U.S. election poses more uncertainty for investors

It would be an extreme understatement to call 2020 merely a difficult and chaotic year, both with relation to financial markets and in daily life. To this already precarious atmosphere, the November U.S. election promises to add yet another degree of uncertainty for investors to contemplate. In September, markets wrestled with the prospect of the presidential vote devolving into a disputed mess, which might not produce an outcome until December or January. At this point, it remains to be seen whether a decisive result with come either the night of the election or a few days following.

By far the most pressing election-related issue for near-term market visibility is the timing and size of the next round of fiscal stimulus. Any political outcome that delivers certainty on this will be supportive of equity prices, which at the moment seem addicted to continued stimulus. A large fiscal injection will also affirm confidence in GDP growth and the reflation of economic activity. Given its potential for providing the most stimulus, a Democratic blowout would appear to be the most attractive option, at least in the near term. Looking further out, altering the pro-business climate and lower-tax environment enacted under U.S. President Donald J. Trump would be a negative, but it doesn’t appear a Joe Biden administration is interested in swinging too far left on either subject.

Biden has an advantage in most swing state polls and is a clear front-runner among oddsmakers: Polling site fivethirtyeight.com has him at 87%, while his betting odds at PreditIt are lower at 64%. Despite this, other research shows investors seem to think Trump’s odds are much better, closer to 45% according to Bank of America Merrill Lynch’s latest investor survey. Indeed, Biden’s odds are not far off from where Hillary Clinton stood four years ago. However, there are a couple of notable differences this time that work in the Democrats’ favor. Firstly, undecided voters swung overwhelmingly for Trump last cycle and there are fewer undecideds in 2020. Secondly, fewer voters—particularly independents—appear to hold deeply-unfavorable views of Biden like they did of Clinton in 2016.

U.S. election scenarios and potential market reaction

Our assessment is there are three probable election outcomes as well as the possibility of a disputed result. The most likely outcome would appear to be a Democratic sweep, followed closely by a Biden Presidency and split Congress, with the Republicans (GOP) retaining the Senate. The least probable of the three, but one that is still very possible, would be the status quo. For brevity, we have not included in our discussion the possibility of the House flipping to the GOP or of Trump winning the election but the Republicans losing the Senate. The Democrats appear to have a 97% probability of retaining the House according toe fivethirtyeight.com. It seems logical that if President Trump, despite the latest polls, is able to retain his office then the GOP likely does the same in the Senate.

Outcome: A Democratic sweep

A Biden win combined with Democratic control of both the Senate and House would promise a substantial COVID-19 stimulus relief package in the order of approximately US$3 trillion, and the recent stock rally suggests investors are already latching on to this outcome. But additional stimulus beyond COVID relief may not be a done deal even with a sweep, as a look at the field suggests that any Democrat majority in the Senate would likely come from Senators representing fiscally-conservative states that may not be on board with massive stimulative measures. This could limit Biden’s ability to spend to his preferred level, and also means that his proposed $2 trillion infrastructure platform proposal is unlikely to pass in any fashion without substantial paring. That said, a Biden administration will have ample ability to pass a very substantial initial relief package.

A plausible scenario would see a stimulus package passed by mid February, likely resembling the $2+ trillion bill brought forward by House Democrats earlier this year. A package of that magnitude would alleviate any near-term concerns of a stalled recovery and would turbo-charge the activity already taking place. This would result in a very bullish equity market where growth and inflation expectations improve meaningfully alongside a steepening yield curve. The primary beneficiaries of this would be cyclicals, financials, small-caps, and ‘value’ stocks which are more dependant on broad economic growth. We would expect earnings revisions and potentially P/Es to move higher for these groups. Certain infrastructure plays and utilities may benefit as well from the hoped for “Green” agenda. Conversely, we would expect short-term pressure on technology, staples, and defensive sectors as rising yields pressure lofty valuation, particularly in technology. Given the sizeable representation of technology in the S&P 500, the headline index level may actually decline despite significant near-term outperformance of various sub-sectors.

