Tom GalvinChief Investment Officer | Oct. 2020

Election Special Bulletin: Beyond the Ballot

The pace of economic growth is unlikely to change meaningfully as a result of the election.

Progress on controlling the COVID-19 pandemic and continued policy support remain critical drivers of growth.

Expected results for asset classes are likely to remain modest, highlighting the need for active management.

Our current portfolio positioning is calibrated to do well in all outcomes and we will make appropriate adjustments once the final result is clear.

Contributing Authors:

David J. Abella, CFA

Steve Denike

Ben Goetsch, CFA

Gregory S. Kaplan, CFA

Charles Luke, CFA

Paul Single

OVERVIEW

The 2020 election highlights the sizable division between Republican and Democrats on key policy issues such as taxes, regulations and the government’s role in the economy. As Americans prepare to go to the polls, we look at how different policy initiatives could play out under different electoral outcomes. Our analysis is intended to be non-partisan and focused on potential implications for economic growth and financial markets.

Though the performance of the stock market is often credited to specific political agendas, the data doesn’t support this link and investors would be wise to think carefully before making decisions solely based on election outcomes. It’s also worth remembering that there is often a big difference between campaign rhetoric and political reality, as candidate proposals can often change considerably while they move through the actual legislative process.

The nature of our system of government, its checks and balances, largely limits the ability of one administration to radically change the course of public policy. Given current polling, we see two plausible election scenarios that have the greatest potential implications for markets and the economy: (1) a continuation of split government control (Trump/Republican Senate or Biden/Republican Senate) and (2) Democrat control (Biden/Democrat Senate). While there are some dramatic policy differences between these scenarios, a couple of similar outcomes are likely, including further fiscal stimulus to aid the recovery from the COVID crisis and higher spending on infrastructure investments, both of which would add to high government debt levels.

Overall, we expect more modest changes in enacted policy under a continuation of divided government, but changes may be meaningful if a Biden victory is accompanied with a Congress strongly under Democrat control. Importantly, regardless of the election results, we expect fiscal and monetary policy to remain exceptionally supportive, with the recovery from the pandemic, and the potential for an effective, widespread vaccine, being the main driving force of the economy and financial markets over the coming years.

MARKET IMPLICATIONS

Markets and corporate earnings have done well under all combinations of political control, and we suspect that will continue no matter the outcome in November (see Exhibit 1). History shows that over time its trends in economic conditions, profit growth, valuations and interest rates that have been the more powerful and lasting determinant for investment returns. Indeed, for all the focus in the media on potential policy changes in Washington, monetary policy has also had a very powerful impact on market returns. Especially over the last 15 years, Fed actions have increasingly been a key driver of market performance, and we think highly supportive monetary stimulus and ultra-low interest rates will persist for the foreseeable future (see Exhibit 2).



ECONOMY & POLICY

Elections rarely significantly alter the course of economies over the long term, and our analysis concludes that this time will be no different. Indeed, in the near term we expect what happens with COVID will likely have a far bigger bearing on near-term economic growth. Though new policies could certainly have impacts across different industries and sectors, we think the overall outlook will be driven primarily by the pace of progress toward a vaccine, the reopening of the economy and continued fiscal and monetary support. This is not to suggest that the path of the recovery will be identical regardless of election outcomes. The differences between Republican and Democrat legislative priorities are substantial, and the election could result in big shakeups for tax, regulatory and trade policy among others. The economic impact of policy under both our election scenarios is shown in the table below. Note that while a Split Control outcome will limit the ability of both a Trump and a Biden Administration to fully enact its agenda, the President does have considerable power to act independently of Congress in several key areas. As a result, we could see significant shifts in existing policy even if government control remains divided. For example, a continuation of the current deregulation agenda would likely be a net positive for the economy, while a return to a higher regulatory environment with a Biden victory would likely dampen growth prospects in isolation of other factors. This dichotomy is captured by the table’s split colored bubbles in the split control column.

