More than a year after Secretary of State Hillary Clinton and businessman Donald Trump entered the presidential race, we still have over two months to go before Election Day. The “campaign season” has turned into a near-permanent state of affairs. A baby born on the day Clinton announced her candidacy will most likely be walking and talking by the election date, and a Major League baseball team will have played about 250 games over this time span. The conventional wisdom for this marathon approach is that a lengthy time in the spotlight separates the wheat from the chaff. But there is ample evidence that most voters don’t think the process worked this time. Both major party nominees are historically unpopular and are viewed as untrustworthy by a majority of the electorate.1 Given that somebody has to win, it may be that for most Americans, November 8th can’t come soon enough.
As we consider the impact of the election on investments, it’s important to keep in mind the words of legendary investor Benjamin Graham: “In the short run the market is a voting machine, but in the long run it is a weighing machine.”2 Graham was warning investors to avoid focusing on a single-event outcome to the exclusion of other factors. Asset prices can be temporarily impacted in the short term by single events (like an election), but over time, they are driven by the same fundamental factors: interest rates, monetary policy, credit availability, economic growth and earnings. Our task in the paragraphs that follow is to consider how the new political environment in 2017—whatever it may be—may impact these key variables. Financial markets are not ideological or partisan, and therefore neither is our analysis. We are not opining on the worthiness of candidates or their policies, but the likely impact on market fundamentals.
What Are the Odds?—A Look at Potential Electoral Outcomes
Time does not permit a recounting of how surprising, extraordinary, bizarre and unprecedented the 2016 election cycle has been to date. After all that has transpired, though, the ultimate surprise may well be an election outcome that leaves Washington with roughly the same partisan divide—a Democratic president and Republican control of at least one house of Congress.
Hillary Clinton is the clear front-runner in the presidential race. In the RealClear Politics “poll of polls,” she maintains a 6.0 percentage point advantage over Donald Trump.3 More importantly, survey data from battleground states suggests that she has the potential to expand on President Barack Obama’s 332–206 Electoral College victory in 2012. In addition to the perennial toss-up states Florida and Ohio, polling suggests the Democratic nominee is competitive in traditionally GOP states North Carolina, Georgia, Missouri and Arizona, while Trump so far appears competitive in only one state that President Obama won four years ago (Iowa).4 The Trump campaign’s strategy of breaking through in the traditionally Democratic industrial Midwest shows no signs of working yet. Recent polls have Trump trailing by double digits in Pennsylvania, Michigan and Wisconsin.5
There is ample time for this trend to reverse. Given her high unfavorable ratings and a strong impulse for change in the electorate, it would be a mistake to view a Clinton victory as a sure thing. There is also a suspicion that the high degree of angst in the electorate makes polling data less accurate than usual.
June’s Brexit vote in the U.K. is a recent example in which opinion polls and oddsmakers both expected a comfortable victory for the “remain” side just days before voters went the other way. At the same time, the Clinton campaign’s larger organization and “get out the vote” machinery suggest the possibility that she could outperform the polls. This far away from Election Day, certainty is out of the question, but Clinton has the edge.
House and Senate races should be just as important for the investment landscape as the presidential race. President Trump or President Clinton would have a much clearer path to implementing his or her agenda with control of both houses of Congress. However, that is not the most likely outcome.
Currently, the GOP has a large majority in the House and a small majority in the Senate. Prospects for a change in control are greater in the Senate, where Republicans have to defend more than twice as many seats as Democrats (see chart below). A Clinton victory at the top of the ticket could well be accompanied by a Democratic Senate majority in 2017. However, it would likely be a small majority (50-53 seats); and because of Senate rules, passing most major legislation—including Supreme Court confirmations—requires 60 votes.
