by Paul Christopher, CFA, Head of Global Market Strategy
- Election news, including surprises, continue to take the headlines — a headwind for risk-asset markets, such as equities and commodities.
- However, even in the face of some challenges of its own, the global economy looks to remain on course for expansion through year-end 2021, at least.
What it may mean for investors
- Election-related uncertainty looks likely to extend beyond election night, but the trends in the economy are comparatively more important for our outlook. We offer suggestions on steps investors may want to consider before and after the elections.
There is a lot going on in the political arena, the economy, and — by extension — in financial markets. Let’s filter out the noise and refocus on what has the potential to affect markets.
Economic recovery remains on track, but Congress missed a chance to help
COVID-19 and the economy’s reopening: Overall, national COVID-19 rates are still falling but have begun to pick up in some Midwestern states. Weekly and daily economic data show a slight rebound for the week of September 25, but may show more restraint in the coming weeks if infections surge again. More generally, the third-quarter data show an impressive rebound following the steep decline in the second quarter, and we continue to anticipate a modest but steady recovery through at least year-end 2021.
Stimulus package: After months of expecting a new economic stimulus program by September 30, markets faced a double disappointment late in September, when a congressional stimulus deal collapsed and the Federal Reserve declined to provide additional measures at its September 15-16 meeting. The setbacks to market sentiment do not change our outlook for sustained economic recovery, but the lack of additional fiscal and monetary support as some unemployment benefits roll off should add some strain to the economy’s recovery into early 2021.
A narrowing gap in the presidential race
President Trump trails former Vice President Biden by roughly seven percentage points in the national polls, but our focus also includes the swing states, where Biden’s advantage is half as large, on average.1 Trump’s polling has tracked with COVID-19 infection rates and the related short-term economic impact: rising June/July infections, with lower economic activity and polling but stronger activity and polling on lower infection rates in August and September.
Projecting the COVID-19 infection rate remains the one crucial election factor that is the hardest to predict. Infections started to increase again in some U.S. regions during mid-September, notably on college campuses. If the accumulated knowledge about managing exposure and treatment limits the next round of infections, Trump could tighten the race further into Election Day. But if the cooler weather and more indoor activities ratchets the infection rate higher, Biden could pull more of the swing states to his column. In our view, the scenario for Democrats to control the Congress and the White House retains the advantage, but Trump still has time to flip the results to our second scenario, namely, divided government matching the current control structure in Washington.2
New issues crowd the election spotlight
The prospect of a tighter presidential race makes more pointed the questions about the Supreme Court and potential election disputes.
Supreme Court nomination: Over the September 19-20 weekend, a Reuters/Ipsos poll showed that a roughly equal number of Trump and Biden voters would switch candidates if Congress confirms nominee Judge Amy Coney Barrett before the election.3
The Supreme Court vacancy may increase partisan interest in the Senate races. The Republicans are defending more seats this year than the Democrats are and could use the Court vacancy to build interest in their candidates. Meanwhile, Democrats would like to retake the Senate majority, to facilitate any legislative adjustments needed if the Supreme Court were to strike down some part of the Affordable Care Act. The Court is set to hear a new case on the law starting November 10. The closest Senate races tightened during the week of September 21-25, with the polls projecting neither party with a clear statistically significant majority.4 We continue to expect that Senate control will follow the presidential election result.
Potential impact of a contested election: The large number of expected mail-in ballots and partisan legal challenges to vote counts could delay the election results for weeks. The longer the delay, the greater the potential turbulence in market sentiment, but there still can be an orderly inauguration on January 20, 2021. The constitutional structure allows no way to extend a president’s term. According to the Twentieth Amendment, Congress is scheduled to meet on Jan. 6, 2021 to certify the Electoral College results for a presidential election winner. If vote counting challenges leave the electoral result ambiguous, then the sitting Speaker of the House will be inaugurated as acting president on Jan. 20, 2021, until the state authorities and Congress resolve the ambiguities.5
As long as the courts play their role in fairly adjudicating these cases, as in the past, then an election result eventually should arrive. During the interim, the government should continue to function, and the economy can continue to recover. Market turbulence in the immediate aftermath of the election may be significant, but our constructive market outlook depends on the economy and — more fundamentally — that voters keep their trust in the electoral system.
The Nov. 8, 2000 election offers a potentially useful and relatively recent example. The S&P 500 Index lost approximately 6% between November 7 and December 13 as the two presidential candidates fought a five-week legal battle over Florida’s electoral votes. But the equity index did not continue to move with every turn in the legal process. In fact, the initial loss was itself consistent with a pattern that year of six pullbacks between 5%-10% and lasting at least a week each through July. It was, after all, the year the internet bubble burst, and the Federal Reserve had tightened credit in the first half of 2000. What’s more, the market did not make its low for the year until after the December 12, 2000 Supreme Court decision cleared the way for a presidential election winner. Even with the unusual election uncertainty, the S&P 500 Index still moved more in line with the economy.
Catalysts that remain
The market environment is likely to remain unsettled into year-end, and possibly into early 2021, but not necessarily from the sources that may generate the most headlines:
Presidential debates: The three presidential debates are scheduled for September 29, October 15, and October 22, and likely will dominate the headlines. (The vice-presidential debate will be on October 7). Although the debates give voters a chance to see the candidates under pressure, and can produce memorable moments, they rarely have changed the election race.6 This year, many voters already will have voted (by mail) before the last debate.
