We are in the homestretch of the 2020 presidential election season. With two polarizing presidential candidates, an ongoing pandemic, recession, social unrest and a mail-in ballot controversy, this cycle is truly like no other.
With the expected increase in mail-in ballots, we may not immediately know the outcome on Nov. 3. The polls, barring an unforeseen “October surprise,” are likely to stay close. And the presidential election may come down to the U.S. Supreme Court, also in flux, significantly impacting market volatility until the outcome is determined.
Given that view, we lay out four possible election outcomes, with our thoughts on how the markets may react.
Potential Outcome 1: Joe Biden Wins, Democrats Sweep the House and the Senate
In this “Blue Wave,” a Biden presidency would most likely retain Jerome Powell as Chair of the Federal Reserve, signaling a continuation of mostly “accommodative” monetary policy.
A Democratic sweep of all levels of government would potentially increase regulations, hampering economic growth. Additionally, higher taxes and a less business-friendly approach could partially offset continued easy monetary policy and the bipartisan spending blowout. This could ultimately burden the market in the coming years.
Potential Market Reaction
Equity Markets:
- We view this scenario as largely negative for equity markets but expect more infrastructure and deficit spending, aiding basic materials and industrials.
- While tax policy and regulation are a negative for equities, corporate tax hikes may not be passed until 2022.
- Another negative for equities, and all financial assets, is the increased potential for a financial transactions tax, although a more moderate Treasury Secretary pick could stop this initiative in its tracks.
- More predictable trade negotiations could be a positive for Asian emerging markets, with Sino-U.S. relations likely to mend.
- But if the Fed has to raise rates in 2021 or 2022 in an effort to curb nascent inflation, that would likely cause a more risk-off scenario for equities. It could also lead to some defensive sectors performing well, benefiting the utilities and telecommunication sectors, especially if longer-dated bond yields remain relatively undisturbed due to economic lethargy.
Fixed Income Markets:
- Short-term interest rates stay low because of slower growth, the lack of an inflationary backdrop and an accommodative Fed policy.
- The budget deficit would remain a trillion-dollar phenomenon, curbing enthusiasm for intermediate- to longer-dated Treasuries beyond the initial flight to safety.
- There would be high volatility as capital markets nervously reassess the implications of a new policy landscape.
- A combination of inflation pressures and reduced trade tensions should be positive for foreign currencies and lead to a weaker dollar.
Potential Positives of a “Blue Wave”
Fiscal gridlock would be lifted, ending roadblocks for additional recovery packages.
Without the spending checks of a Republican Senate, Democrats are emboldened to increase spending to help the U.S. recover from the pandemic.
Potential Market Reaction
Equity Markets:
- Equity markets continue to rely on the hope—and delivery—of stimulus, treating all positive political developments with risk-on enthusiasm.
- Should economic activity surprise to the upside, cyclicals and value stocks that are most closely linked to GDP growth may finally catch a bid and begin to close the gap on their growth counterparts.
- International relations improve, leading to coordinated policy action.
Fixed Income Markets:
- Potential for higher yields in Treasuries if growth picks up.
- Credit spreads tighten with the support of both a monetary and fiscal backstop.
- The path of the dollar is mixed, balancing weakness—given the widening deficit—and strength, given the more stable path forward for the economy.
Potential Outcome 2: Joe Biden Wins, Democrats Retain the House, the GOP Retains the Senate
Political gridlock would remain, with lower growth. A bipartisan spending blowout and an environment where Fed policy is once again a primary driver of economic and market outcomes continues.
Potential Market Reaction
Equity Markets:
- From a tax perspective, this is a positive scenario for U.S. equity markets and should lead to 2020’s top success stories, such as the tech sector, seeing more upside at the expense of cyclical groups.
Fixed Income Markets:
- Fed policy remains on “autopilot” based upon its new policy framework of average inflation targeting.
- Short-term rates remain anchored, but intermediate- to longer-dated yields will be influenced by how this “new” policy framework is executed.
- We recommend securing incremental income from spread products, which are poised to outperform Treasuries.
Potential Outcome 3: Donald Trump Wins, the GOP Retains the Senate, Democrats Retain the House
With Trump talking about stimulus-via-tax cuts, we could see something like the 2017 market environment, where stocks were juiced higher on that prospect. Additionally, with the GOP throwing fiscal thrift out the window in recent years, deep deficit spending could enable the economy to reach escape velocity in 2021 – at the cost of long-term fiscal health.
Potential Market Reaction
Equity Markets:
- Economic reopening should support a cyclical reversion in 2021, with Small Cap Value benefiting from 2020’s pent-up demand.
- Sector-wise, we are constructive on Financials in this backdrop, as the probability of a financial transactions tax and a rise in corporate tax rates would shrink toward zero.
Fixed Income Markets:
- Fed policy remains on “autopilot” with its new policy framework of average inflation targeting, keeping short-term rates anchored.
- Intermediate- to longer-dated yields will be influenced by how this “new” policy framework is executed. The yield curve could steepen.
- We recommend securing incremental income from spread products, which are poised to outperform Treasuries.
Potential Outcome 4: Donald Trump Wins, the GOP Sweeps the House and Senate
A “Red Wave” would continue the bipartisan spending blowout, pressure the Fed to maintain easy monetary policy and begin immediate talks of additional tax cuts. The business-friendly regulatory environment would please domestic energy, as would the higher inflation that we foresee developing in 2021 and 2022 as a consequence of 2020’s monetary expansion. This could force the Fed to reverse its current zero interest rate policy to quell inflation.
Potential Market Reaction
Equity Markets:
- Many of the groups that performed strongly this year – “Work from Home” stocks, tech and communications services, countercyclical lockdown retailers – would begin to lag. Groups like commodities, banks and debt-burdened Value stocks may catch relief if we catch a whiff of inflation.
- Emboldened GOP China hawks would probably apply enough pressure to hinder the relative merit of emerging markets relative to the U.S., causing the former to underperform in an “America First” regime.
- In addition to “relief-that-its-not-Biden” sectors like Financials and Energy, we suspect the GOP would be quicker to encourage reopening. This could provide relief to airlines, hotels and real estate investment trusts (REITs).
Fixed Income Markets:
- Risk-on tends to prevail, as the 2016–2017 episode of the “Trump Reflation Trade” is revisited.
- The yield curve would likely steepen as inflation expectations rise.
- Credit would outperform safe haven fixed income, but absolute returns are likely to be challenged. Secure income while limiting duration risk.
- The Fed outlook gets revisited, with the timetable for potential rate hikes and balance sheet normalization being pushed up.
- The dollar would be vulnerable during initial “risk on,” but its future direction will be dictated by the interplay between increasing Treasury supply and the market’s concern, or lack thereof, with respect to money supply.
- Emerging markets local debt is well positioned to perform in this environment.
There are risks associated with investing, including possible loss of principal.
This material contains the opinions of the authors, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product, and it should not be relied on as such.
Kevin Flanagan is WisdomTree's Head of Fixed Income Strategy and Jeff Weniger is WisdomTree's Director of Asset Allocation. They are registered representatives of Foreside Fund Services, LLC.
