Final thoughts before the U.S. election
Markets are volatile ahead of Election Day. Here’s what we think of it, and what we’ll be looking for on Tuesday night.
Our Top Market Takeaways for October 30, 2020.
Things got volatile
The S&P 500 may end up having its worst week since the March depths of the Virus Crisis (the index is down -4.5% week-to-date, and was trading in the red on Friday morning). To some extent, D.C.’s failure to reach a phase-four fiscal relief agreement and the worsening wave of COVID-19 infections are to blame. Notably, though, the equity declines have been broad-based. Not even conventional pandemic outperformers have managed to emerge unscathed. Meanwhile, Treasury yields across the curve are roughly unchanged, offering little positive offset to the stock market rout.
It seems that would-be buyers are paralyzed by the uncertainty of the imminent election in the United States. Indeed, if we look at S&P 500 volatility, it’s clear that investors are worried about the here and now—near-term volatility is the highest it’s been since June; relative to volatility expectations six months out, it’s in the 96th percentile over the last five years.
Market jitters around elections aren’t uncommon, but the recent price action may still be unnerving to some. In our view, it’s crucial to look through the noise. We expect that volatility will subside once investors gain clarity on the election outcome (regardless if it comes next week or next month, and regardless of who wins). Short-term volatility has been a feature of investing for decades, and it has yet to derail the longer-term growth of the stock market.
Beyond that, it’s worth reemphasizing that the macroeconomic and business cycle conditions matter much more for markets than elections themselves. In the wake of the elections that have taken place since 1980, the S&P 500 was higher 12 months later eight times out of 10. The two exceptions? The aftermaths of 1980, when the Fed was forced to aggressively tighten policy in response to high inflation, and 2000, when we were in the midst of the tech bubble bursting.
So, as Americans cast their votes, what does the investment backdrop look like today?
Our final thoughts before Election Day
As we wrote about at the end of summer, there are powerful forces shaping the current investment landscape. We expect these dynamics to persist regardless of the election outcome:
- Monetary policy support: The Federal Reserve and other central banks around the world are likely to maintain their supportive policy stances for the foreseeable future. Inflation is still well below a level that would prompt the Fed to tighten the reins on economic activity.
- Fiscal policy support: Along with the Fed’s action, fiscal support (such as the CARES Act) helped stave off the worst-case scenario for corporate defaults—much of the pain was concentrated in already challenged sectors such as energy and retail, and we expect defaults to continue to decline. Similarly, aid to households helped replace lost income as unemployment rose, leading to a relatively quick snapback in aggregate consumption (particularly in economically important areas such as the housing market). Once the election dust settles, we expect the federal government to deliver another tranche of stimulus that should help sustain the recovery.
- Healthcare progress: High-contact sectors will continue to face challenges so long as the virus poses a threat, but the global healthcare community has made good progress in identifying ways to treat infected patients and mitigate superspreader events. Although some European countries just announced the most stringent lockdown orders seen since the spring (France, in particular, is back to nonessential business closures and stay-at-home guidelines), the hurdle for reimposing such draconian measures in the United States remains high. Furthermore, vaccine trials are progressing and moving us closer to a major step forward in combatting the pandemic.
On net, we believe the momentum behind the economic recovery will continue in a positive direction, and we expect U.S. economic growth to return to its pre-crisis levels by the end of 2021. This backdrop looks supportive for risk assets broadly over the next few years, even as investors will have to grapple with certain challenges:
- Navigating volatility is more difficult. An allocation to core bonds conventionally offers investors a degree of portfolio defense when stock markets get bumpy. (We build portfolios to weather all conditions, not just periods when we have a constructive outlook, after all!) While we do still think core bonds offer diversification benefits to equities, the low-rate environment diminishes the effectiveness of that feature (i.e., rates can’t go much lower, meaning that bond prices can’t move much higher). High-quality dividend growth stocks, companies with strong balance sheets and durable growth profiles, and strategies such as derivatives may offer investors alternative sources of protection.
- It is hard to find yield. Easy monetary policy means interest rates will remain low and that cash yields will be negligible—holding too much over time could erode purchasing power. Yield is out there, but investors may be forced to take on more risk to find it. We see opportunities in areas such as U.S. high yield corporate bonds, pockets of the municipal space, and select short-dated corporate credits in emerging markets.
- Growth is still scarce, but for how long? As economic growth continues to recover and broaden out, investors should put thought into finding the appropriate balance between secular growth exposures (in long-term megatrends such as digitization, healthcare innovation, and sustainability) and cyclical beneficiaries that could be poised for a catch-up trade. On the cyclical side, we see compelling opportunities in parts of the industrials sector, such as transports, construction and infrastructure. As for secular growth exposure, we think investors should consider looking at markets outside of the United States for more attractive valuations, particularly in the digital realm. For example, the MSCI Emerging Markets tech sector is trading at a meaningful discount to its S&P 500 counterpart (16.5x forward earnings versus 26.3x).
And, of course, the outcome of the election could have more nuanced implications at the sector level. Those will depend on the feasibility and timeline of policy proposals, which in turn will depend both on who wins the presidency and the balance of power in Congress.
As the data rolls in on Tuesday night, we’ll have an eye out for:
- Presidential race results in swing states such as Florida and North Carolina. Some of the northern swing states won’t start processing mail-in ballots until Election Day (e.g., Wisconsin and Pennsylvania), meaning that we might have to wait a few days for official counts to finish. Florida’s and North Carolina’s laws allow the process to start sooner, so it’s more likely we’ll have a sense of their results on Tuesday night. If President Trump isn’t trending well there, he’ll have a hard time getting to the 270 Electoral College votes needed to secure the election.
- Senate races in Iowa, Georgia, Maine, Montana, North Carolina and South Carolina. These look to be the toss-ups that could tip the scales in either party’s direction. The House of Representatives is very likely to remain in Democrats’ control; we (and most political pundits) would be quite surprised to see that change.
- State-by-state margins of victory, in general. As polls and prediction markets moved more in Biden’s favor over the past month, chatter around the probability of a contested election died down a bit. It’s still a possibility, especially if races are close in key battleground states. The larger a margin looks for one candidate over the other in individual states on Tuesday night, the lower the chance we’ll have to wait for a conclusive result.
We’ll be back with our takeaways and thoughts on whatever information we have available soon after the elections. In the meantime, we encourage you to stay true to your long-term financial plan, look through the short-term volatility, and remember that the macro inertia matters more for the broad market outlook than the election itself.
All market and economic data as of October 2020 and sourced from Bloomberg and FactSet unless otherwise stated.
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