Republicans have the largest House majority for either party in 30 years. Democrats would need a net gain of 30 seats to regain control. Results from the last several congressional elections suggest that decades of gerrymandering have resulted in ideologically lopsided districts, with very few of the House’s 435 seats truly up for grabs. By one measure, only 31 GOP-held seats are competitive,6 so Democrats would need a huge electoral wave to win 30 of these 31 competitive seats plus retain all their current seats. This is a tall order, to say the least.
Historically, so-called generic ballot polling—when people are simply asked whether they plan to vote Republican or Democrat—has done a good job of predicting congressional election trends (see table below). The survey almost always favors Democrats because more are polled. So, in 2010 and 2014, small Democratic polling margins actually translated into GOP seat gains. The most recent generic party ballot is +4 for the Democrats. This does not suggest a congressional drubbing for the GOP. July’s reading was tied, so there has been movement toward the Democrats. If history is any guide, though, the Republican House majority would be at risk only if these numbers move close to a double-digit gap.
In short, a current assessment of the situation favors a Democratic White House and majority control of at least one house of Congress by the Republicans. This is an outcome we believe financial markets could live with, as it represents only a slightly revised version of the status quo. For all the complaints about gridlock in Washington since divided government commenced in 2011, stock and bond markets have prospered. Based on recent trading action and a variety of investor surveys, this is the outcome we believe is “in the market” already.
Partisan sweep scenarios are less likely, but present more risk of market volatility. That is because they increase uncertainty and raise the specter of more significant changes to the economic and regulatory landscape. Generally speaking, a Democratic sweep would likely entail more aggressive federal spending and regulation and a populist reordering of the tax code. Implications of a Republican sweep are harder to decipher because of key differences between Trump and congressional leadership on trade, immigration and defense policies. But, significant personal and corporate tax cuts and a deregulatory business environment would likely unfold if the GOP runs the table in November.
What It Means for Policy
Markets don’t root for candidates. They assess how various policy outcomes might impact the investment landscape. Below, we review these at both the macro and micro levels.
Fiscal Policy: As can be seen in the graph below, after ballooning during the Great Recession, the federal budget deficit has come down sharply for the last six years. This has been dubbed a period of austerity due to tighter federal budgets and tax increases. We believe that the populist surge in public opinion, along with the proposals laid out by both candidates, raises the odds that the budget deficit will rise in the years ahead. In addition to the proposals listed below, both candidates have shied away from entitlement reform, where the biggest funding gaps exist. Trump has said repeatedly that he does not want to touch Social Security, while Clinton proposes an expansion of Medicare eligibility.
All else being equal, a burgeoning federal debt would put upward pressure on interest rates. While this is likely with either nominee, there is probably more upside potential for both economic growth and bond yields in a Trump presidency. He is embracing a more aggressive fiscal agenda of tax cuts and spending increases to stoke the economy, and shows more willingness to accept the fiscal risks. Trump’s attitude toward debt has been well chronicled, as evidenced by this well-known Trump quote, “I am the king of debt. I do love debt….”7
A review of Clinton policies by the Committee for a Responsible Budget (CFRB) estimates $1.75 trillion in additional spending over the next 10 years, which would be centered around:
- More infrastructure spending
- Expansion of the Affordable Care Act
- Student debt relief and early childhood education
- Targeted tax breaks (e.g., repeal of the Affordable Care Act’s “Cadillac Tax”)
Her tax proposals call for:
- Limiting itemized deductions for upper income taxpayers
- Lowering the estate tax exemption amount and raising the tax rate
- Taxing capital gains held fewer than six years as ordinary income
- Enacting the “Buffett rule”—a minimum tax on incomes over $1 million
- Initiating a 4% surtax on incomes over $5 million8
Taken together, a Clinton plan would require a relatively small amount of funding and would slightly accelerate the rising share of federal debt as a share of gross domestic product (GDP) that is currently projected by the Congressional Budget Office.
