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The US election – just political noise?

I voted

For financial professionals only

The weakness in US equity markets in September appeared to come as a surprise to many investors, despite history pointing to this being seasonally quite typical. After such a strong and persistent rally since the Covid-19 lows of March, profit taking and market consolidation should be seen as a positive rather than a negative. However, what does make it different this time are three factors, increasing questions over market valuations, slowing economic momentum as further waves of Covid-19 restrictions take effect, and heightened uncertainties around the US election.

The narrowness of the US market rally has been well documented, but when analysed through the disciplined lens of cashflow, which is what ultimately drives value creation, the leading technology and communication services stocks of the S&P 500 have largely exceeded consensus earnings expectations, and actually been beneficiaries of the increased working from home and lockdown environments we have all become familiar with. What this means is that because of the earnings strength of these companies the relative valuation (P/E multiple) is not as extended as many would have us believe – see chart below.

Source: FactSet, MSCI World Index and AllianceBernstein (AB)

Now this doesn’t mean to say that mean reversion will not occur if for example an additional significant US fiscal stimulus package is passed or an approved vaccine rolled out, as those sectors that have lagged catch up in anticipation of an improving cyclical recovery. But it should reassure investors that the rally thus far does have a reasonable foundation to it, thereby reducing the risk of an impending collapse.

Momentum in the global economic recovery has waned of late as further restrictions and local lockdowns have been applied, however high frequency data still broadly point to sustained incremental improvement. There will undoubtedly be further regional set backs, but the recovery was never going to be a straight line and we should be prepared for many more undulations and twists and turns.

Similarly, the excitement around the US election was always going to build in the run up to the November 3rd election day, but the question for long term investors is does it really matter? And in this instance I think it does a little more so than in the past because of the marked differences in policy between Biden and Trump (acknowledging that Trump has yet to announce his policies so I am simply assuming a continuation of what he has done in his first term), specifically on tax, expenditure, minimum wages, regulation, infrastructure and the environment. Having said that, given the checks and balances that exist within the US political system means that the probability of a fast and draconian shift in economic direction is less likely, and therefore the shock and awe that many media headlines are leading us to believe is somewhat sensationalist and melodramatic.

Republicans good, Democrats bad?

Perception is that a Republican administration is good for financial markets and Democrats bad. The reality, as seen in the table below, is that this has not been borne out through history. Instead, it is not so much which party is in the White House but who has control of the Senate and House of Representatives that is key.

Dow Jones Industrial Average Performance
When the US government has: % gain/annum % of time
Democratic President, Republican Congress 9.1% 10.1%
Democratic President, Split Congress 10.4% 3.4%
Democratic President, Democratic Congress 7.2% 33.4%
Republican President, Republican Congress 7.3% 23.5%
Republican President, Split Congress -2.9% 11.5%
Republican President, Democratic Congress 2.4% 18.4%

Source: Charles Schwab, Ned Davis Research

We have learnt over time that the reliability of polls to predict the outcome is no longer what it was, so indications of a Biden Democrat clean sweep are to be taken cautiously. This is all the more so because for the Democrats to secure a meaningful majority in the Senate, i.e. win 60 seats and therefore be assured to pass all new proposed legislation, is an enormous challenge. With 33 seats up for election of which the Democrats need to not only retain their 12 that they currently hold but also win 13 of the 21 Republican seats up for grabs is a big ask. This is not impossible, but it is a low probability, meaning that a split Congress is most likely. Based on history therefore, from the table above, a Democrat President with a split Congress looks reasonably promising for investors.  However, history also shows that the probability of an incumbent winning a second term is greatly enhanced if year-to-date equity markets are positive, and so far they are with the S&P 500 up 8.7% and the Nasdaq up 33.2% to 9th October 2020. So, this election is far from a done deal and as is often the case in life, things rarely turn out exactly as we expect.

Do policies matter?

What the markets do appear to be more jittery about is the prospect of the Democrats raising corporation tax from the current level of 21% to 28% (see chart below) and introducing regulation and antitrust suits against big tech companies. Investment banks forecast the impact of such an increase in corporate tax to reduce aggregate earnings by ~6-8%, however this is expected to be offset by a sustained fiscal stimulus programme including a hike in minimum wages from $7 to $15 per hour which will help to support domestic consumption, a huge infrastructure plan which will improve long term productivity (and is massively overdue), and an environmental focus to reassert the US as a leader and supporter of global sustainability initiatives. What this means therefore is that the market implications of all this are likely to be far more nuanced with specific sector winners and losers, which for good active managers is expected to yield long term investment opportunities.

Source: IRS, joebiden.com, J.P. Morgan Asset Management

What’s not changing

Regardless of the outcome of the election and potentially more important for investors is to remember what is not changing, and that is the Fed’s continued very supportive monetary policies of extremely low interest rates, QE and possible yield curve control. In this environment it is expected that abundant liquidity will continue to buoy markets with the real economy slowly but surely recovering.

Equally the bipartisan caution towards China is not expected to change, albeit the approach and tone of language may well become less hostile. The implications of this are that the trends of onshoring and deglobalisation are expected to continue and with that some upward inflationary pressure. But with the Fed’s revised average inflation targeting approach they are indicting a willingness to run the economy ‘hot’ rather than pre-emptively stifle activity through raising interest rates, helping to support corporate earnings growth and employment, which is their other key point of focus.

Keep calm and carry on

As such despite the strengthening political winds of change and the myriad of perceived policy changes that could come to pass, for long term investors we continue to advocate staying the course.  The checks and balances that exist within the US political system may well be put to the test over the next few months, but I expect them to stand the test of time and serve their purpose to support a steady path forward.

As a result, maintaining a diversified portfolio which is aligned to an investor’s attitude to risk and capacity for loss remains key as well as staying invested for the long term. And remember, whilst politics will come and go and economic growth ebb and flow, corporate cashflow is the primary determinant of future returns, something which our selected managers have been and continue to focus on.

Photo by Element5 Digital on Unsplash



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