The pandemic presidential election & financial markets
Financial market events

The US Presidential election is on Tuesday 3 November 2020 (Wednesday 4 November 2020 AEDT).

Former US Vice-President Joe Biden leads incumbent US President Donald Trump in opinion polls.

A close election is expected with a contested outcome considered the ‘worst case’ scenario for financial markets. An expected surge in postal voting due to the pandemic, continuing civil unrest and a possible lift in virus infections in colder months ahead of the election could add to uncertainty.

We find that sharemarket corrections and recessions reduce the likelihood of an incumbent President winning a second term in the Oval Office.

Professional investors are buying protection for their portfolios against expected volatility as the equity risk premium builds ahead of the election – which is already the most expensive event risk on record.

¾ Commonwealth Bank Group currency strategists expect a small Aussie dollar reaction if Mr. Biden wins office. But a large fall could be recorded for the Aussie against the greenback should President Trump be returned for a second term.

US Presidential elections are periods of uncertainty, potentially affecting investors, businesses and consumers decision-making.

What does it all mean?

• At the start of the year, most investors would have thought that the US Presidential election on November 3 would be the biggest market-moving event in 2020. But not long after the US-China ‘Phase 1’ trade deal was inked in mid-January, the world changed. A ‘Black Swan’ event – typically described by economists as an unexpected and unpredictable episode with severe consequences – arose with the coronavirus outbreak across the globe.

• Since February, the world has experienced the biggest health crisis in a century and the largest contraction in economic activity since at least World War II, but most likely the Great Depression. Financial markets have been volatile with sharemarkets rebounding sharply after hitting lows on March 23 – courtesy of unprecedented policy stimulus. During the coronavirus crisis, global policymakers – governments and central banks often working in tandem – have become more aggressive and innovative in defending their economies from recession and the threat of deflation.

• So what next for investors? Professional fund managers or investors like to talk about the impact of ‘tail risks’ on their portfolios. Typically when you have a unforeseeable shock – like COVID-19 – investors incur sizeable losses on their investments as asset prices fall sharply, meaning that they find themselves on the left ‘tail’ of a distribution of returns. To prevent losses, investors typically try to protect or hedge their portfolios from ‘tail risks’. In fact, a lot of effort is put into modelling various scenarios to prevent capital losses. And so to the US Presidential election due in over a month’s time.

• Unsurprisingly, in the September edition of the much-followed Bank of America Merrill Lynch (BofAML) survey of global fund managers, the outcome of the US election ranked second to the coronavirus as a ‘tail risk’ for investors.

• Some of you will ask why? After all isn’t this is a ‘known’ event and ‘foregone conclusion’ with former Vice-President and Democratic Party nominee Joe Biden ahead of incumbent US President Donald Trump in the bulk of popular opinion polls? Sure, but in the unpredictable world of populist politics – especially during twin economic and health crises – along with America’s much maligned electoral system, investors should prepare for the unexpected. In fact, we’ve seen this playbook before – Trump’s win in 2016, the Brexit vote, Aussie Prime Minister’s Scott Morrison’s surprise victory in 2019 to name a few. Financial markets, therefore, will become increasingly jittery in the lead up to polling day with alleged “foreign interference” and President Trump’s mail-in voting threats looming large over the outcome.

Trump versus Biden

• In every election – especially the US – personality politics dominates. In this election period, President Trump is confronted with a unique set of circumstances – the deepest US recession since the 1930s-1940s, high unemployment, civil unrest and the biggest health crisis in a century. His opponents are seeking to make the election a referendum on his government’s handling of the pandemic with the US COVID-19 death toll currently the highest worldwide with over 200,000 tragic deaths.

• Recent polling (September 15) by FiveThirtyEight shows that a large portion of the US population remains concerned about the virus with 35 per cent “very worried” about infections and a further 35 per cent “somewhat concerned” about a COVID-19 ‘second wave’. And Reuters’ Ipsos survey on September 15 shows that 58 per cent of respondents “disapprove” of President Trump’s handling of the COVID-19 outbreak. According to Pew Research Centre, 80 per cent of registered voters nominate the economy as “very important” to their vote, followed by health care at 65 per cent in a survey conducted from July 27 to August 2.