Fiscal policy proposals under a Trump administration focus on dramatic individual and corporate tax reform, with revenue losses funded by a combination of base broadening and higher economic growth estimates. Trump recently moderated his original tax proposal to mirror a House Republican plan with personal rates of 12%, 25% and 33%. He also favors a lower 20% tax on capital gains and elimination of the estate tax.9 Federal deficit estimates under a Trump plan vary widely due to differences in the assumed benefit to GDP as a result of reform. Regardless, tax cuts would be front-loaded and the economic benefit would likely accrue with a lag. The mismatch in costs and revenues, whether transitory or more prolonged, would require significant increases in Treasury debt.
Generally speaking, the lower personal tax rates under a Trump plan would likely lead to a loss of relative value for municipals, while the higher rates proposed by Clinton would increase the value of tax exemption in municipal bonds. However, according to the Tax Policy Center, tax-exempt interest would be subject to the itemized deduction limits she proposes, so any relative benefit would be muted.
Monetary Policy: It is unlikely that the election results will have any near-term effect on the conduct of the Federal Reserve. Janet Yellen’s term as chair concludes in early 2018, and the Federal Open Market Committee (FOMC) should face a narrow range of unemployment, inflation and financial market metrics for the months leading up to and following the November presidential election. Should either party gain control of both the White House and Congress, the fiscal policies proposed during the campaign would face an easier passage, leading to a lower required contribution from monetary policy. In other words, normalization of interest rates toward higher levels would accelerate. Our base case, where leadership of the executive and legislative branches remains divided, would likely mute any material change to fiscal policies, leading to a continuation of the extraordinary “lower for longer” interest rate policy of the Fed.
Foreign Trade: While Clinton has adopted a more skeptical position on free trade during the primary season, once again, Trump has staked out a more decisive and potentially game-changing view. Both candidates have come out against the Trans-Pacific Partnership (TPP), a major Asian free trade deal designed to lower tariffs and other barriers, and serve as a counterweight to China’s rising economic influence.
Clinton was a lead negotiator and advocate of TPP when she was at the State Department, and it may be that her recent opposition was a political necessity, given growing antipathy toward open markets on the left. In other words, her approach appears more tactical than ideological. Trump, on the other hand, has made strong opposition to trade deals a cornerstone of his campaign, going all the way back to NAFTA 23 years ago. He has threatened tariffs and other barriers in the belief that it will allow the U.S. to cut better trade deals with other countries.
A combative trade policy runs potentially large risks for our financial markets. Foreign interests own 45% of U.S. Treasury debt.10 And, as can be seen in the graph below, there has been a dramatic increase in the share of U.S. corporate profits coming from abroad. The idea that the U.S. holds all the cards in trade negotiations is wishful thinking. This is important to realize as the Democratic nominee shies away, and the Republican nominee runs away, from the globalization trends of the last 25 years.
Regulation: This is one area where the divide between the candidates falls along conventional partisan lines. Clinton takes a skeptical view of the free market, believing that government intervention is often necessary to prevent market distortions. Trump believes that the Obama administration has been overzealous in imposing regulations and that it has slowed the economy’s growth rate. He proposes “a temporary pause on new regulations and a review of previous regulations to see which need to be scrapped.”11
While media attention around the Supreme Court is usually focused on hot-button social issues, the majority of cases it decides relate to business and regulatory topics.12 Thus, the current court vacancy and the fact that three justices are near or beyond age 80, suggest that this could be the next president’s most significant long-term impact on the way American business operates. It will not be a blank check, however. The next Senate is likely to be closely divided, and current Senate rules require 60 votes to break a filibuster against a Supreme Court nominee.
Stock Market Sectors: CEOs and analysts are already perusing the candidate’s policy positions for potential impact on the operating environment for their companies. Below, we focus on the three sectors we believe have the most at stake on the election outcome.
Financials. Broadly speaking, a win by Clinton and a Republican Congress would be seen as a continuation of the status quo. Clinton has made comments about greater oversight of non-bank financial companies, including hedge funds, investment banks and other non-bank finance companies. The candidate has proposed a “fee on risk” on big banks, taxes on high-frequency trading and a stronger Volcker rule, which places trading restrictions on financial institutions.
