to win. Polls have shifted in their favour both in the presidential election and in many of the key Senate races. Prediction markets put their chances of winning the presidency at 60%, up from roughly 40% only a few months ago, and suggest that it is increasingly likely that the Democrats also win control of the Senate. (See Chart 2.) It is very unlikely that the Democrats could take the Senate without also winning both the presidency and House of Representatives. A Democratic Congress would make it far more likely that Biden could put many of his proposals into practice.

Chart 2: US Election Probabilities (%)

Sources: PredictIt, Bloomberg Capital Economics

2. How much does politics matter?

Some historical context is helpful in judging how much Democratic ‘clean sweep’ should worry investors. Admittedly, the big picture is that the S&P 500 has climbed fairly consistently since the end of the second world war, regardless of who is in the White House. (See Chart 3.) Somewhat counterintuitively, given that the Republicans are seen as the more business-friendly party, the S&P 500 has risen by more on average under a Democratic president than a Republican.

Chart 3: President’s Party & S&P 500 (Log Scale)

Sources: Refinitiv, Capital Economics

That is probably because broader developments in the economy have tended to matter more for US equities than politics. On this front, the Republicans have been ‘unlucky’. Richard Nixon and Gerald Ford’s presidencies coincided with the stagflation of the 1970s, and George W. Bush’s with the recessions that began in 2001 and 2007. In contrast, the economy boomed under Bill Clinton, while Barack Obama oversaw the recovery from a deep recession.

However, politics clearly can make some difference, at least in the shorter term. Other evidence suggests that equity investors prefer Republican presidents. One crude demonstration of this is how in the months following election day in the post-war era the S&P 500 has risen on average when a Republican has won but fallen following Democratic victories. (See Chart 4.) In recent years, the Trump administration’s tax cuts and light-touch approach to regulation have provided a supportive backdrop for US equities.

Chart 4: Changes In S&P 500 (Avg. Since 1948, %)

Sources: Refinitiv, Capital Economics

What’s more, investors seem to expect this election to be more pivotal than most recent ones. Chart 5 shows the ratio of the VIX futures contract for October 2020, the final contract before election day, versus an average of September and November. This is a rough proxy for how much additional volatility investors expect in the S&P 500 around election day. This measure fell sharply following the ‘Super Tuesday’ primaries, in which Biden established a lead over Bernie Sanders, his more left-wing rival for the Democratic nomination. But as the Democrats election chances have improved in recent months, it has edged higher. Investors do not seem to have anticipated nearly as much additional volatility around election day back in 2016, 2012 or 2008.

Chart 5: Ratio Of October 2020 VIX Futures Contract To Average Of September & November

Sources: Bloomberg, Capital Economics

That expectation for volatility might partly reflect the uncertainty surrounding the election itself. While changing the date of a national election in the US is not impossible, the process is a legally complex one that requires broad agreement in Congress. It is therefore probable that the election will go ahead as planned on 3rd November, albeit with many states expanding access to postal voting. That said, there is an outside chance that Trump tries to have the election postponed if his polling remains poor, which could spark a constitutional crisis.

Perhaps a bigger risk is that Trump refuses to accept the election result if he loses. Although there is evidence that postal voting increases turnout, it is not clear that it gives either party an advantage. That has not stopped Trump suggesting that postal voting puts the Republicans at a disadvantage and, more seriously, that it leaves the election open to fraud.

If the outcome of the election were contested, the closest parallel in modern times is probably the fallout from the 2000 presidential election. Then, the outcome hinged on the result in Florida, which was initially too close to call. The ensuing uncertainty weighed on the US stock market in the weeks following election day. (See Chart 6.)

Chart 6: S&P 500 Around 2000 Election

Sources: Refinitiv, Capital Economics

However, more of the expected volatility probably reflects how the various possible outcomes of the election appear to have quite different implications for US equities. In the next section, we explain why we think that a ‘clean sweep’ for the Democrats would be the worst outcome for the US stock market. In the subsequent section, we lay out our view that the other possible outcomes of the election would pose less of a risk to US equities.

3. A ‘clean sweep’ could hold back US equities

Judging exactly what a ‘clean sweep’ would mean for US equities is complicated by uncertainty around just what kind of president Biden would be. Many of the policies which presidential candidates float on the campaign trail never see the light of day. Often that is because they are meant to rally the base during party primaries but hold less appeal for the broader electorate. In other cases, a lack of support in Congress makes them unfeasible.

On the one hand, Biden has consistently positioned himself at the Democratic Party’s centre, and he is certainly much less left-wing than Senators Elizabeth Warren and Bernie Sanders, whom Biden had to fend off to win the Party’s nomination. Their platforms looked like a major threat to the US stock market.

But on the other hand, Biden’s views have also been flexible, changing over time as those of his party’s mainstream have. That suggests he may pursue some policies that reflect how the Democrats have shifted to the left in recent years. A lot could hinge on where the balance of power in Congress lies. If, for example, the Democrats win a very narrow majority in the Senate, Biden may find that reaching a bi-partisan compromise with moderate Republicans is an easier route to getting things done than securing the full support of the Democratic left-wing.

Despite these uncertainties, we think that a few of Biden’s proposals are worth highlighting as risks to US equities, especially if the Democrats also won full control of Congress. Winning full control would mean that these policies would stand a much better chance of being enacted.

Most important by far are Biden’s proposals to raise corporate taxes. Biden has said he wants to hike the headline rate of corporation tax in the US quite sharply, from 21% to 28% (see Chart 7), and to close some loopholes. We estimate that Trump’s corporate tax cuts raised the earnings per share of the S&P 500 by around 10%, which seems to be one of the factors which has helped US equities outperform their peers elsewhere in the world in recent years. If enacted, Biden’s proposals on corporate tax would presumably unwind some of that boost to earnings per share.