• Importantly, in the latest PredictIt opinion poll (September 20), former Vice-President Biden’s implied probability of winning the contest sat at around 57 percentage points. And FiveThirtyEight’s average of national polls on September 17 had Biden ahead of Trump by “about 7 or 8 percentage points.” With President Trump’s net approval rating standing at -12 percentage points, it appears that his chances of a second term in the White House are slim. Only President’s Nixon, Reagan and Clinton have been returned with ‘solid’ election wins, but all three had net approval ratings of between +15 and +18 percentage points prior to their elections, according to historical FiveThirtyEight polls.

• So why are the odds stacked against President Trump? Well in 2016 Democratic presidential nominee, Ms. Hillary Clinton won almost 2.9 million more votes than President Trump. Despite losing the ‘popular vote’, Mr. Trump exploited the mismatch between the national vote and the US Electoral College outcome by seizing ‘battleground swing’ states. US states are allocated 538 delegates in total based on their population sizes. Those candidates with the highest number of votes take all the delegates for that state and the candidate that wins a majority (270 or more) of the US Electoral College wins the election.

• In 2016, President Trump won key ‘battleground’ states – turning swathes of the Great Lakes region (i.e. Michigan and Wisconsin) ‘Republican red’ – while also taking key state, Florida. But polls are suggesting that he is behind in the 2020 race in all six state contests – Wisconsin, Michigan, Minnesota, Arizona, Pennsylvania and Florida – by between 4 and 7 percentage points, on average, according to recent FiveThirtyEight polls.

• If polls are to be believed – their track record has been questionable in recent years – Mr. Biden will win a clean sweep: the Presidency, the US House of Representatives and the US Senate. The Democratic Party already holds the ‘House of Reps’, but require a further three seats to take the Senate, enabling the former Vice-President to gain the necessary majority to pass legislation unobstructed by Republicans.

What would a Biden Presidency look like?

• If Mr. Biden’s bid for US President is successful, what can we expect on the policy front? And will it be the same sort of administration as under President Barack Obama? Well Mr. Biden’s presidential pitch focuses on several key policy platforms with a lot of overlap with the Administration from which he served as ‘VP’ (source: joebiden.com):

Ø (1) COVID-19 response: Provide universal free testing with at least 10 testing centres in every US state, supported by the addition of 100,000 health workers.

Ø (2) Jobs, wages and industry: Called the “Build Back Better” plan, Mr. Biden supports the extension of small business loans and direct government payments to families. He is proposing an additional US$200 in social security payments per month and supports raising the minimum federal wage to US$15 an hour. He has also called for a US$400 billion to “Buy American” program alongside a US$300 billion investment in US-made materials, services, research and technology.

Ø (3) Taxation: Mr. Biden is keen to redistribute income through the taxation system and rescind the Trump tax cuts. He wants corporations and high net worth individuals to pay “their fair share” and has proposed increasing top income tax rates, along with ‘tax base broadeners’, such as eliminating or limiting various incentives currently available to these taxpayers.

Ø A Biden Administration would immediately dismantle the Tax Cuts and Jobs Act by increasing the corporate tax rate to 28 per cent (by reversing half of Trump’s cuts), return the top marginal tax rate to 39.6 per cent (from 37 per cent) and tax capital gains and dividends as ordinary income. Profits earned by foreign subsidies of US firms would be doubled to 21 per cent and small business income deductions above US$400,000 would be phased-out. A financial risk fee would be imposed on large banks. If elected, tax credits would be provided to first homebuyers, renters and for childcare. The cost is estimated at US$3-4 trillion over the next decade.

Ø (4) Health and education: Former Vice-President Biden supports universal pre-school, the expansion of tuition-free colleges and US$10,000 student loan debt ‘forgiveness’. And ‘Obamacare’ would be expanded with a plan to insure 97 per cent of all Americans with the plan estimated to cost US$2.3 trillion over 10 years.

Ø (5) Immigration: Mr. Biden has promised to protect ‘Dreamers’ – people brought to the US illegally as children – as well as rescind limits on asylum seekers and travel bans on some Islamic countries.

Ø (6) Climate change and energy policy: Mr. Biden is proposing US$1.7 trillion federal investment in green technologies research; wants the US to reach net zero emissions by 2050 and says the US will re-join the Paris Climate Accord. He also wants a US$2 trillion investment in green energy. Vice Presidential hopeful, Ms. Kamala Harris, (Biden’s running ‘mate’) was a co-sponsor of the Green New Deal, a policy paper that advocates overhauling the US economy to tackle climate change.

