With the U.S. presidential election just weeks away, the focus is broadening from the singular emphasis on the politics of the election to the potential policy implications.
At PIMCO, we think the two most likely election scenarios are worth exploring:
- A Democratic sweep, with former Vice President Joseph R. Biden, Jr. winning the White House, and Democrats keeping their majority in the House of Representatives and taking back the Senate (albeit by a very narrow margin). We address this scenario first and in detail below, since it would likely lead to substantial policy shifts.
- A status quo election, with President Donald J. Trump winning reelection and the composition of Congress remaining the same (a Democratic House and Republican Senate).
How would risk markets respond under each scenario?
It is, of course, hard to definitively predict what the market response would be. The conventional wisdom in 2016 predicted a Trump victory would trigger a market sell-off, yet it outperformed for years. Indeed, if history is any guide, risk markets are somewhat impervious to the outcome of the election, having done well under both Democratic- and Republican-led White Houses since 1932. As measured by the S&P 500 Index, the market has historically performed marginally better under Democratic than under Republican administrations, but best under divided government.
While the direction of the overall stock market may be hard to predict, it is easier to forecast which sectors are likely to be winners and losers under the two election scenarios.
What policy changes should we expect from a Democratic sweep?
We expect a Biden White House and a Democrat-controlled Congress to prioritize legislation that would:
- Modernize infrastructure by going beyond bridges and roads to a national broadband build-out and climate-friendly buildings and schools.
- Strengthen the Affordable Care Act (ACA) by putting it on firmer legal standing and ensuring it is actually more affordable for middle-income earners. We could also see Democrats pass prescription drug pricing reform that would lower drug costs by allowing Medicare to negotiate prices, similar to current programs in other government agencies, including the Veterans Administration.
- Raise taxes modestly to pay for some of these changes. We believe only more evolutionary, rather than revolutionary, tax changes could pass a narrowly Democratic Senate (such as a 25% corporate tax rate versus the 28% rate proposed).
- Focus on climate-friendly regulatory changes, such as curbing emissions from fossil fuels and limiting fracking on public lands.
- Provide significant COVID-19-related funding for states and cities, in addition to businesses, if Congress still has not passed any additional stimulus by January 2021.
Outlook for credit sectors under a Democratic sweep
- Renewable energy
- Construction, particularly homebuilding and infrastructure-related
- Oil and gas exploration and production, particularly firms exposed to drilling on U.S. federal lands, both onshore and offshore
- Healthcare, pharmaceuticals
Equity and credit markets may not anticipate a Democratic sweep
The 2020 U.S. elections represent a meaningful wildcard to credit fundamentals in 2021 and beyond, as a Democratic sweep would likely result in material policy changes with significant implications at the macro and sector levels.
Since March, we believe credit markets have primarily focused on the effects of the global pandemic and the path to economic recovery in 2021. The pandemic-related distractions and uncertainty about the election outcome may mean credit spreads at the sector level are not fully pricing in the implications of a Democratic sweep, and we think, if it occurs, sector volatility may heighten in early November.
Under a Democratic sweep, we believe the financial markets would initially price in higher taxes – including corporate, personal, and capital gains. This could be problematic for equity and corporate credit markets currently trading at above-average valuation multiples. The S&P 500 one-year forward P/E multiple is roughly 20.0x consensus 2021 estimates, well above the 10-year average of 15.5x. Similarly, credit spreads have normalized since March. The BofA Merrill Lynch U.S. High Yield Index troughed at an 11.39% yield-to-worst in late-March, and has since tightened to 5.30%, not far from 5.14% pre-pandemic. Still, we think this potential dislocation will be temporary.
Other potential wildcard risks we are monitoring include the possibility that investors, anticipating higher capital gains tax rates, will be tempted to sell assets and realize capital gains under current tax rates, which could heighten market volatility in November and December; the potential for corporates to pull-forward income and defer discretionary spending; and the potential for companies to delay tendering higher-coupon/higher-priced debt until higher corporate taxes are enacted (as we saw the reverse occur in 2016/2017). By and large, while we expect a Democratic Congress to move forward with tax increases at some point, we expect tax changes to be more evolutionary than revolutionary.
What policy changes can we expect under a status quo election?
The list of policy changes under a second Trump term and divided Congress (Democratic House, Republican Senate) would be much shorter, with many policies unchanged. Trump may try to pass a tax bill, but that will be dead on arrival in a Democratic House. Mostly, we expect a continuation of the lighter-touch regulatory environment, especially around traditional energy, financial institutions, and telecommunications.
- Pass a small infrastructure bill, since it is one of the few issues that has relatively broad bipartisan support, albeit the devil is in the details.
- Narrow the ACA and its insurance coverage provisions. This could occur if the Supreme Court elects to “sever” (overturn) portions of the ACA, and the new Congress and administration remain divided on legislatively re-instituting those provisions.
Outlook for credit sectors under a status quo election
- Renewable energy
- Technology, particularly sub-sectors with U.S.-China policy exposure
- Energy: pipelines and exploration and production firms exposed to federal lands
We believe a Trump victory and divided Congress would be slightly positive for credit markets, as it would reduce uncertainty, and current tax policy would remain in effect. Still, this would be somewhat offset by Trump’s combative foreign policy, particularly with China.
As a reference point, in the two months following President Trump’s victory in 2016, financials, communication services, and energy outperformed, while the defensive, less economically sensitive sectors – namely consumer staples, utilities, and healthcare, underperformed. We expect a status quo election would induce a similar knee-jerk reaction as the market anticipates a more robust economic recovery.
Still, history doesn’t always repeat itself.
A few more takeaways:
- Financial sector faces challenges: Despite what we think would be a broader economic recovery and a reprieve from large-scale financial regulation under a Trump win, the persistently low interest rates that banks have faced over the past four years will likely remain a negative overhang to underlying equity performance. Select credits will likely fare much better.
- Energy suffers from secular changes: President Trump’s energy-friendly policies have done little to aid oil and gas companies, which have been hampered by heightened environmental, social, and governance (ESG) concerns, limited availability of incremental investor capital given poor returns, and secular headwinds, (i.e., electric vehicles and renewable energy).
- Technology is caught in political fallout: Finally, we would expect U.S-China trade tensions to continue simmering with spillover effects primarily hitting the technology sector equities and high-yield credits, as witnessed with the ongoing Huawei and TikTok issues.
For more about PIMCO’s longer-term outlook for markets and the economy, please read our recent blog post, “Secular Outlook Takeaways: Escalating Disruption.”