As we approach the US November elections with no clear leader in the presidential race, the market has turned its eyes toward the implications on the US economy as a whole and what sectors are most likely to feast or famine over the next four years. In our view, although there obviously will be impacts on the economy and markets coming out of the election, neither political party appears ready to enact austerity measures but will likely move to expand fiscal deficits requiring additional US Treasury (UST) debt. This will lead to tangible impacts on economic growth and inflation. However, any changes in government are less likely to have large systemic shifts but will be more noticeable on the margin through changes in areas such as regulation and tax policy. By focusing on higher-quality assets and limiting exposure to rising spreads, we are currently positioning our portfolios to both withstand and benefit from increased levels of market uncertainty as we progress further along in this election cycle.
History won’t just repeat itself
It seems like every four years there are arguments as to why the election cycle is different from history, but we believe that there are characteristics of the current market and political backdrop that do not lend themselves to using recent election cycles as a hard guide. In the current environment, equity markets reached all-time highs, fixed income sector spreads are historically tight, and intermediate- and long-term UST yields remain low. Even the candidate selection process from both political parties in the 2024 presidential race has been unlike any that the United States has experienced, with both candidates serving in high federal offices giving the market a greater familiarity with each of them.
Former President Donald Trump, the Republican Party nominee, served as the US president from 2017–2021, giving the market a good sense as to what it can expect from an additional four years at the helm. In his first year in office, Trump enacted the Tax Cuts and Jobs Act which, among other provisions, lowered the tax rates on US corporations and higher-earning taxpayers. The former president also favored reduced federal regulations across wide range of industries, causing him to be seen as a more “corporate-friendly” candidate. Increased tariffs on foreign goods and limits on immigration were other hallmarks of the first Trump presidency.
On the Democratic side, Vice President Kamala Harris emerged as her party’s nominee, stepping into the shoes of President Joe Biden after he was pressured not to seek another term. Harris has announced her plan to enact an “Opportunity Economy” focused on lower taxes for individuals making less than US$400,000 a year. In addition, she has plans to issue subsidies for new home buyers and tax credits for new small businesses. She plans to pay for these measures by increasing taxes on large corporations and an increased tax rate for high earners. Once again, these policies will increase government outlays and have the potential to expand the fiscal deficit and UST issuance.
Early in the election cycle, when Biden was seen as a shoo-in for the democratic nomination, Trump picked up steam leading in nationwide and battleground state polls. The equity markets responded by moving continuously higher with lower levels of volatility. Although there has been some retracement in the S&P 500 Index, it remains elevated. Credit spreads hover at decade-low levels on corporate bonds. As the polls became more balanced, showing the difference between the candidates was within the margin of error, the equity market failed to substantially unwind this trade.
Every vote counts
Almost equally important to the presidential election are the “down ticket” races for congressional and Senate seats. A sweep by either party, which in the past ushered in an ability to push through aggressive agendas, will only have a marginal impact on overall level of government spending, in our view. Even in the case of a sweep by either party, it will be hard to push through substantial changes to policy such as regulation and government spending. Over the past several election cycles there have been slim margins in both legislative chambers. This gives enormous power to holdouts from the ruling party that are required to move legislation, limiting the ability to enact large changes.
A more likely scenario is a divided government, which can lead to legislative gridlock. In either case, fiscal deficits are projected to grow at an unsustainable pace regardless of who is in power. Neither party is eager to reduce outlays fearing that it may add to slowing economic growth. This higher spending has a significant impact on the economy and capital markets. Increased outlays should support an expanding US economy as federal dollars flow into corporate and consumer pockets. Additionally, both parties are eyeing tax cuts.
Trump has stated that he will extend, and possibly expand, the corporate tax cuts that he initiated while president, which are set to expire in 2025. In contrast, Harris has said she will focus her efforts to reduce taxes for lower-income taxpayers and to enact stimulus programs for home buyers and new small businesses. However, all these plans come at a cost. With expansionary spending by the federal government, we believe that the path of disinflation may stall or revert. This, in turn, can be a negative for equity markets and could cause UST yields to rise.
We are most likely to see changes only on the margin. A locked government limits the ability of the president to make sweeping changes. It is most likely that either candidate will attempt to use executive orders to implement their agenda, but this has its limitations. Trump has advocated for increased tariffs on imported goods and deregulation of US banks. Both of these policy initiatives have the potential to be inflationary. Increased tariffs on goods will raise costs for the US consumer on a number of products. A Harris administration is likely to move forward on a number of steps to reduce the burden on lower income taxpayers. This too would be expansionary and inflationary as beneficiaries would have additional money to spend in the economy.
Who do you listen to in this market?
As we approach the elections, signals from the equity market and fixed income yield levels are at odds, to say the least. In our view, equity and corporate bond spread levels paint a rosy picture for the near future as valuations remain high. In contrast, low yields on intermediate- and long-term USTs, short-term expectations for aggressive US Federal Reserve (Fed) rate cuts, and the inverted yield curve portend the picture of a slowing US economy which may flirt with an upcoming recession. In our view, both can be wrong.
In terms of equity and bond spreads, there is not much room to compensate for a downturn in the economy. Although company fundamentals remain strong, they are beginning to show some deterioration in credit metrics. On the other side of the coin, bond-market forwards are projecting an active Fed which will cut rates aggressively to avoid a slowdown in the economy. This has led to artificially low UST yields. The Fed has repeatedly emphasized that it is apolitical, and the approaching election does not influence its policy responses, but nothing exists in a vacuum. The Fed, no doubt, realizes the implications that larger deficits and higher UST issuance will have on the market. It is our belief that we are entering into a rate-cut cycle, but our projections call for a slower, shallower path, with the Fed stopping its monetary easing with the fed funds rate settling in the 4.0% area.
Where does this all land?
Our current portfolio positioning is not tied to a particular candidate. We believe that the upcoming election will lead to increased market volatility as we move closer to November, despite who is leading in the polls. We are avoiding taking on wholesale risk at these levels. Most fixed income spread markets appear to be fully valued and offer little support in the case of a slowing economy.
For some time, we have advocated being on the short end of the yield curve, reducing the negative impact of widening spreads. This allows us to take advantage of attractive yield opportunities, locking in income levels that will provide additional returns, in our assessment. No matter who ends up in the White House, we feel that expansionary spending could positively impact economic growth, but this will come at a cost of inflationary pressure. This, in turn, may limit the number of rate cuts the Fed can implement.
A higher neutral fed funds rate and increased UST issuance should put upward pressure on intermediate- and long-term yields, but we are being prudent in our duration stance. We are looking for better entry points as the markets appear to have bought into the narrative that the Fed will move aggressively to avoid any economic slowdown. Elections, especially tight races like we currently have, coupled with a pivoting Fed, will lead to uncertainty. This will uncover opportunities to take advantage of the changing market landscape.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
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