Outcome: Biden win, GOP Senate, Democrats retain U.S. House of Representatives

This is perhaps the most challenging scenario for the markets to process because it promises a continuation of the deadlock over the COVID-19 relief bill, meaning more delays and ultimately a substantially smaller relief package than Democrats have been planning. An interesting question is whether the departure of President Trump would bring with it a shift in tone for the government that could translate into GOP Senators adopting a more conciliatory tone than they have of late. However, history suggests a Republican Senate—with or without Trump—would more likely take an obstructionist approach under the banner of fiscal conservatism, such as in 2011 when the GOP refused to pass a routine increase in the debt ceiling in order to force spending cuts from the Obama administration. The event prompted a summer of equity price volatility and prompted Standard & Poor’s to downgrade U.S. government debt.

In this divided-government scenario, some of the recent equity gains would likely unwind in the election’s aftermath as fiscal stimulus visibility fades. We would expect multiples to contract in the near term and should the economy slow, 2021 EPS estimates would come under pressure. Consumer staples and defensives likely outperform in the near term while technology would be in a better position than under a Democratic sweep. Ultimately, if equity prices depreciate meaningfully or there is clear evidence of the economy slowing, we would expect another round of stimulus but the magnitude would likely be lower. This action would, in turn, propel the market and cyclicals higher once again.

Outcome: Trump win, GOP Senate, Democrats retain U.S. House of Representatives

The status-quo option is currently the least likely of the three based on PredictIt & fivethirtyeight.com, but one still very much in play. We would expect a similar market reaction to a Biden win with a GOP Senate but with more optimism around the prospect for fiscal stimulus. With the election in the rear-view mirror and the prospect of working with a Republican president for the next cycle, it’s likely the GOP would be in the political clear to support a larger relief bill than they would under Biden. This would be sufficient to keep the economic recovery chugging along and to support 2021 earnings expectations. A Trump win would also portend more of the same in terms of the domestic pro-business environment and combative trade rhetoric.

The President has recently pushed for a nearly $2T stimulus (after calling off negotiations with Democrats) but he is wildly unpredictable and may change course again should he win re-election. In the medium term, we expect equity markets to react based on stimulus expectations. In short, a large stimulus package favors cyclicals, and to an extent value, while small-to-no stimulus should favor growth.

Outcome: A disputed result

Of course, there is also the chance for a highly-contentious election that sees neither party concede and results in weeks and perhaps months of confusion about the outcome. In this unfortunate scenario, the matter may end up before the Supreme Court of the United States. This seems less likely than it did in early September, but if it did come to pass it would be undoubtedly the most precarious scenario for equity markets as it would deprive investors of certainty and would greatly raise the prospect of significant delays of stimulus or none at all. There is also the potential for massive social unrest that could lead to other unforeseen consequences and would, at the very least, damage consumer confidence.

We’ve discussed our various near-term expectations around U.S. election outcomes, but it is important to acknowledge their impact on equity markets are not in isolation. We expect the interplay between politics and policies, the reaction of consumers to COVID-19 case growth as we enter the winter months and development of vaccines and treatments to be significant on equities. Effective vaccines and improved treatment options are key to a rapid and well-distributed economic recovery, and further stimulus will be necessary for equity markets to bridge the gap to a time when the economy returns to more traditional behavior. To the extent that positive developments on treatments are delayed, there will be an even greater need for political resolve and continued stimulus.

While we believe it is important to monitor macro activity and asses the risks associated with a changing political landscape, it is critical that investors recognize the U.S. stock market is full of global leaders that have grown and prospered throughout almost every political administration in recent history. At Gluskin Sheff we own a diversified collection of high-quality global businesses that we firmly believe will continue to innovate and add significant value to their customers regardless of which party or leader is in power in the U.S.