Positioning equity portfolios for divided government

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by Global Equity Strategy Team

Key takeaways

  • An election’s impact on the market has been short term historically, with equities having gone up during the terms of presidents from both political parties.
  • An increased likelihood of a divided government reduces the risk of significant policy and regulation changes, which we believe points to a continuation of the trends in the equity market over past months.

What it may mean for investors

  • We prefer to stay focused on growth and quality-oriented areas, including U.S. Large Cap and Mid Cap stocks, as well as the Communication Services, Consumer Discretionary, Information Technology, and Health Care sectors.

Investing during the election cycle can be challenging, and 2020 has been no exception. The equity markets had been pricing in a blue sweep, which likely meant higher taxes, sizable fiscal stimulus, and tighter regulations. A week after the election, the likelihood of a divided government is rising, and the markets have been repositioning for this outcome. Here we want to share our analysis to help investors navigate the post-Election Day equity market.

Equity markets have historically enjoyed a period of price growth when the election dust settles. The market has tended to account for uncertainty and probable election outcomes ahead of time. After the election, the market has tended to enjoy a period of expansion as greater clarity prevails.

As shown in Chart 1, since 1988, the S&P 500 Index generated a 13% average return in the 12 months after elections, higher than the 8% long term return average over the same period.

Chart 1. Equity price and volatility during the election cycle

Chart 1. Equity price and volatility during the election cycle
Source: Wells Fargo Investment Institute, Bloomberg. Average of past elections since 1988, except when recession overlaps with election (i.e. 2008). S&P 500 price is rebased to 100% on the Election Day. Date axis shows the days before and after Election Day. The VIX index is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

While elections can create short-term noise for the markets, the long-term drivers have been the economy and business earnings. Chart 2 shows that S&P 500 earnings and gross domestic product (GDP) have risen with the S&P 500 Index over the long term regardless of which party controlled the White House.

Chart 2. S&P 500 price went up during both Republican and Democratic presidencies

Chart 2. S&P 500 price went up during both Republican and Democratic presidencies
Source: Wells Fargo Investment Institute, Bloomberg. Data is rebased to 1 in December 1960. Red and blue areas indicate the periods when Republican and Democratic presidents are in office. GDP=gross domestic product. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

A divided government points to a potential continuation of the leadership of growth and quality stocks that we have seen in the past. Equity market performance before the election appeared to be tracking the polling numbers, suggesting a blue sweep that could benefit more cyclical sectors. A divided government, however, likely would mean no changes to tax policy and a smaller amount of fiscal stimulus. We believe this should benefit U.S. equities over international equities and that U.S. Large Cap Equities, which have had higher earnings and growth, should continue their leadership over U.S. Small Cap Equities. This dynamic was reflected in post-Election Day trading activity, where the 10-year Treasury yield fell and growth and quality stocks outperformed.

A divided government can also mean lower political risk for sectors, such as Health Care and Information Technology. The new administration likely will find heavy resistance against policies that increase tax rates and regulations, or create a public option within the healthcare system. We believe this reduced political risk supports continued outperformance of tech-oriented sectors, including Information Technology, Communication Services, and Consumer Discretionary. In our view, the Health Care sector, which has been haunted by political uncertainties, should also benefit, given its favorable valuations and strong earnings growth.

Easing of trade tensions, a weakening U.S. dollar, and a more contained COVID-19 situation can be tailwinds for Emerging Market (EM) Equities. Under a Biden administration, there could be less trade tension with China and the possibility of fewer tariffs, benefiting EM earnings and equity prices. Both long and short-term drivers, such as low interest rates and a higher money supply, point to the possibility of more dollar weakening. U.S. dollar-denominated international equity and fixed income assets are exposed to currency movements — everything held equal, when the dollar weakens, the value of international assets increases after accounting for exchange rates. Further, Eastern Asian countries, a big component of the MSCI Emerging Markets Index, have contained the spread of COVID-19 relatively well with a lower likelihood of future economic shutdowns. This leaves their equity market better positioned relative to developed markets.

We believe our current equity asset class and sector guidance align well with the new political environment. We continue to favor asset classes and sectors with high growth and high quality exposure that have less reliance on fiscal stimulus. We are favorable U.S. Large Cap and Mid Cap equities over Small Cap, and we prefer U.S. equities over international equities. From a sector perspective, we favor the Information Technology, Communication Services, Consumer Discretionary and Health Care sectors, which we believe should benefit from continuation of low tax rates and reduced regulatory risk under a divided government.

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Risk Considerations

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.

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. 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. Risks associated with the Information 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.

Definitions

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.  An index is unmanaged and not available for direct investment.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

General Disclosures

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy.  Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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