Can investors 'price in' the US election?

As ever, both the nomination race and the eventual fight for the White House will dominate the news cycle. In politics, polarisation and volatility are likely to reign supreme. But what are investors to make of it all?

Institutional capital is apparently twitchy. When recently surveyed by Bank of America Merrill Lynch, global fund managers said the outcome of the election had replaced global trade wars as the most significant tail risk for markets this year.

You might not have spotted these jitters from the S&P 500 Index (SPY), which has continued its rise despite the appearance of numerous secondary tail risks so far in 2020. Nor are those risks – presumably stemming from a changing rather than a continuous political backdrop – reflected in betting markets. Although pricing will only start to mirror polling when the Democratic party announces its nominee in July, the odds currently suggest Mr Trump is on course for re-election.

All the presidents' odds

Several of the portents for Mr Trump are good. Of the nine re-election races since 1956, just two – Jimmy Carter in 1980 and George HW Bush in 1992 – failed in their bids to re-take the White House. And while only Barack Obama won a second term with a trailing GDP per capita growth rate below 2 per cent, a recent Gallup poll found that 61 per cent of Americans consider themselves better off than they were three years ago.

That’s a higher proportion of voters than in any incumbent re-election year of the past three decades, suggesting that GDP 1.8 per cent growth has been enough to spark an improvement in most Americans’ financial circumstances. The past three years have been a good time for American shareholders and job-seekers.

Other factors suggest the race will be much tighter. Ever since he took office in January 2017, Mr Trump’s net approval rating has been negative. RealClearPolitics’ latest poll of polls from the first half of February suggests just 45.3 per cent of American adults approve of the president. Added to this, Mr Trump trails almost every 2020 Democrat candidate nationally, and is in an unconvincing position in many swing states. And although Mr Trump has the fundraising jump on the Democratic candidates, fellow billionaire Michael Bloomberg has essentially stepped in with an open cheque book to spend big, regardless of whether he secures the nomination.

There’s also recent precedent. Despite losing the popular vote in 2016, Mr Trump has done little to reach out beyond his base. Record voter turnout in 2018 led to the Democrats winning back the House of Representatives, suggesting a more cohesive and galvanised opposition could make life hard for the president’s re-election prospects. And let’s not forget last time, when polls, pundits and markets incorrectly predicted Hilary Clinton would carry the day.

Investor battlegrounds

While financial markets tell us lots about expected economic and business trends, they are less useful at forecasting binary events such as elections. That’s understandable: democratic change is by its nature gradual, then sudden. But there is already evidence that valuations are starting to reflect some of those fund manager nerves.

Take the S&P 500. Although the index is trading at a historical premium – as defined by standard deviations above the index’s median forward price/earnings ratio over the past five years – analysis by Goldman Sachs shows that more politically-sensitive sub-sectors such as pharmaceuticals, for-profit education and large banks carry a discount. Surprisingly, this includes big tech companies, presumably over concerns that the sector could be broken up.

Should the left-wing Vermont senator Bernie Sanders secure the Democratic nomination – as currently appears the most likely outcome – then these discounts could well widen, as markets weigh the possibility of policies that include a student debt jubilee, backing for the Green New Deal, and a wealth tax for individuals with more than $32m (£25m) in assets. Chief among Mr Sanders’ proposals, from the perspective of corporate earnings, is the mooted reversal of Mr Trump’s 2017 tax cuts. In turn, that could reduce the recent flood of share buybacks to a trickle.

Depending on the result of the Democratic primaries, financial markets could soon adopt a pro-business versus anti-business narrative.

“So far few election-related impacts look to have been priced in,” argues Ritu Vohora, an investment director at M&G. “As we head towards polling day, a wide range of potential policy outcomes and competing policy agendas may weigh on sentiment, with ramifications for both the economy and markets.”

There are good reasons to doubt this narrative, should it appear. In a note to clients in January, Deutsche Bank analyst Alan Ruskin suggested that the long lag for policies to impact structural growth means that the president’s influence is “far less profound”.

“Be careful in avoiding becoming too doctrinaire in asserting one party is better for growth than another,” Mr Ruskin argues. “The US political centre of gravity is historically right when compared with the likes of Europe, and the dominant private sector is relatively unencumbered with considerable capacity to innovate, whoever is the president.” History suggests investors are well-appraised of this reality: just two of the past 20 election cycles have seen a fall in US equity markets in the 12 months before the vote.

It is also important to separate the race for the White House from policy, and the chances various proposals have of making their way through the various branches of government.

“Investors should consider total government outcomes – not just the White House – to gauge the impact on the economic cycle and individual sectors,” says Michael Zezas, head of US public policy research at Morgan Stanley, whose team drew up four possible scenarios for this year’s elections, and their likely impact on markets, interest rates and the greenback.

The somewhat obvious insight here is that united government is most likely to bring about the greatest shifts in asset prices and policy. Should Republicans sweep the board, investors can expect fiscal stimulus via more tax cuts. In the improbable event that the Democrats take the White House, Senate and House of Representatives, investors can expect fiscal stimulus via big infrastructure commitments.

Otherwise, there is reason to believe that the biggest mover of markets – monetary policy – will remain relatively undisturbed. That’s according to Deutsche Bank, at least, which calculated that interest rates are no more likely to change in an election year than any other.