America Tests Positive For Political Dysfunction
What impact will US elections have on financial markets?
October 8, 2020
- Presidential elections have historically been very weak actionable trends for markets.
- Still, America’s waning global leadership and political dysfunction has diminished the attractiveness of its country as a destination for foreign capital.
- Whether Republican or Democrat, the US government is clearly committed to running massive budget deficits as far as the eye can see. This is the new normal.
- The big surprise next year, regardless of the US election outcome, will be global growth that is higher than consensus expectations. Investments outside the US tend to catch a strong bid in this environment as confidence in the world economic outlook improves.
With three months remaining in 2020, the US has easily notched its darkest year in peacetime history. A quick scan of the facts provides confirmation. America accounts for a quarter of the world’s recorded deaths from COVID-19. Its citizens are still ignominiously barred from entry to the EU and other allied territories. Through willful neglect, countries continue to slip out of Washington’s orbit. A largely incoherent trade war is still ongoing. And social imbalances have intensified. America is now more fractured than ever.
On top of all that, toss in the horror show that was last week’s “presidential” debate — surely a low point in American history.
Of course, none of this political pugilism has helped America’s divisiveness (if you doubt that, Twitter offers a masterclass in vulgarity). “Build the wall” and other repeatable slogans may be the currency of populists, but they also capture the tenor of the times: a political conversation that has become downright dirty where the volume of America’s ambient chatter has been turned up to an eleven (to tap into the metaphor of Spinal Tap’s lead guitarist).
And yet, despite all this, America remains uncontested in holding the world’s rapt attention. Perhaps for good reason. This is a country that, for decades, spearheaded the institutions that led to the post-war world order. It is also, at least for now, the leading land of brand power, with its cultural magnetism of Netflix, Instagram, and all-conquering pop stars. And, its stock market is soaring this year (we will get to the investment implications shortly).
As it is, America’s reputation may be manifestly in decline; its captivating hold on the rest of humanity is not. All of which makes November’s election a globally important one — and one where this period of discontent, dare we say, is careening toward some type of climax.
Beware The Investor’s “Binary Trap”
To be sure, pundits proclaim every US presidential election as the most pivotal one in history. Macro money managers, especially those that feel the hand of history, will immediately recognize the trap. Political events typically have binary outcomes. By this we mean a scenario would either produce a large portfolio loss or gain (remember the runup to the 2016 Trump vs Clinton election?). There is no knowing which is right ahead of time. As such, narrowly focusing on one type of risk is speculative at best.
What’s more, such speculation hinges upon achieving two near-perfect tactical portfolio actions. One is getting out at the right time; the second is to get back into the markets at the right time. The first decision is difficult at best. The second step is often overlooked. There are plenty of analysts who have predicted doom (most far too early) only to fail to re-invest at the appropriate time. Both errors can be catastrophic.
A far better approach is to accept that a wide possible set of scenarios may unfold. From there, investors can insulate against a number of outcomes by diversifying portfolios across global investment classes and also prepare for a change in the macro outlook.
That doesn’t mean that one shouldn’t manage risks. To the contrary. What we advise against is a non-diversified definition of risk. Sadly, many investors will continue to fall into these binary traps (betting the proverbial farm every time), while-longer-sighted strategists with strong investment processes make off with gains. The current election cycle is another one of these familiar setups.
Managing Election Risks
First, let’s address election risks. As a baseline, presidential elections have historically been very weak actionable trends for markets. Of course, profound differences exist in both style and substance between Biden and Trump — just as there were between Obama and Trump. But the US political system is designed in such a way that the President (particularly with no congressional support) cannot exert much power at any given time.
What about a disputed election? Again, risks are overstated. An examination of the laws governing elections and of past ructions suggest any market turbulence will be limited and short-lived. The US electoral system is designed to force a result within six weeks of the election. US institutions have also handled the assassination, resignation and impeachment of past presidents.
And while there is risk that a contested result will trigger protests, a long series of precedents suggest any civil unrest will have little or no effect on financial markets. Stock markets shrugged off nationwide protests following the 1968 assassination of civil rights leader Martin Luther King, the 1965 and 1992 Los Angeles riots and, most recently, the unrest that has swept US cities since the death of George Floyd in late May.
Policy Matters Most
What then matters for financial markets and client portfolios? It’s always about policy. Here, there are several potential policy shifts in corporate taxation, healthcare and regulation. Yet, at a high level, three important questions need to be answered. First, will US monetary policy change after November? Absolutely not. The Fed recently changed its policy framework to an “average inflation” targeting regime. Translation? The central bank will now actively target a near-term inflation rate above 2% to make up for past undershoots. Given that the Fed has undershot its inflation target for over a decade (and a cumulative 500 basis points), expect monetary policy to remain ultra-easy for years.
Secondly, will US policy towards China change dramatically after November? The jury is out on this one. A Biden win would provide an opportunity to reset the bilateral relationship between the two countries. However, one thing is certain — corporate America is currently behaving exactly opposite to Washington’s hawkish rhetoric. China’s trade surplus with the US has grown almost 25% since the start of the Trump presidency. US investment in China is strong. Perhaps the biggest lesson is that it is incredibly difficult to untangle the sprawling and complex web of supply and demand chains between China and America. These will not be unraveled any time soon. Markets once again trump politics.
Finally, and most importantly, will fiscal policy change after November? The beneficiaries and relative size of federal largesse will change if the color of the administration changes (our investment team is actively mapping out different scenarios and sectors that will thrive under each presidential candidate). But whether Republican or Democrat, the US government is clearly committed to running massive budget deficits as far as the eye can see. This is the new normal.
US elections arrive at a time when America has been a chronically strong performer. This extends all the way back to 2009 — its stock market, its bond market and its currency have all outpaced global counterparts since then. And even though the US share of global GDP declined from 28% in 2008 to only 23% recently, its stock market capitalization nevertheless commands 66.1% of the MSCI World index.
Yet those days of outperformance look increasingly numbered. Why? Consider that global financial market prices are set on a relative basis. Take for example, the US dollar. Currencies encapsulate a broad constellation of a nation’s value proposition — economic, financial, social, and political — as viewed against comparable qualities of other nations. Yet the US dollar is now over-valued at a level that compares to the past two secular peaks. Currencies tend to trend once momentum is established in one direction. The same can be said of the US stock market. It’s overvaluation relative to other countries just hit a historical record.
In general, high valuations (and built-in high expectations) lead to disappointments. At the same time, several US tailwinds are now turning to headwinds. Politics cannot meaningfully change these over the short term. America’s waning global leadership has already diminished the attractiveness of its country as a destination for foreign capital. Big Tech, the darlings of the US stock market over the last decade, face multiple federal, state and congressional antitrust investigations. More regulation is coming.
We are also now heading into a period where the global economic outlook is improving. The big surprise next year, regardless of the US election outcome, will be global growth that is higher than consensus expectations. The world will look better. Investments outside the US tend to catch a strong bid in this environment as confidence in the economic outlook improves. Capital becomes braver in its search for alpha. This time will be no different. Don’t let political theatrics (including Trump calling off Congressional talks) cast a shadow over that cyclical trend.