Per Stirling Capital Outlook – August
In a November of 1947 speech, Winston Churchill famously noted that “no one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government, except for all those other forms that have been tried from time to time.”
One can only imagine what Churchill would think about the current U.S. political environment, when the country is as divided as at any time since the Vietnam War (perhaps even the Civil War), and there seems to be a broad and staunch perception (regardless of party) that, if the other party comes into power in November, it would be nothing short of an unmitigated disaster.
Indeed, in a time of social unrest, depression-like economic conditions, a global pandemic, and a growing and potentially dangerous rift between the world’s two superpowers, it is nothing short of remarkable that it is the upcoming elections that seem to represent the overwhelming source of angst for the public in general, and investors in particular.
Europeans have long held that the United States has “donut politics” because the electorate “has no center”. Indeed, in a world of gerrymandering, extreme partisan politics, human rights-related unrest, and a historic divide between the “haves” and the “have-nots”, that political center seems harder than ever to find.
Nonetheless, for the purposes of this commentary, we will attempt to steadfastly occupy that center ground, and to offer a non-partisan perspective on the potential election outcomes, and what the lessons of history suggest might be the most likely impact of different scenarios on both the economy and the capital markets.
The single most important question is probably regarding the outcome of the presidential race, where the polls, the prediction markets, and historic precedent all suggest that former Vice-President Biden will be the next occupant of the White House.
In regard to historic precedent, if you go back to 1952, there has never been an election year that included either a recession or an equity bear market, when an incumbent president (regardless of party) was ever reelected, and 2020 included both a bear market and the greatest economic contraction since the Great Depression. Of course, in light of the COVID-19 pandemic, it remains to be seen whether or not the electorate will hold President Trump accountable for these outcomes.
Moreover, as is illustrated in the below chart, one would likely have assumed approximately the same odds of a Clinton victory exactly four years ago, and we know how that turned out. Additionally, President Trump presents a unique conundrum for pollsters as, according to a June survey by the Democracy Institute, “only 37% of Trump voters would want their friends and family to know how they had voted, while 74% of Biden supporters are comfortable with it being known. Indeed, the “silent” vote for the President may be on par or larger than it was in 2016.” As a result of the so-called “silent Trump voter”, the polls and prediction markets may provide even less insight than usual.
Further, there are more and more reports coming from the “progressive” Democratic camp that younger voters in general, and “liberal progressives” in particular, are so unenthusiastic about the Biden /Harris ticket that they may not show up to vote. Reports are that this political demographic was also very frustrated by the fact that, during the mostly virtual Democratic National Convention, Alexandria Ocasio-Cortez was only allowed a total of 96 seconds to nominate Bernie Sanders for president, and to advocate for the highly-liberal legislative agenda being promoted by the progressive left of the Party.
If anything, we view this lack of air-time as a strong indication that Biden is not going to allow himself to be pulled from the center, where he has traditionally stood, to the far-left of the party.
We further believe that this should provide an element of comfort to investors, in the event that he is elected as president, which is the outcome currently predicted by the prediction (political betting) markets, the consolidated polling data (as per Real Clear Politics), and even the highly respected FiveThirtyEight Presidential Election Forecast, which assigns a 71% probability to a Biden victory. Of note, the FiveThirtyEight estimate assumes an 81% likelihood of Biden winning the popular vote, but modestly reduces his odds for election, as they assume that the electoral college format improves Trump’s chances by 10%.
We agree though with FiveThirtyEight that it is too early to write off a potential Trump victory, and suspect that it is very possible, and perhaps even probable, that the election outcome will ultimately be determined by something that is yet to occur. That said, we believe that it is only prudent, at least at this point, to assume a Biden victory for the purposes of crafting an investment thesis.
Just as was the case four years ago, there seems to be very little likelihood that President Trump will win the popular vote, as polls currently show that he trails Biden by between 9% and 11%. However, the election does not belong to the winner of the popular vote, and because of the electoral college system, many analysts believe that the election will likely be decided in ten “swing states” where Trump only trails by an average of 2%. As such, a Trump re-election remains very possible, particularly if the “progressive Democratic voter” fails to turn out in those ten states.
