Our election framework
A simple guide to a very complicated set of possibilities.
As followers of this space know, our market positioning remains modestly cautious, scaled back from our more aggressive stance before and through the market lows earlier this year. And within this scaled-back equity overweight, we are tilting, finally, toward cyclical/value and international stocks. This said, we remain longer-term bullish, with a 3-year S&P 500 target of 5,000, and plan to put additional cash back into stocks over the next three months.
Our guess is that we will get opportunities to do so on the back of short-term risks: the coming presidential election and potentially confusing aftermath, which got a dose of added uncertainty this morning on news that President Trump tested positive for Covid-19; the potential for another Covid spike bad enough to slow the currently strong economic rebound; and the risk that even without another major Covid resurgence, the current economic recovery will fizzle as fiscal support wanes and large components of the pre-Covid economy likely won’t make it back.
We believe these risks are short term in nature, and will be solidly in the rearview mirror by spring. Hence our ongoing overweight stance on equities and determination to use weakness, if and when it comes, to add to this overweight rather than blow the bugle and ride the bull into the sunset.
In my next three memos, I want to review for you how we are thinking about each of these key near term risks. Today’s focus is the election.
Technically, 9 possible outcomes with a non-zero chance of happening
Some time ago, we put together a matrix of possible political outcomes post-Nov. 3. Starting with the presidency itself, there are three possibilities: Trump, Biden and Too-Close-to-Call/Contested Election. When you overlay possible control of each house of Congress by either party—all conceivable—you end up with a 9-cell matrix. In short, a mess that is almost too complex for the markets to even assess, which may partly explain why even now, it seems not to be doing so.
With the first presidential debate behind us, and the president’s apparent failure in that debate to win over the remaining undecided voters he will need to win, the possibility of a sufficient Trump landslide to retake the House is off the table. Assuming the president recovers quickly from his contraction of Covid, we think the race can be boiled down to two possible outcomes from a future policy-making perspective: “No Change in Direction” (divided government with the Republicans holding the Senate, the Democrats holding the House, and either Trump or Biden holding the presidency) and “Tax, Spend and Regulate” (Democrats sweep the presidency, Senate, and House). We see a 40% chance of the former and a 60% chance of the latter. We also believe there is nearly a 60% chance of a temporarily (4-6 weeks) contested election, but one which by year’s end will be settled.
The wrong playbook?
Though I am no political strategist, years of observation of human psychology have taught me that one of the greatest flaws of any plan is that it is targeted at winning the last war, not the present one. In President Trump’s case, the last war was the 2016 election, when he was able to secure victory by delivering the votes of a forgotten base of voters who’d previously not shown up at all, or had voted Democrat. Though this demographic is in decline, it worked, barely, in 2016 because the Democratic base did not come out in size for Hillary Clinton. But in 2020, a different dynamic is in play. The president himself has fired up the Democratic base against him, and turnout there is likely to be historically high. Potential for gains over 2016 within the president’s working-class base are limited given demographic trends, so gaining votes in the center is paramount. (For example, in Pennsylvania, non-college whites, a key component of the President’s base, have declined in relative size since 2016 such that the president would need to increase their turnout a further 5 percentage points just to get back to the same number of votes he received from them in 2016.)
The president’s raucous performance this week suggests that he has abandoned the middle and instead is all in on raising turnout for his loyal base, while trying to discourage Biden’s turnout from the left as he did with Clinton in 2016. “You just lost the left!” should have been “You just conceded the center!” Wrong playbook. With this, we’ve cut back our odds of a Trump win from 50-50 to 35-65. There still is time for the president to fix this, but with polls already effectively open, not much time. And now that he will be forced off the campaign trail for a period, perhaps even less.
Another cell in our 9x9 matrix was the possibility of a comeback by the Republicans in the House. Needing only 17 seats to do this, all of them in districts carried by Trump in 2016, a resounding Trump victory might be enough to carry these 17 races with him, and produce another all-red government. While this outcome is still out there as a long-odds possibility, we think with Trump’s own prospects sinking and his chances of winning down to a squeaker rather than a landslide, it seems this possibility is one worth ignoring for now. So we now are doing so.
It will come down to the Senate…
While Trump and Biden favor nearly opposite approaches to governing, neither is likely to pass much meaningful legislation without control of the Senate. And with the likelihood of flipping the House very low, there effectively are only two outcomes for investors looking into 2021: the Republicans hold the Senate and we have divided government (with either Trump or Biden at the helm), or the Democrats retake the Senate and we have a unified Democratic regime. We think the odds on these two possibilities are 60-40 in favor of a Democratic sweep. Here’s why.