If Republicans control just one house of Congress after the election, it will be difficult for Clinton to push through any of this legislation; however, she could lean on regulators to assert their authority more aggressively. She has called for strengthening Dodd-Frank, an already vast set of federal regulations that many financial institutions have complained burdens them with increased costs and bureaucracy.
Trump has expressed a desire to bring back the Glass-Steagall Act, which separates commercial and investment banking. A return of Glass-Steagall would be operationally painful and expensive for banks, which have spent many years integrating their commercial and investment banking operations. A Trump victory would almost certainly come with a strong GOP majority in one or both houses of Congress. Given that most Republicans oppose bringing back Glass-Steagall, a change is unlikely. On the other hand, Trump has called for dismantling Dodd-Frank. While full repeal is unlikely, he would find common ground with congressional Republicans in rolling back parts of it, which would be well received by the financial sector.
Healthcare. The implications here are more nuanced, with each candidate’s policies posing potential risks and rewards for different parts of the healthcare industry. Both candidates have decried rising pharmaceutical prices and support the notion of Americans being able to import cheaper drugs from other countries. Beyond that, the differences are enormous.
Trump wants to repeal the Affordable Care Act (ACA)—an area of agreement with most congressional Republicans. This prospect would be unfavorable for hospitals and managed care companies, who have benefited from the rising number of insured patients seeking care. Clinton, on the other hand, wants to effectively expand ACA by including a public insurance option and increasing the number of people covered by Medicaid.13 This would be viewed as beneficial for those same industries. She has a more aggressive set of plans to control pharmaceutical prices, and this poses a risk to pharmaceutical and biotech stocks.
Again, our base case of a divided government scenario would indicate a lessened likelihood of any radical changes. Congressional Republicans have been strongly against government-imposed price controls and want to shrink or kill the ACA. Given the recent bad news on ACA—rising premiums, insurance companies dropping out and slowing enrollment—some change is likely coming regardless of the election outcome. The shape of that change could impact investment prospects for various healthcare sub-sectors and stocks.
Energy. Both nominees reflect the middle ground of their respective parties, resulting in strongly differing views. Trump’s view is reminiscent of a prior GOP rallying cry: “Drill, baby, drill!” He favors rolling back regulations and opening more land and waters to oil and gas production. Clinton is generally supportive of the more restrictive regulatory approach to the fossil fuel industry of the Obama administration and places more emphasis on climate change and subsidizing alternative energy solutions.14 Our divided government scenario would likely produce little in the way of legislation, but with a Clinton administration using its regulatory powers and the courts to press its agenda.
Conclusion
As we stated at the outset, it does not make sense to make major portfolio changes based on an election forecast. However, it is important to track how Washington may change the investment landscape in the future. There is little doubt that between now and Election Day, there will be more surprises. We will keep you abreast of these developments and our view on how it impacts asset allocation and security selection. For an updated view, register now for our September 8th political webinar.
David L. Donabedian, CFA, is chief investment officer of Atlantic Trust, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.
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1 New York Times/CBS News News Poll, nytimes.com, 07.14.2016.
2 Benjamin Graham, The Intelligent Investor, 2006.
3 realclearpolitics.com, 08.25.2016.
4 Cook Political Report, 08.15.2016.
5 RealClearPolitics.com as of 08.25.2016, based on two most recent polls in each state.
6 Cook Political Report, 08.10.2016.
7 cnn.com, 05.10.2016.
8 hillaryclinton.com as of 08.24.2016.
9 donaldjtrump.com, as of 08.24.2016.
10 federalreserve.gov as of 08.10.2016.
11 donaldjtrump.com as of 08.24.2016.
12 Legal Information Institute, Cornell University Law School.
13 Cornerstone Macro Research, 08.11.2016.
14 Evercore ISI, 08.18.2016.