In an election year that has more than its fair share of wildcards, the most unpredictable of all of them is probably the COVID-19 pandemic itself, and not just because of the massive implications that the coronavirus has on the economy, monetary policy and fiscal policy, but also because of the very high correlation that has persisted between the odds of Biden becoming president, and the pervasiveness of COVID infections. One of President Trump’s biggest weak spots is how his administration has managed the pandemic, which potentially makes very important the current downwards trend in COVID case counts.
In general, equity markets don’t like change and they hate uncertainty, which is why markets have a tendency to sell off somewhat in anticipation of an incumbent president losing an election.
When such a change does occur, the stock market averages monthly declines of -2.7% three months before the election, -4.2% two months before the election and -0.2% the month before the election, and those losses have historically been much more substantial when it is a Republican president being replaced.
That said, according to Ned Davis Research, such politically-driven declines have historically presented great buying opportunities for equity investors as, while the past is not necessarily prologue, the market has normally, in such cases, snapped back sharply in the year after the election.
In regards to how the market has historically performed over the full term of Republican versus Democratic administrations, most studies provide classic examples of statistical bias (i.e., “why statistics never lie, but liars always use statistics”), as you can twist the numbers any way that you want, depending on start date, selected measure of the markets, are the returns inflation-adjusted, etc.
As a result, any amount of time spent on Google will produce a vast array of studies that will claim to definitively prove that the markets do better under one party or another, and that who controls the White House has a measurable impact on the performance of the stock market.
However, in our experience, there is almost no evidence to support a strong correlation between who occupies the White House, and the performance of the markets. If anything, history suggests that, on a purely nominal basis, the stock market has actually performed better under Democratic administrations than Republican ones. That said, even this statistic is misleading, as almost all of the Democrat’s average outperformance can be explained by the Y2K technology boom under Bill Clinton and the subsequent unwinding of that dotcom bubble and Global Financial Crisis, under George W. Bush. If you exclude these two presidencies, the difference in returns is negligible.
In fact, during an August 8th interview on CNBC, Bespoke Investment Group’s Paul Hickey provided an interesting example of the presidency’s lack of impact on the stock market, when he noted how hard it is to imagine two presidents with more diverse policies and philosophies than Presidents Obama and Trump, and how, despite this fact, the top performing equity sectors during both administrations have been technology and consumer discretionary, while the worst performing sector over both administrations has been energy.
Further, of the six sectors that under-performed the broad market during Obama, five of them have also under-performed the broad market during the Trump administration. Presidential influence on the markets seems thin, at best.
Of course, how much of an agenda a president can push through normally depends largely on whether or not there is unified government, or if the opposition party maintains control of one branch of government. In this instance, the Republicans face a bit of an uphill battle, when you consider that, in addition to overcoming their party affiliation with an increasingly controversial President, they need to successfully defend considerably more seats in the Senate than do the Democrats. The Democrats keeping the House is a foregone conclusion.
At this point, the prediction markets are assigning a 56% likelihood that the Democrats will take control of both houses of Congress, and a 51% likelihood that the Democrats will take control of all three branches of government, in a so-called “blue sweep”.
Based upon recent investor surveys, the potentiality of a “blue sweep” is a major point of concern for many investors, but here too, history suggests that this concern may be unwarranted. Indeed, as is illustrated in the above chart, the S&P 500 has, since 1951, actually averaged 13.2% per year during periods when the Democrats controlled all three branches of government.
Moreover, according to DataTrek Research, since 1945, there have been 30 years when Washington was under the control of one party and, contrary to common opinion, stocks actually performed better on average than in years with a divided government.
In the eight years when Republicans controlled Congress and the White House, the S&P 500 averaged returns of 16.0%. In the 22 years that Democrats had complete control, the S&P 500 gained on average 14.3%. Both numbers compare quite favorably to the 11% average annual return gained over the years with split government.
Regardless of the above, one of the lessons of history is that election day has tended to catalyze powerful market rallies, as election uncertainty is replaced with political clarity, and that this rally tends to take place regardless of party affiliation and/or whether control is unified or divided.