Ø (7) International trade: Former Vice-President Biden is expected to take a multilateral approach, enlisting allies and partners in a bid to achieve US trade and economic goals. As President, Biden wants to rebuild strained relations with the EU and work with the World Trade Organisation (WTO) to address unfair trade practices. As mentioned above, Biden’s economic plan includes a US$400 billion plan to buy American-made goods and reduce US reliance on critical products – such as medicine and personal protective equipment – from China. He would prefer to rally allies against “commercial abuses” by China instead of raising tariffs.

Ø (8) Infrastructure: So far Mr. Biden has announced a US$2 trillion building plan – part funded by higher corporate tax rates – to rebuild roads and bridges, increased spending on mass transit and high speed rail network, investing in 5G wireless internet and rural broadband networks.

Crystal balls: The US sharemarket and economy

• Clearly, there is a temptation by commentators to use historical US election outcomes – including movements in US sharemarkets – as a guide to what will happen in future presidential races. Of course, much depends on the set of economic and political circumstances during the election cycle, along with the closeness of opinion polls.

• That said, historical Bloomberg data suggests that the benchmark US S&P 500 index typically lifts in calendar years when there is a US presidential election. Since 1928 (prior to 1957 the benchmark index was the S&P 90 index), total returns have been positive in 19 out of 23 election years, with an average total return of 11.3 per cent through to 2016. In fact, when the incumbent US president is up for re-election – or seeking a second term in the Oval Office – the index has risen in every year except for two of Franklin D. Roosevelt’s re-election bids (Roosevelt won a record four presidential elections from 1933-1945).

• And what about the impact of an economic downturn on presidential hopefuls? While it is incredibly rare for an incumbent to lose a re-election campaign, it typically happens when an economic downturn has hit the US in the lead up to the election. George H.W. Bush lost a second term in 1992 following a brief eight month recession between July 1990 and March 1991. The period included on oil price shock due to the Gulf War. And the election defeat followed aggressive increases in interest rates between 1986 and 1989 as the US Federal Reserve tried to dampen down inflation.

• The chances of re-election is dented by recessions and plunging US sharemarkets during a presidential campaign. Since 1952 every time the US S&P 500 index has suffered from a ‘bear market’ correction (fallen by 20 per cent or more) or the US has endured a ‘technical’ recession (two quarters of negative GDP), the incumbent president has lost the vote for another term in the White House. In fact, analysis by Ned David Research shows that the state of the US economy has played a key part in determining the winner of every presidential election going back to the Great Depression.

• Of course, history is against President Trump. In the June quarter of 2020, the economy (real GDP) contracted by 9.5 per cent or by an annualised rate of 31.7 per cent – the biggest fall since 1946. And despite the coronavirus-fuelled bear market of 2020 being the shortest ever at just 33 days, the S&P 500 index still fell 33.9 per cent from its February 19 high to its March 23 low. While it remains to be seen whether President Trump can convince voters that the virus shock wasn’t entirely his fault, the S&P 500 index has roared back to be up 46.7 per cent (to September 21) from March lows, straddling record highs.

• President Trump may face an uphill battle to regain the presidency, but a Democratic Party presidency and control of the US Congress could potentially be ‘better’ for investors. Bloomberg data from 1950-2019 shows that Democratic presidents have outperformed their Republican counterparts across most US congressional compositions when total annual returns of the S&P 500 index are observed. Oddly, a combination of a Democratic President combined with a Republican Congress has produced the best annual returns over the period, up 18.3 per cent. Next best is a Republican president with a split Congress (+17.9 per cent), then a Democratic president, also with a split Congress (+15.9 per cent).

• Polls currently point to a combined Democratic presidency and US Congress. Under this scenario, a 13.2 per cent S&P 500 gain had been recorded over the period. Whereas Republican presidents have posted annual returns of around 9 per cent with both Republican and Democratic Congresses – the most likely outcome if President Trump is returned.

How are investors positioned ahead of the election?

• Investors have plenty to consider at the moment. Returning to the BofAML survey of fund managers, the “most crowded” trade at the moment are long (overweight) investor/fund positions in US technology, growth and government bonds. But with mega-tech valuations now stretched, some investors are already rotating out of these ‘high flying’ market leaders – taking profits – with the Nasdaq index down sharply in September so far.

