Rightsizing the Election Year Risk to Markets

Prediction markets are not necessarily great at predictions, but they are a good measure of sentiment. These markets think the murder of George Floyd and its aftermath have done what even the pandemic-induced depression did not, and that is to make Joe Biden the favorite to defeat Donald Trump this fall. In the space of two weeks, Biden has gone from being a slight underdog on PredictIt to having a 58 percent probability of winning the election. Investors, respecters of sentiment, will renew their focus on the likely impact a Biden win could have on financial markets.

A good approach is to start with what history has to say and then to ask if history can be a useful guide to the future. History says investors should not be nervous. The most thorough work on the effects of partisan control of the White House was written by Alan Blinder and Mark Watson in 2013. Looking at 66 years of data, they found real GDP growth was 1.8 percent higher per year under Democratic presidents, and the S&P 500’s annual return was 5.4 percent higher. The former effect was statistically significant while the latter wasn’t, but it’s hardly a foreboding result.

Yet there is no question that in the short term, investors prefer GOP victories. Most notable was the U.S. stock market rally following President Trump’s surprise win in 2016.

But putting 2016 in a global perspective, the partisan effect wears off. For 12 months from the day before the 2016 election, the S&P 500 returned 24.0 percent, and the return on a portfolio of stocks invested in an index of non-U.S. stocks was virtually the same, 24.6 percent. In retrospect, the United States was participating in a global rally following a slowdown in 2015-16 caused by China and oil price weakness.

Even before considering what Biden may want to accomplish, the congressional outcomes will be a huge constraint. When Barack Obama was elected in 2008, Democrats had just under 60 percent of the seats in the House and Senate. With a decent tailwind on Election Day, Democrats might have a 50-50 split in the Senate, with Biden’s vice president breaking the tie. To get even to 51-49, Democrats would need to win Republican seats outside those rated as toss ups by most election forecasters. Little on the progressive agenda, such as Medicare for All or the Green New Deal, will clear the Senate. Senator Joe Manchin (D-WV) will have far more say over what passes Congress than any Biden vice presidential pick.

Even the House is likely to be a constraint on a progressive agenda, as Speaker Pelosi will need to protect her majority by looking after the political interests of those Democratic representatives from previously Republican districts. Intra-party fighting is likely to be a first-order feature of a Biden presidency.

If there is a Democratic sweep in November, what are the policy implications? On taxes, there will be a progressive redistribution and some increase in taxes on capital income, which will be constrained by the narrow congressional majorities.

There is no question there will be re-regulation, particularly in the antitrust field. That is true even if the Senate stays in GOP control. We know it is an article of faith among many investors that regulation is a significant negative. But in fact, market research showed no correlation between sectors that benefited from deregulation by Trump and those sectors’ relative performance.

Another feature of a Biden presidency could well be less fiscal support for the economy, contrary to the expectations of many who believe fiscal support will continue. Very likely Biden will press for deficit-financed programs, but Republicans have a demonstrated preference for fiscal restraint when they are not in the White House, and further stimulus would require the support of some fiscally cautious Senate Democrats. Fiscal cliffs may be a challenging part of the economic policy landscape if Biden wins.

On trade, Democrats have been protectionist for years, even as Democratic presidents have resisted protectionism. But no leading Democrat favored the kind of protectionist moves that Trump has implemented, as he often invoked emergency powers in an unprecedented way. While there may be an Overton window effect here, giving some Democrats space to push ideas they hadn’t before, Biden would likely act in a less disruptive, more multilateral way, not seeing trade as a zero-sum game.

Last, an assessment of the election’s importance to financial markets must include the likely effects of a second Trump term. Trump’s challenges in effective crisis management have been evident in the Covid-19 response; he would have further opportunity to put his own imprint on the Federal Reserve (and his frequent criticism of Jerome Powell has raised considerable doubts about whether he would replace Powell as chair in a second term); he is likely to return to global trade activism (not just against China but also Japan and Germany); and he could possibly withdraw from both the World Trade Organization and NATO. Republicans are thought to be good for the supply side of the economy. In Trump’s case, the effects of lower marginal tax rates and deregulation have to be netted against reduced immigration and higher trade barriers.

The impact of elections on markets is often a political debate disguised as an investment debate. The reality is that policy is very important to market performance, and each candidate will offer a series of risks and opportunities for markets to evaluate on a continual basis, only some of which will be apparent on Election Day.

Thomas Gallagher and Kevin G. Nealer are principals of the Scowcroft Group. Kevin Nealer is a senior adviser (non-resident) with the Economics Program at the Center for Strategic and International Studies in Washington, D.C.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

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