Indeed, the major differentiator of rally strength tends to be the perceived closeness of the presidential election, with the closest elections producing the strongest rallies. This is due to the fact that highly contested elections, by their very nature, involve more uncertainty, and therefore a greater market reaction once that uncertainty is removed.
This election season, there is a unique concern being revealed in both investor polls and even client conversations that the very left-leaning elements of the Democratic Party, which seems to view wealth and capitalism as the enemy, could ultimately prevail on Biden to adopt their “progressive” agenda.
There is no doubt that there is an element in the Democratic Party that wants to restructure the U.S. economy (and even American society) in ways that are very unfriendly to the investor class, and for the capital markets themselves. We just don’t think that the relatively moderate Biden/Harris ticket will be the administration to push that kind of agenda.
Moreover, when you consider the aforementioned 96 seconds allotted to Alexandria Ocasio-Cortez at the convention, we don’t see the indications that a Biden/Harris administration is susceptible to being pulled to the far left. If anything, they recognize that much of Biden’s support is more “anti-Trump” than it is “pro-Biden”, and that their success in the election ultimately comes down to the votes of moderate independents and the growing number of “Biden Republicans”.
We believe that investors should also take some comfort from a Bernie Sanders statement made during a recent “This Week.” interview with ABC Chief Anchor George Stephanopoulos. Sanders said, “A lot of my supporters are not enthusiastic about Joe Biden”. Indeed, in sharp contrast to the constant Bernie Sanders/Elizabeth Warren harping on “millionaires and billionaires” as the root of all evil, Biden told donors at a fundraiser at the Carlyle Hotel in Manhattan last year that “Rich people are just as patriotic as poor people”, and he noted at the Brookings Institution in 2018 that, “I don’t think 500 billionaires are the reason why we’re in trouble.” It’s a very different tone.
Indeed, when Chris Krueger, who serves as the Managing Director of the Cowen Washington Research Group, was asked how Wall Street should respond to Joe Biden’s selection of Kamala Harris as running mate, he replied that “investors should breathe a sigh of relief”.
Moreover, a recent Citigroup survey of 140 fund managers revealed that “asset managers at major investment banks are preparing for not only a Biden win, but potentially a Democratic sweep of the Senate and House too”, and that 62% of those managers now expect a Biden win, which reflects a dramatic reversal from the 70% who expected a Trump victory when the same question was asked in December.
Since a Biden victory is the prevailing expectation, it is logical that forward-looking markets (like equities) would already be selling off, rather than waiting until after the election to sell, if a Biden victory was viewed as being bearish. If anything, a look at the winning and losing sectors on a year-to-date basis (above) suggests that the markets are already pricing in much of an anticipated Biden victory.
While there are some who disagree, like emerging markets guru Mark Mobius, who predicts that a Biden/Harris win “would be disastrous”, most of Wall Street seems to be remarkably comfortable with the idea of a Biden presidency, as is illustrated by the fact that financial industry donations to the Biden campaign ($44 million) are swamping the $9 million donated to the Trump campaign.
The same trend is holding across party lines, albeit to a lesser extent, with the financial sector donating $222.4 million to Democratic candidates and $219.5 to Republican candidates. According to the Washington Post, this is the first time since 2008 that the financial sector has weighted their donations towards the Democrats. It is also being reported that even private equity firms and hedge funds are heavily weighting their donations to Democratic candidates, and we find it hard to believe that this would be the case if they did not consider Biden to be better for the markets.
Over recent weeks, UBS, Bank of America, and Goldman Sachs have released reports supporting the idea that Biden could be the better alternative. Most of their rationale, involves a belief that Biden would be stronger in regards to fighting the pandemic, less chaotic in regard to foreign and trade policy, and a “steadier hand at the ship of state”.
President Trump’s nomination of Judy Shelton to the Fed (where he reportedly wants to appoint her as Chair) provides just one recent example of the kind of Trump decision that concerns Wall Street. Among other things, Sheldon has proposed returning to the gold standard and eliminating the Federal Reserve (or, at minimum, removing its independence). So ill-suited is Trump’s nominee that more than 38 former members of the Fed, including a former Vice-Chairman, just wrote a letter to the Senate pleading with them to reject the nomination due to the fact that “Ms. Shelton’s views are so extreme and ill-considered as to be an unnecessary distraction from the tasks at hand”.