• Investors are also weighing up US-China trade tensions, COVID-19 vaccine developments, the outlook for virus relief stimulus (now threatened by a partisan battle over the appointment of a successor to former Supreme Court Justice Ruth Bader Ginsburg) and the economic outlook.

• So what about the lead up to the US election? So far the rise in Mr. Biden’s polls has not undercut the US sharemarket rebound from March lows. But it also appears that retail investors are not actively responding to Biden’s tax plan – which are less market friendly – with proposed increases in capital gains, corporate taxes and more progressive personal income taxes. At this stage, it appears that US Federal Reserve Chairman Jerome Powell’s ultra-accommodative policy settings are supporting risk assets and undermining the US dollar. Historically, capital gains tax rate changes in the US have not drastically altered total returns, more the mix of returns between capital gains and dividends.

• Nevertheless, with the presidential candidates facing-off against each other in televised debates in coming weeks, investor attention will quickly turn to a focus on possible electoral outcomes, introducing volatility into markets. The biggest risk is that the pandemic introduces huge volumes of mail-in ballots. President Trump has already criticised plans to expand postal voting in the election claiming, “there’s tremendous fraud involved.” Of course, this opens the door to potential legal challenges around results, denying a quick outcome, introducing heightened election and post-election day volatility.

• A contested election outcome could result in US shares falling 5-10 per cent or even more. The last contested election was in 2000 when US President George W. Bush declared victor a month after election-day following US Supreme Court intervention after a vote recount in Florida. Once again, the ‘Sunshine State’ looms large as the key ‘swing state’ in November after President Trump’s narrow win in 2016.

• While former Vice-President Biden has a decent lead in national polls, they are still at levels that seasoned political and investment strategists would perceive as being ‘close’. If the polls narrow ahead of election-day it could result in a sell-off in shares, reflecting the uncertain risk premium associated with equities.

• To mitigate risk ahead of the election, some investors are already hedging their portfolios against potential volatility. In fact, it is currently the most expensive event risk on record based on a common way to bet on volatility known as a “butterfly trade” – based on futures spreads (z-scores) tied to the CBOE Volatility (VIX) index.

• In addition to the equity risk premium, what about the all-important US government bond market? The ICE BofA MOVE index – which measures expected swings in US Treasury yields across the curve – shows the spread between 1-and 3-month indexes rising to a level seen only once in the past decade. And swaptions – options markets on interest rate swaps – show traders positioned for huge market swings.

• Average monthly volatility for every US election year since 1928 (using the average of CBOE Volatility index since 1990 and monthly average of the US S&P 500 index prior to 1989) shows a 28 per cent increase or ‘step up’ from 14.2 points in July to 18 points in November, using Bloomberg data.

What are the implications for Aussie investors?

• Can the US election impact Aussie financial markets? Absolutely. Global financial market linkages and real-time news and data feeds mean that Aussie investors will be glued to their televisions, Bloomberg and Reuters screens on the Wednesday morning of November 4.

• Those who observed the 2016 US election ‘carnage’ will no doubt recall that the S&P/ASX200 index was highly volatile on November 9, 2016 as the US election results trickled-in. The index opened 0.9 per cent higher, but slumped by almost 4 per cent after it became apparent that Mr. Trump would win. The ASX200 eventually closed 1.9 per cent lower, but whipsawed as US S&P 500 and Nasdaq futures slumped almost 5 per cent due to Mr. Trump’s unexpected victory. The Aussie dollar lost 2 per cent against the greenback and almost 5 per cent against the safe haven Japanese yen. Spot gold jumped 4.1 per cent as risk-off sentiment drove investors towards government bonds.

• Commonwealth Bank Group currency strategists have assessed a range of scenarios for the Aussie dollar against

the greenback based on the 2020 US election result, as follows:

• Given the uniqueness of this pandemic presidential election, investors should expect the unexpected come election-day. Markets hate uncertainty, so a contested election would be the ‘worst case’ scenario for investors. US voter turnout is always a huge unknown. And civil disobedience and another potential wave of virus infections ahead of winter will feed voter angst.

• That said, Bloomberg data shows that close elections – with extreme bouts of volatility – have typically been followed by strong US sharemarket (S&P 500 index) rallies – averaging around 5 per cent – into year-end regardless of whoever is in the White House.

• Rather than focusing on the election outcome, investors should assess whether their existing investment allocations still align with their current set of personal circumstances and speak to their financial advisor.

Published by Ryan Felsman, Senior Economist, CommSec