November 6, 2020—As votes continue to be counted for key states including Nevada, Arizona, Georgia, North Carolina, and Pennsylvania, the outcome of the U.S. election is still uncertain, but the fog is starting to lift. Specifically, former Vice President Biden appears to be on track to the necessary 270 electoral votes, having taken the lead in both Pennsylvania and Georgia this morning. However, the vote counts are not complete and we anticipate recounts and litigation. The Senate also remains in flux, control of which may end up coming down to runoffs for the two Georgia seats in early January. Despite political uncertainty remaining and the possibility of further delays in the official results, investors have begun to price in the likelihood that the makeup of Washington will be some form of divided government that retains the Democrat-led House and Republican-led Senate.
The prospect for a divided government maintains the likelihood of additional stimulus and reduces the risk of dramatic changes for taxes and other policy. That result, along with a continuing improvement in the economic backdrop, is leading us to add to risk in portfolios. We are bringing overall portfolio risk from a slight underweight to approximately neutral. Specifically, we are reducing our overweight exposure to investment-grade fixed income and maintaining an underweight to high-yield municipal bonds. We are also taking our modest overweight to liquid alternatives to neutral. These proceeds are being added to U.S. large cap and emerging markets equities, where we will hold neutral and slight overweight positions, respectively, versus our long-term strategic targets. We recognize that there are always risks, and indeed political, economic, and health challenges are expected to persist. However, at this time we assess the balance of risks warrants a neutral allocation to risk assets in portfolios as, in our view, the election has lessened the probability of the worst-case economic scenarios from our analysis.
The Senate is pivotal
Critical for the direction of policy- and investment-related considerations is the status of the Senate. At this stage, Democrats and Republicans are in a dead tie 48–48, with results for North Carolina and Alaska races expected next week—likely to both result in additional Republican seats. This would potentially leave a pair of pivotal runoffs in Georgia on January 5. If North Carolina and Alaska ultimately go to Republicans and both seats in Georgia go to Democrats, then the vice president would break the tie in the Senate. Otherwise, the Senate would remain in Republican control.
Majority rules in the U.S. Senate
Sources: Congressional Research Service, WTIA.
Importantly, we view divided government as quite constructive for equities. There are a number of key factors pivotal to markets in the short to medium term:
- Prospects for stimulus— A divided government could result in challenges in passing additional fiscal aid for consumers and businesses. Nonetheless, we would expect a sufficient stimulus package in the short term to avoid a return to outright economic contraction even if the overall government spend is smaller. We expect that stimulus to be smaller than what would likely have been the case under a “Blue Wave” scenario (Biden win, Democrat majorities in the Senate and House). The smaller package we now expect could continue to weigh on U.S. cyclical,small-cap and bank stocks in the short term, which are more in need of aid than their mega-cap growth brethren and would have benefitted from higher interest rates (especially bank stocks). However, growth equities would likely continue to do well in this scenario.
We believe that as the country’s public health crisis worsens this fall and potentially leads to new closures, Congress may feel increasing pressure to act. If Biden does win, this could lead to a less partisan climate within Congress. In this connection, former Vice President Biden and Senate Majority Leader McConnell have a decades-long history of constructively working together.
The continuing impact of the COVID-19 crisis itself should not be underestimated, but looking out a year from now we expect the economy to be in a much better place. The economy remains reliant on stimulus and at the whim of the virus, but at this point we do not expect new closures to approach the magnitude of lockdowns experienced last spring. They may nonetheless exacerbate the economic challenges to the broader recovery in the short term.
Bottom line: Passage of stimulus will be no easy lift under a divided government, but with either a Trump or Biden presidency, we expect fresh fiscal aid to be delivered. With this assumption in mind, we encourage clients to look through any volatility or bumps in the road as it relates to the short-term economic trajectory.
- Taxes, regulation, and long-term policy change—Partisan challenges are likely to exist in passing any major legislation, and this “gridlock” scenario is generally a constructive outcome for stocks. Also, a divided government (Republican Senate/Democratic House or even, arguably, a 50/50 Senate) and a clearly divided country is a recipe for a more moderate cabinet (in the event of a Biden presidency) and modest—if any—policy change as it relates to taxes, health care, energy, etc. “Status quo” is always an easier environment for businesses to plan and tends to reduce the equity risk premium for investors.
Regulation and trade are areas where “personnel is policy,” so we could see more stringent regulation but more moderate trade policy in a Biden presidency vs. a Trump presidency. We believe a Biden outcome and divided Congress could benefit U.S. large cap over small cap, and potentially result in a modest weakening of the U.S. dollar, benefiting international equities as well.
Bottom line: Long term, stocks have often done well in a divided government given the reduced likelihood of broad, sweeping change. Looking beyond the immediate challenges with the virus and additional fiscal stimulus, we believe that a more moderate Biden cabinet, no tax increases, and no major overhaul of health care or energy policy would create a more bullish scenario for equities.
A word on recounts
President Trump’s campaign has signaled that it will request a recount of votes in Wisconsin, a key battleground state that helped seal a victory over Hilary Clinton in 2016. Others, including Georgia, are likely to follow. Recounts are not uncommon in elections and can occur in the event of a thin margin of victory or if a candidate has concerns over the validity of results. While recount guidelines vary among states, empirically they share the common dimension of rarely having a material impact on election results.
Finally, in an environment that continues to be emotional for many on both sides of the political aisle, we especially stress these foundational investment planning tenets:
- Remain invested. Currently we are taking overall portfolio risk to neutral but retaining a modest allocation to gold. We would advise looking through any near-term election-related volatility.
- Use volatility to get invested. Somewhat volatile, choppy markets are possible over coming days, particularly if the election results end up hinging on legal challenges, recounts, or runoffs. For those clients not fully invested, we advise using any potential pockets of volatility opportunistically to get invested and build long-term positions.
- Confirm your diversification. Rotation in market leadership is almost always inevitable. Remain diversified across asset classes, regions, and equity factors.
- Know your downside risk with a PARAGON® (Portfolio Analysis, Risk Assessment & Goals Optimization) analysis to stress test:
- Thousands of hypothetical portfolios to see how they might manage drawdown risk in the event of a shock, showing the likelihood of a particular asset allocation to fund goals
- Balance sheets to detect cash flow continuity risks
- Liquidity readiness and the need for a line of credit to help ensure preparation for significant funding requirements in case of unexpected or underestimated events and to also capitalize on opportunities that arise without disrupting your carefully constructed investment portfolio
- Your wealth plan, to assess its mettle in the face of potential regulatory and tax changes.
Paragon is a portfolio analysis, risk assessment, and goal optimization tool. The Paragon report uses hypothetical examples in conjunction with forecasts for inflation, economic growth, and asset class returns, volatility, and correlation and provides you with general financial planning information and to serve as one tool in helping you develop a strategy for pursuing your financial goals. It is not intended to provide specific legal, investment, accounting, tax or other professional advice. For specific advice on these aspects of your investments, you should consult your professional advisors.
Drawdown risk measures the potential drop in portfolio asset values from the most recent stock market peak to the most recent stock market trough.
The term equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio. It also changes over time as market risk fluctuates.
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