COVID-19: Infection rates could increase as the cooler weather sets in. The increase in European infection rates also could create fears of a similar increase in the U.S.
Fourth-quarter economic growth: The cross-currents between strength in housing and the prospect of fading unemployment relief could deal surprises for the economy’s pace into year-end. The contrasts are likely to alternate in the weekly data and could roil markets.
Actions we favor taking now, and later
The combination of a growth outlook for the economy and more political noise (now) and uncertainty (after Election Day) leads us to continue to favor some steps now and others after the election.
- Between now and Election Day, we prefer aligning portfolios with economic trends that we believe should continue well after the elections. In particular:
- Overweighting U.S. compared with international financial markets.
- Tactically adding a small weight to commodities, including gold.
- Overweighting U.S. large- and mid-cap equities compared with long-term strategic allocations, but taking small-cap equity positions to long-term strategic weights.
- Focusing on U.S. equity sectors that have combinations of better cash flow, earning potential, and attractive debt – including Information Technology, Consumer Discretionary, Communication Services, and Health Care. The latter two also show less volatility than the composite.
- Emphasizing credit (including investment-grade and high-yield credit, and preferred securities) and municipal securities – but using a credit manager to help sift out unattractive individual credits.
- In all of these cases, we prefer to put cash to work when any of these markets or sectors pulls back.
- Between now and the end of the year, we also prefer to plan for potential tax increases in 2021.7 We favor:
- Evaluating the tax status of retirement accounts, especially if income may increase in 2021.
- Defining charitable goals and weighing whether to increase 2020 contributions, in case tax changes limit deductions in 2021.
- Accelerating income into 2020, in an effort to avoid proposals for higher Social Security taxes in 2021.
- After the New Year, we favor making a plan in an effort to take advantage of policy changes, once the policy agenda becomes clearer.
- In the event of a Trump win and a divided Congress, the sectors that we believe could benefit are Energy, Financials, and Health Care, as well as Information Technology.
- If the Democrats control the White House and Congress, the sectors that we believe could benefit are Industrials, Materials, and the biotech industry in the Health Care sector.
- Between now and Election Day, we prefer aligning portfolios with economic trends that we believe should continue well after the elections. In particular:
1 The Real Clear Politics average as of September 24-25, 2020 was roughly a 7% national lead for Biden. Polls from the same time frame gave Biden significant leads in Michigan, Wisconsin, Pennsylvania; but a toss-up or a slight Trump lead in Arizona, Florida, Georgia, North Carolina and Texas. See www.RealClearPolitics.com for more details.
2 For more on our main scenarios and the factors driving each, please see our report, A Guide to the 2020 Elections.
3 Reuters/Ipsos, “Ginsburg Supreme Court Vacancy”, September 21, 2020.
4 Based on Real Clear Politics polls as of September 24-25, 2020.
5 Please see “Preparing for a Disputed Presidential Election: An Exercise in Election Risk Assessment and Management”, Edward B. Foley, Loyola University Chicago Law Journal, Winter 2019, especially pages 321-335.
6 For an overview, please see, “Do Presidential Debates Impact Election Outcomes?” by Dante Chinni, NBC News, September 25, 2016. A more comprehensive academic study of public opinion measurement and impact on elections appears in, “Tides of Consent: How Public Opinion Shapes American Politics”, 2nd edition, by James A. Stimson, Cambridge University Press, August 2015.
7 Wells Fargo and its affiliates are not legal or tax advisors. Be sure to consult your own legal or tax advisor before taking any action that may involve tax consequences. Tax laws or regulations are subject to change at any time and can have a substantial impact on individual situations.
Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. Preferred securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer’s capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Investing in gold or other precious metals involves special risk considerations such as severe price fluctuations and adverse economic and regulatory developments affecting the sector or industry.
Communication services companies are vulnerable to their products and services becoming outdated because of technological advancement and the innovation of competitors. Companies in the communication services sector may also be affected by rapid technology changes; pricing competition, large equipment upgrades, substantial capital requirements and government regulation and approval of products and services. In addition, companies within the industry may invest heavily in research and development which is not guaranteed to lead to successful implementation of the proposed product. Risks associated with the Consumer Discretionary sector include, among others, apparel price deflation due to low-cost entries, high inventory levels and pressure from e-commerce players; reduction in traditional advertising dollars, increasing household debt levels that could limit consumer appetite for discretionary purchases, declining consumer acceptance of new product introductions, and geopolitical uncertainty that could affect consumer sentiment. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Investing in the Financial services companies will subject an investment to adverse economic or regulatory occurrences affecting the sector. Some of the risks associated with investment in the Health Care sector include competition on branded products, sales erosion due to cheaper alternatives, research and development risk, government regulations and government approval of products anticipated to enter the market. There is increased risk investing in the Industrials sector. The industries within the sector can be significantly affected by general market and economic conditions, competition, technological innovation, legislation and government regulations, among other things, all of which can significantly affect a portfolio’s performance. Materials industries can be significantly affected by the volatility of commodity prices, the exchange rate between foreign currency and the dollar, export/import concerns, worldwide competition, procurement and manufacturing and cost containment issues. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market.
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