  • Split Control: Under a second Trump administration, we would expect a continuation of lower tax rates for households and businesses, a preservation of the existing private healthcare system with a focus on lowering drug prices, efforts to curb immigration and a more unilateral trade approach. Under a Biden Administration, with Republican Senate control, we would expect modest tax increases for high income earners and corporations but reduced taxes for those in other income groups, as well as tighter regulations, an expansion of the public healthcare option, higher immigration and a more multi-lateral approach to trade. Infrastructure spending is likely to be prioritized by both Administrations.
  • Democrat Control: This would likely boost implementation of some of the Biden policy agenda mentioned above, most notably on taxes, healthcare and fiscal spending initiatives.

Despite these differences, our analysis indicates neither party’s policy priorities would likely fundamentally alter the overall trajectory of the economic recovery. The economy had been performing well before the COVID outbreak, and a general continuation of Republican policies of lower taxes and deregulation should be supportive for economic growth. On the other hand, a Biden victory, particularly with Democrats winning back the Senate, would likely lead to substantial new spending programs, and higher taxes to pay for them, but on net should likewise be a positive for the economy.

The next Administration and Congress will be inheriting an economy that has been badly damaged by record job losses and the shutdown of businesses across the country. While the economy has improved notably from its April lows, a return to full normalization and prior GDP levels is unlikely until 2022. Given this, no matter which party holds power over the next several years, we suspect that economic recovery and additional fiscal stimulus will likely be prioritized over policies that could dampen growth.

Over the long term, history shows that economic growth can flourish regardless of the particular political alignment of government (see Exhibit 4). The reality is public policy is only a small part of what shapes and moves a complex modern economy. Demographic, social and technological trends, which politicians have little control over, matter much more in terms of forces that drive economic potential. Even in areas where government does have power to shape the economy — appointing Fed officials, guiding fiscal and regulatory policy, responding to crises and external shocks — the link between governmental action and economic outcome is often much less than popularly imagined.

Equity Focus

Equity returns over the long run are driven by the pace of economic and profit growth. We continue to believe that investors should expect moderate returns going forward, regardless of the election outcome. As we have detailed in our proprietary CNR 4P’s framework (see Exhibit 5), there are several key factors that go into determining long-term economic and profit growth. While policy initiatives will likely change with a change in control in Washington, history has shown that after an initial adjustment period in stock prices the market does well regardless of the composition of US government, as there are other are critical differentiators that are impactful in corporate earnings growth and stock returns. If we are correct that fiscal spending would likely increase in all election outcomes, we believe from a global investment perspective that U.S. equity markets will likely continue to outperform other regions of the world, though at a diminished pace.

For the most part, the impact on the equity market under Democrat control is similar to that of a Split Government outcome. Policy decisions are expected to have differing but overall positive effects on economic growth, while the pace of technological innovation and population and demographic trends will likely be largely unaffected. The one area of potential difference is profitability. Assuming higher corporate tax rates of 25-28% under Democrat control, corporate profits could be reduced by as much as 4%-9%. However, because of the offsetting impact from other policy proposals, we would only expect a modest difference in S&P 500 EPS between each election outcome (see Exhibit 6).

Policy changes would impact companies and industries differently, and there are likely to be both positive and negative effects. In certain industries where increased fiscal spending would go up, policy initiatives could provide growth opportunities. Conversely, increased regulations, for example, could pose as headwinds for industries like Tech, Financials, Healthcare and Energy. Rigorous analysis of each company’s business model will be required to fully assess the net impact of policy change, highlighting the importance of active management for investors. The table below provides examples of industries that are particularly impacted by certain issues, and an indication of the potential impact of policy changes.

CORE EQUITIES

Our focus continues to be high-quality companies that are selling at reasonable prices and that benefit from our favorite themes such as the digital revolution, healthcare innovators and industrial leaders. We are currently positioned for a split government outcome. As we assess the impact of policy changes under potential Democrat control, our focus is on underweighting companies that would be most negatively impacted by corporate tax increases and regulatory changes. We are also researching companies that would benefit from increased economic activity and investment in areas such as transportation, environmental, R&D, housing and healthcare, as well as policies that would boost consumer spending, such as minimum wage increases and housing credits. Clearly any potential portfolio shifts would be considered in the context of the COVID crisis.

