Quick Thoughts: US elections—entering the final stretch

For investors and market returns, however, politics can be overrated. Despite shifts in polls and other indicators, our primary investment conclusion remains unchanged. Investors should stay focused on long-term objectives and not overreact to US politics and election outcomes. As we have noted in earlier research, markets have thrived, paused, corrected and rebounded under both Republican and Democratic presidencies, as well as under various constellations of power in Congress. The broad contours of the stock, bond and even currency returns are typically dictated by fundamentals determined outside the sphere of politics.

That does not mean, however, that specific sectors, such as energy or pharmaceuticals, won’t be impacted by the outcome of the election. In that regard, some portfolio implications are worth considering, as we detail below.

The odds have shifted

Across almost every metric—national polls, “battleground state” polls, political futures markets, and spread-betting—the data tell a consistent story of an election up for grabs. That is in marked contrast to just a few months ago, when most indicators showed former President Trump with a clear lead, and with Republicans enjoying the inside track for control of both houses of Congress. In June, therefore, we explored the implications for investors of a Republican clean sweep.

Today, that outcome seems far less likely. National and key swing state polls show the presidential race a dead statistical heat, with Vice President Harris enjoying small leads in most swing states and nationally. Majority outcomes in the Senate and House of Representatives are also tougher to predict, with Republicans enjoying a slight advantage in the Senate, while the Democrats have better chances of having a majority in the House.¹

The probabilities have therefore shifted toward divided government in Washington, where one party controls the White House and the other has a majority in one or both chambers of Congress.

Divided government is not novel in recent US history, including recent US history. Since 1968, for example, a form of divided government has existed in 38 of 56 years (68% of the time).²

Broad market implications

The sharp shift in the polls over the past two months is a reminder that a lot can still change. Relatively few voters may remain undecided, but US elections—at all levels—are often decided by swings in relatively few votes in just a few states. For example, the outcomes of the 2016 and 2020 presidential elections hinged on less than a million votes cast in six key swing states, out of a total of about 150 million total votes cast nationwide. US politics has been, and remains, closely divided.  It is therefore still too soon to draw firm conclusions regarding the outcome in political or market terms.

Nevertheless, it is worth briefly considering what divided government might mean for investment risk and returns.

Investors often welcome a divided government because, perhaps perversely, it diminishes uncertainty. The scope for sweeping legislative changes to tax laws or regulatory policy is constrained by the need for compromise. The status quo persists, allowing firms and investors to make decisions without having to consider major fiscal or regulatory policy shifts.

Divided government can even permit deficit reduction, as occurred from 1994-2000 and again from 2010-2016. Bond investors, therefore, may have grounds for welcoming it as an avenue to reduce deficit and debt burdens.

The one area of potential concern under divided government, however, resides in political default risk. Government shutdowns and the potential for the Treasury to miss interest payments on the national debt have been a concern when impasses led to an inability to increase the US debt ceiling. In all such cases since the mid-1990s, those near misses (but including US debt downgrades by ratings agencies) have occurred with a Democrat in the White House and a Republican majority in the House of Representatives. Democrats, thus far, have not engaged in similar political negotiating tactics under circumstances where they controlled the House of Representatives under a Republican president. The implication is that default risk would be higher in divided government with Harris as president.

Market implications of a divided government

The primary driver of returns in US Treasuries and the overall direction of interest rates will be determined by the business cycle (growth and inflation) and corresponding Federal Reserve (Fed) policy, not by fiscal policy or sovereign risk premiums. No matter the legitimacy of long-term concerns about US government deficit and debt trajectories, there is no evidence that the current size of the debt or even its projected growth is or will soon have significant near- or medium-term impacts on the level or directional moves of the US Treasury market.

For equities, valuations and profits determine returns. Raising the corporate income-tax rate (Harris favors raising it from 21% to 28%) would lower after-tax corporate profits, but as president she may struggle to enact any increase if Republicans control the Senate.

The more important consideration for equity investors is regulatory action, which resides chiefly with the president. Harris and the Democrats are apt to push for greater regulation of fossil fuel energy and the pharmaceutical industry (e.g., further caps on prescription drug pricing), while promoting alternative energy. The opposite would be true in a Trump presidency. Accordingly, we think those sectors are likely to react more to the presidential outcome than the broader market.

In foreign exchange markets, the dollar will adjust to changes in interest differentials and expected equity return differentials between the United States and other countries. With US growth showing signs of slowing and the Fed indicating significant easing over the next 12 months, the dollar is apt to depreciate somewhat against other major currencies. But in our view, dollar weakness is likely to be contained by weak growth and relatively poor returns in fixed income and equity markets in Europe and Asia, as economies in those regions remain hamstrung by weak global growth, tepid world trade growth, and other factors, such as political risk or heavy debt burdens (e.g., China).

The wildcard for the dollar and capital markets would be a Trump victory followed by the imposition of large, across-the-board tariffs. If countered by other countries, the risk of trade wars could push up risk premiums, leading to sharp falls in equity markets and a surge into traditional safe-haven currencies (Swiss franc, Japanese yen), or gold and cryptocurrencies.

Finally, anti-trust policy is worth watching. The Biden Administration has taken a tougher stance against large capitalization technology companies, led by Federal Trade Commission Chairperson Lina Khan. A Harris administration could also pursue that approach. On the other side, Republican Vice-Presidential candidate JD Vance is an advocate of anti-trust with respect to the technology sector. In both cases, anti-trust captures populist sentiment that ordinary Americans are concerned about the growing power of large firms.