For a Democratic sweep to occur, the Democrats will need 50 seats in the Senate, with then Vice President Harris as the deciding vote. While the Republicans have 22 Senate seats up for grabs next month, most are in relatively safe red states absent a complete (and unlikely) Republican meltdown at the polls. Netting out states that currently seem likely to flip either to or from the Democrats, the fight for Senate control will likely come down to four states: Montana, Iowa, North Carolina and Maine. Currently the Democratic challenger has an average 6-point lead in North Carolina and Maine, respectively, according to RealClearPolitics. So there’s a decent 60% chance, in our view, that on the tails of a Biden win, both these red Senate seats will flip and result in a (barely) Democratic controlled Senate. If either GOP Sens. Tillis or Collins can come from behind and hold their seats, the Republicans would probably control the Senate.
As we have been saying, Federated Hermes believes a sustainable economic recovery already is underway and is likely to shift to a sustainable expansion early next year, supported by easy Fed policy, the delayed impact of the fiscal support/bridge loan already in the hands of consumers and improved Covid developments. Given this positive backdrop, the economy needs little additional fiscal support. In fact, the natural forces of the expansion underway are so strong, even fiscal restraint, higher tax rates and a tightened regulatory regime might have minimal impact—in the short term. This reality alone may explain why the market so far has behaved benignly even as the election prospects of the Republicans and Democrats have waxed and waned over the past several weeks.
In our view, the best possible outcome for the market is the 40% probability of a Republican Senate and either Biden or Trump as president. Given the ill will between the two political parties, little likely would be done other than perhaps an infrastructure bill, which would be market positive. Trump’s lower tax regime would remain in place, supportive of growth and earnings. The market would for once be able to ignore politics and focus instead on the strength of the economy and next year’s likely dramatic earnings rebound. Given that this is the more positive outcome, and the less expected one, we think the market could rally 10% or more if a divided government results from the election.
The 60% chance of a Democratic sweep has both positives and negatives for the market, which in our view may net out to be a wash, at least for 2021. While taxes almost certainly would be going up, both personal and corporate, demand would be stimulated even more by spending/redistribution programs in excess of the real tax take. On the corporate side, while a 28% tax rate would probably hit earnings in most sectors between 10-15%, that hit would probably be dwarfed early on by the dramatic earnings rebound as the economy laps the lockdown months of February through July of 2020. Longer term, while supply-side thinkers like Federated Hermes would probably cut our out-year growth forecasts, demand-side economists (many of whom work on Wall Street) would project better growth. Net net, a Democratic sweep might not cause an immediate pop in markets post the election, but we think it would likely not cause a big retrenchment either.
A ‘no decision?’
Assuming the race tightens again between now and Nov. 3, which we think is likely although this morning’s news about the president adds a wild card, it seems almost a sure thing that we won’t know who won several of the key swing states, and even key Congressional districts, until well after the mail-in ballots are all counted, argued over, thrown out and brought back, and argued over some more. This would likely be unsettling, though it would represent one of the most well-flagged black swans in the history of the stock market. And importantly, the market would probably be comforted by two realities: one way or the other (and there are quite a few “other” scenarios we could entertain you with if you care), a president will be in place on Jan. 20. And whoever that is, as noted above, the outcome would be viewed as relatively benign. So while a “no decision” could cause some volatility in November and December, we would view that volatility as short term in nature and very much buyable. Our guess is most other market participants would as well.
In the end, the bull has no party affiliation
Over the long term, the ebbs and flows of fiscal policy have less impact on the market than many policymakers think it should. Indeed, seven years out of 10 for the last 100 years, the market has gone up, not down, on the back of an ever-growing global economy and the earnings improvement that accompanies it. Certainly, in crises such as 1933, 2008 and March 2020, emergency fiscal support is often critical to keeping market participants liquid until the panic passes, and often the government is the only player who can stand in the breach. But the rest of the way, fiscal policy is often more of an accelerant, or a compressor, not a driver. We think that’s the case today. With a major recession behind us, the Covid threat seemingly ebbing, an historic earnings rebound in place for 2021 and Fed policy on near-permanent ease, the market looks poised to make new highs over the next three years, regardless of this election’s outcomes. Those new market heights might be somewhat compressed by a Democratic sweep and the higher-tax, higher-regulation environment that would ensue, but higher is still higher.
So tighten your belts for the uncertain election ahead. But stay long while you’re doing so.