Asset Management: Multi-Asset Insights

U.S. Elections: Split or sweep?

sweep-or-split

In our September Strategy Spotlight, (Un)popularity Contest? Markets May Not Care, we illustrated how the political affiliation of the president tends to have little bearing on the broad U.S. equity markets in the long run. While we remain confident in that assessment, we thought it would be wise, with only weeks remaining in the torturously long presidential race, to reassess the state of the election and its implications.

Hillary Clinton has a significant lead on Donald Trump, with prediction markets and data-driven forecasters giving her an 80% to 90% chance of winning. Democrats look well positioned to re-take the Senate, which they ceded to Republicans two years ago. The increased probability of a Democratic House majority has been a notable change over the last month. Prediction markets now peg the odds of a Democratic House majority at slightly below 20%, which we believe is highly correlated with the Democrats’ odds in the presidency and Senate.

How the odds have changed

 

Base case: Business as usual

Our expectations for a split government remain unchanged: we anticipate that the Democrats will take the presidency and Senate while the Republicans will maintain the House. We believe Clinton will continue many of the policies of the Obama administration, removing some uncertainty from the market. The Fed will continue its accommodative stance and Janet Yellen will serve out the rest of her term to 2018, with the potential for re-appointment. In the international arena Clinton may implement a slightly more hawkish foreign policy than Obama, while trade policy may take a marginally more protectionist tilt. While politically these changes have repercussions, for markets they should be digestible, despite bouts of volatility.

November surprise: Potential Democratic sweep

Though not our base case, a Democratic sweep in two of the three branches of government — with the potential to take the third through Supreme Court nominations — holds implications for many facets of the economy. Results would be mixed, even intrasector, though corporations and wealthy individuals would bear the brunt of the higher tax regime. For example, the Democrats have pushed for affordable housing through looser credit standards from the Federal Housing Administration, which could spur a mild building boom in the lower-end housing market. However, they also propose a cap on itemized deductions, which would hurt the higher-end housing market. In corporate policy the Democrats have proposed taxing all overseas profits for U.S.-based multinationals, which would lead to higher effective taxes. New regulation and potential taxes could affect entire industries, so risk premiums in certain sectors of the market would invariably increase.

Tax and fiscal policy

Tax policy and fiscal policy will be affected too. Clinton’s personal income tax plan would keep taxes essentially at current levels for the majority of tax-payers, but would boost taxes on the highest earners to pay for her expanded social programs. It is more difficult to assess the impact of Clinton’s corporate tax plan, as it includes broad reforms. Some policies could effectively offset each other — making it harder, for example, to execute “tax inversion” while at the same time giving tax credits to companies that hire workers from apprenticeships or engage in profit sharing with workers.

Regarding fiscal policy, we believe many investors are getting ahead of themselves with expectations of a potential growth boost from fiscal stimulus. While both major political parties broadly agree on the need for fiscal stimulus, the overall size of it will likely be relatively quite small (perhaps 0.2%–0.3% of GDP over a few years). Additionally, there is typically a significant lag with investments in areas like infrastructure. Still, with potential GDP likely significantly lower than in the past (and with central banks nearing the limits of monetary policy), a fiscal stimulus would be welcomed by markets.

We remain modestly overweight equities, with a tilt toward U.S. equities. In the likely event of a split government, we would expect this position to fare well. As we noted in our quarterly review, we see election-related policy risk increasing at a greater rate outside the U.S., and we would not be surprised to see a meaningful selloff in the next few quarters. If this occurred without much support from fundamentals, we would consider adding to equities, as we did in February after the market sold off on a limited set of weak data.

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