US equities: the election effect

With November’s US presidential election fast approaching, investors’ focus will likely gradually switch from the COVID-19 pandemic to the possible outcomes of the election. While post-election policy priorities remain somewhat uncertain, most of the impacts should be felt at the stock rather than index level.

Uncertainty abounds

Current polling three months out from the US election indicates that Democratic nominee and former Vice President Joe Biden appears well positioned at this time. The landscape, however, remains highly fluid related to COVID-19, both in terms of health and economic conditions, in addition to other topical items, such as US social unrest. Given the continued uncertainties surrounding health testing and the development of a vaccine or therapy, the macroeconomic outlook is likely to remain blurred for some time, so implications – along with voter sentiments – could evolve as the election nears.

While Biden is in the process of announcing four broad initiatives covering a ‘Buy American’ plan, clean energy, a “caring economy” and racial equality, detailed legislative proposals, prioritisation and execution on such initiatives, if he is elected, will remain highly uncertain for some time. If President Trump is re-elected, he is expected to continue to focus on regulatory relief for the business sector and a trade policy that conforms with the administration’s “America First” approach.

While either candidate may be able to implement parts of their agenda through appointments of personnel at agencies and with executive orders, most structural reforms require Congressional approval, and that may be challenging depending on the makeup of Congress (particularly the Senate which has a heavy influence over personnel nominations).

The four likely outcomes

Between the presidential race and the elections for control of Congress (both the House and the Senate), there are eight possible permutations that could emerge from November’s election.

Without prejudging any outcome, four scenarios very much in play currently based on recent polls include: a Democratic “sweep” in which Biden wins and Democrats retain control of the House and win a majority of the Senate; a Biden victory with a divided Congress; Trump re-elected with the Republicans regaining control of the House and retaining the Senate; or a Trump re-election with Democrats winning control of the Congress.

Of those scenarios, an election that results in a unified control by one party of the White House and Congress would produce the most likely scenario that campaign proposals by either candidate could be enacted into law.

Taxes as the main area of interest

While the presidential candidates’ positions on some subjects may still need clarifying, tax policy appears to be a key topic in this campaign. Democratic candidate Joe Biden has proposed amending tax law and focusing on the top 1% of households and raising the corporate rate from 21% to 28% in order to finance a host of programmes related to infrastructure and climate change, healthcare and higher education. As seen in 2017, any changes to corporate tax rates can have significant implications for companies’ earnings and are therefore of particular interest to equity investors.

Evaluating the impact of higher taxes

In December 2017, the statutory tax rate for US companies was brought down to 21% from 35%. In the three months following this statutory change, the expected earnings growth for the S&P 500 index for 2018 jumped by 7.5 percentage points (ppts). While it’s impossible to determine precisely how much of that additional growth came from the tax cut versus other factors, it has been viewed as a contributor.

More importantly, it transpired that the relationship between tax cuts and earnings growth was not perfectly linear as, in percentage points, the positive revisions to earnings expectations were only half the size of the tax cuts. Based on this, Joe Biden’s proposal to raise the statutory tax rate to 28% from 21% could result in a 3- 4ppts headwind to earnings growth from 2021.

There could also be second order impacts, both positive and negative. However, on a net basis these are likely to have only a marginal incremental impact, based on looking at the overall rate alone and not other unknown policy variables that could emerge in any effort to amend the 2017 tax law.

Sectors and stocks will react differently

At the index level, the effect of a seven percentage points increase in the statutory tax rate should be relatively limited. That said, some sectors and companies could be affected much more, depending on specific tax situation or other tax code amendments beyond the topline rate. Likewise, other spending or reform measures could hit targeted segments of the equity market. For example, increased infrastructure spending may support machinery and industrials while healthcare reforms could alter the outlook for hospitals and health insurers.

Positioning for the unknown

Investors often try to anticipate known catalysts for financial markets, such as the US presidential election, by tweaking portfolios in light of their expected outcome. This approach isn’t ideal in our opinion. First, to be successful this strategy requires getting both the outcome and timing right.

Second, as we’ve highlighted previously, uncertainty is high not just with regards to the outcome of the US election but also as to which policies might be prioritised and successfully enacted and/or implemented. As such, selecting companies simply because they could profit from a Democratic or a Republican victory appears futile. Instead, investors should focus on assets that look likely to be impacted, irrespective of the outcome. In particular, volatility and dispersion of sector and stock returns are likely to increase as we move closer to election day.

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