HIGH DIVIDEND & INCOME EQUITIES

Within the high dividend universe, continued low interest rates could favor certain industries, like utilities, over others, like banks. Energy companies could benefit from continued economic growth, though a Democrat sweep could lead to policies less favorable to the sector. In all cases, our focus remains on preservation and growth of dividend income, and we continue to carefully assess the outlook for individual companies through this unique environment.

FIXED INCOME FOCUS

Fixed income returns are driven largely by interest rates, credit-worthiness and tax policy. Interest rates and credit-worthiness are largely driven by the pace of economic growth, the expected level of inflation and monetary policy, while tax policy is a government decision that is heavily influenced by the political environment. Regardless of the election outcome, we expect monetary policy to keep short-term interest rates low for years, while increased fiscal spending could modestly increase inflation expectations over the longer term, pressuring long-term interest rates modestly higher. To the extent additional government spending supports economic growth, credit trends will likewise be positive. Tax rates are expected to increase under a Democrat sweep, impacting the relative attractiveness of tax-exempt municipal bonds.

TAXABLE FIXED INCOME

Accommodative monetary policy will keep interest rates low under most election scenarios, but a Democrat sweep is a clear and present danger for modestly higher long-term interest rates as government spending may spur a rise in inflation expectations. We expect this impact to be small as the loss of economic output and high levels of unemployment will limit growth in 2021, countering Democrat spending initiatives. A split government or continuation of the status quo will result in little change, and all outcomes point toward low returns for investment grade fixed income investors. Given low yields, we believe areas of opportunistic fixed income, such as high yield bonds and structured credit, show promise as the economic recovery continues. These sectors provide a high level of income and remain attractively priced, despite swift returns from the March lows. However, a split government result could negatively impact emerging markets if foreign policy and trade issues remain stressed. The virus and uncertainty around the election will lead to unpredictable outcomes and investing in opportunistic income involves higher risk, making it crucial to actively manage bond exposures. Given the uneven impacts of the current economic decline, there has not been a better time for active management since the crisis of 2008.

Municipal Fixed Income

In addition to the broader macro impacts to fixed income markets outlined above, potential changes to tax policy and government spending can directly influence the relative attractiveness of municipal bonds. A significant fiscal package, more likely under a Democrat sweep, is expected to include significant aid to state and local governments, improving their credit profiles. Further, higher levels of government spending would likely support economic activity adversely affected by the pandemic and thus improve the outlook of the municipal sector. The tax increases that would likely accompany a Democrat sweep would also make tax-exempt bonds modestly more attractive on a relative basis, providing support for total returns. While such policy decisions would likely be supportive of the municipal segment generally, interest rates are expected to remain low, limiting the return potential of investment grade municipal bonds and supporting the outlook for high yield municipal bonds (see Exhibit 10).

Key Points

The pace of economic growth is unlikely to change meaningfully as a result of the election.

Progress on controlling the COVID-19 pandemic and continued policy support remain critical drivers of growth.

Expected results for asset classes are likely to remain modest, highlighting the need for active management.

Our current portfolio positioning is calibrated to do well in all outcomes and we will make appropriate adjustments once the final result is clear.

Contributing Authors:

David J. Abella, CFA

Steve Denike

Ben Goetsch, CFA

Gregory S. Kaplan, CFA

Charles Luke, CFA

Paul Single

Index Definitions

S&P 500 Index (S&P500) is a stock market index that tracks the 500 most widely held stocks on the New York Stock Exchange or NASDAQ. It seeks to represent the entire stock market by reflecting the risk and return of all large-cap companies.

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future results.

Investment management services provided by City National Bank through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor.

CNR is free from any political affiliation and does not support any political party or group over another.

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