Chart 7: US Corporate Tax Rate (%)

Sources: Bloomberg, Capital Economics

Higher corporate taxes have quite broad support among Democrats. What’s more, if some action is eventually required to put the US public finances on a more sustainable footing, it seems as if it would be politically unpalatable for many Democrats to vote for any fiscal tightening that did not involve some corporate tax hikes. After all, large parts of the US corporate sector have received substantial support as part of the fiscal response to the virus.

Other types of tax hikes could also hurt US equities. Raising capital gains taxes, as Biden has also floated, could make it less attractive for individuals to hold equities. Meanwhile, further limiting the ability of corporations to deduct interest expenses from their tax bills could also hurt the profits of US firms.

Another issue that would probably be a priority for Democrats, particularly given the nature of the current crisis, is healthcare reform. This could have a sizeable impact on the US stock market, given that healthcare companies account for roughly 15% of the market capitalisation of the S&P 500. Admittedly, healthcare reform does not necessarily need to be bad news for healthcare stocks. The Obamacare reforms of 2010 benefitted some firms in the sector, by increasing both insurance coverage, and overall healthcare spending. Biden’s proposals also aim to boost coverage and spending. However, his proposals have two others features that could hurt healthcare stocks.

First, Biden’s plan to make a ‘public option’ available to all Americans as an alternative to private health insurance could undermine the business models of many health insurance companies. Second, reform could limit the prices that healthcare firms can charge, either because the government uses its greater bargaining power to negotiate lower prices, or legislation is introduced to cap charges. That would hurt the profits of healthcare providers and pharmaceutical firms.

Another risk to equities should the Democrats achieve a clean sweep comes from anti-trust policy. Anti-trust has become an increasingly hot topic among some Democrats, as shown by both Bernie Sanders’ and Elizabeth Warren’s platforms during the primary race, which included calls to break up ‘big tech’ firms and large banks, as well as for a tougher enforcement of anti-trust rules more generally. If such policies were enacted, they could have a big impact on US equities, given that five technology firms now account for almost 25% of the market capitalisation of the S&P 500. What’s more, academic evidence suggests that a lax enforcement of anti-trust policy in recent decades has boosted the profits of large US companies in many industries.

That said, Biden does not appear to support the kind of heavy-handed trust busting favoured by Sanders or Warren and seems unlikely to whole-heartedly adopt their positions anytime soon. But the risk that others within the party push for a tougher line on anti-trust policy is certainly something to watch, particularly if some large companies are seen to have benefitted from the current crisis at the expense of smaller firms or households.

Meanwhile, most Democrats, including Biden, support more than doubling the federal minimum wage, from $7.25 per hour to $15. While we are sceptical that this would lead to either much higher unemployment or weaker economic growth – many states already have minimum wages higher than the federal requirement – it could be a small headwind for US equities, in so far as it raised labour costs for some firms.

Finally, Biden’s plan to stop issuing new permits for oil and gas extraction both offshore and on public land would make little immediate difference when oil prices are as low as they are now, and US production is falling sharply. But it could clearly be a headwind for energy companies in the future.

4. Other outcomes pose less immediate risk

We think that the other possible election outcomes pose less risk to US equities, at least in the near term. A second term for Trump would probably be quite good for the stock market. We published a Focus in January setting out what we thought his priorities for economic policy would be. In short, while his unpredictable approach to trade policy would remain a key risk, we think that a continuation of the tax cutting and deregulation that characterised Trump’s first term would provide a favourable backdrop for the US stock market.

Admittedly, another round of corporate tax cuts – which already seemed less likely given the sharp rise in public debt required to respond to the coronavirus – would probably be a non-starter if the Republicans failed to regain control of the House. And prediction markets put their chances at only around 15%. But, at the very least, an increase in corporate taxes seems very unlikely if Trump wins a second term.

Trump could also reshape the Fed, if the Senate let him nominate dovish figures to its board. Most notably, he would have an opportunity to nominate a more dovish replacement for Jerome Powell, when his term expires in 2022. That could benefit US equities, at least in the short term, if it meant the Fed pursued even looser monetary policy, and provided yet more support for the markets for risky assets.

A situation where Biden won the presidency, but the Democrats failed to win control of Congress would also be much less of a risk to equities. After all, it would remove a great deal of uncertainty over trade policy, since this is an area where the President has a lot of power, and Biden is broadly in favour of free trade. Meanwhile, a Republican-controlled Senate would be unlikely to accept Biden’s current proposals on corporate taxes, nor on many other areas of policy.

5. Conclusion

We think that a ‘clean sweep’ for the Democrats in the upcoming US elections would be a bad outcome for US equities. That is chiefly because such an outcome would probably mean higher corporate taxes, but there are also risks in a few other policy areas, including healthcare, anti-trust, energy, and the minimum wage. In contrast, we think that other election outcomes pose less of an immediate risk.

While politics can have a big influence on equities, history suggests that broader developments in the economy tend to matter more. We think that a gradual economic recovery and continued support for financial markets from the Federal Reserve mean that the outlook for US equities is fairly bright, regardless of the election result. Even so, we think that US equities will gain less ground over the next few years if the Democrats win both the presidency and full control of Congress, even if that outcome were broadly neutral for the US economy as a whole. It would also be another reason to think that US equities might fare worse than those elsewhere in the world over the next few years.


Oliver Allen, Assistant Economist, oliver.allen@capitaleconomics.com