Some of the recent comments coming out of UBS are indicative of the opinion through much of Wall Street. Brian Rose, senior economist, with UBS Global Wealth Management noted that, even the prospect for a Democratic sweep is “no reason to sell equities – a sweep will have a roughly neutral impact on markets with enough benefits because of government spending to offset a potential tax hike.”
Solita Marcelli, chief investment officer for UBS Global Wealth Management echoed that sentiment, when she noted, “While we’ve seen investors express concern over higher taxes under a Democratic sweep, we believe that recovery spending on stimulus – for health care, infrastructure, climate change and other initiatives – will more than offset these tax headwinds,” and that Biden’s spending proposals exceed his tax proposals by $3.5 trillion, which should be highly stimulative to the economy.
There is no doubt that a President Biden will want to raise taxes on corporations and on individuals making more than $400,000 per year, and that he will put back in place many of the regulations that President Trump removed primarily via executive order. There is also no doubt that, all other things being equal, Wall Street would prefer lower taxes and less regulation. That said, there is a remarkably low correlation between corporate tax rates and corporate earnings per share. It is also perhaps illuminating that the year 2013 produced the millennium’s highest equity returns, despite the slew of new taxes and regulations that the Obama administration introduced that year.
In general, we believe that investors are in a pretty good situation in regards to the elections, based upon our presumption that Wall Street can live with either outcome in the presidential election, and can even bear up under a “blue sweep”, where the Democrats control all three branches of government. As a result, we suspect that the capital markets are somewhat inured to most political scenarios that are likely to exist by the turn of the year.
However, that is not to, in any way, suggest that the election season will be devoid of potential portfolio risk, particularly around election day. Indeed, there are three potential scenarios that we believe would likely cause a very negative reaction in the risk markets. We will address them in order of perceived probability.
The first potential risk involves mail-in ballots, and the timing of when investors get election clarity. At least 78% of Americans (in all but seven states) will be able to vote by mail and, in light of pandemic-related safety fears, mail-in voting could represent a huge percentage of the voting total. That could also lead to a significant delay in determining the outcome of the elections, and markets abhor that kind of uncertainty. If you want proof, look no further than the market’s violent reaction to the “hanging chad” controversy of November 2000, when the Supreme Court ultimately had to decide who won the presidency.
This massive surge in mail-in ballots, when combined with the fact that President Trump is already using words like “fraud”, “coup” and “corrupt” to delegitimize the election before it even takes place, and even Trump’s claiming that he would “have to see” if he would accept the results if he loses, introduces the second election-related risk, which is that President Trump would make accusations of election fraud and, at least initially, not accept the results.
Such an outcome would further divide an already highly-divided country, and create a possible constitutional crisis that risk markets like stocks would likely react very badly to. Futures and options markets are already starting to price in this potentiality. Indeed, according to Goldman Sachs, “the particularly high level of implied volatility in the periods before and after the election imply an extended period of election-related uncertainty.’’
We believe that either of the above scenarios would likely cause a short and potentially violent correction in equity markets (probably even globally), and that any such correction would likely provide investors with an extraordinary buying opportunity, as was the case in late 2000.
We consider the third bearish scenario to be significantly less likely, but much more of a long-term negative in its impact should it occur, and that would be for Biden to be elected president and appoint someone like Elizabeth Warren either to the Fed or as treasury secretary, as this would strongly suggest that Biden is much less of a free-market candidate than what has been maintained throughout his campaign. While this has been rumored, we consider such an outcome to be fairly unlikely.
Unlike under the first two bearish scenarios, we would not necessarily consider any sell-off catalyzed by this third scenario to be a buying opportunity. Instead, we would likely view it as a shot across the bow for the domestic equity markets, and a reason to significantly shift money into other investment opportunities, particularly those overseas.
In the short term, we expect for the political circus to ramp up overall market volatility, and that volatility could become very elevated around the election. However, over the long term, we do not expect for the upcoming election to be transformative, and believe that non-political factors will continue to be the major market drivers. These include, first and foremost, monetary policy and progress against the pandemic.