Baseball legend Yogi Berra famously remarked that “it’s tough to make predictions, especially about the future.” Political elections are no exception, of course. But as difficult as forecasting an election can be, predicting market reactions is arguably even more challenging. That being said, with the 2020 US elections only a few weeks away, now seems an opportune time to think through the various potential outcomes and their implications for fixed income and currency markets.
While most market participants are focused on the presidential election, which party controls the Senate is of equal importance in the event of a Biden victory; it matters less under a Trump presidency given that Democrats control the House of Representatives, with little chance of a flip there. Thus, the three possible outcomes to consider are :
- Trump presidency, Democratic or split Congress
- Biden presidency, Democratic Senate
- Biden presidency, split Congress
1. Trump presidency, Democrat or split Congress
In the event of a Trump victory in November, we believe the market reaction would be markedly different than in 2016. At that time, Republicans controlled Congress as well as the presidency, so markets were quick to price in the reflation that would presumably result from lower corporate taxes and deregulation. This time around, we think the market reaction would be disinflationary, as a Trump presidency would likely yield the least fiscal stimulus of the three options above.
- Currencies: Less fiscal stimulus is likely to be supportive of the US dollar (USD) broadly. However, in 2016, the USD performed particularly well against emerging markets (EMs). This time may be different as NAFTA has already been renegotiated and there is also a trade deal with China, so renewed trade wars might be focused more on Europe, with potentially negative consequences for the euro.
- Nominal and real interest rates: A stronger USD could translate to lower inflation expectations going forward, which in turn could move nominal US Treasury yields lower (a so-called “bull flattener”). At the same time, real rates could rise due to lower future fiscal spending.
- Credit: While a Trump presidency would keep corporate tax rates at current levels, credit markets might weaken on less fiscal stimulus, which the market deems very important as we recover from the COVID-19 recession. In this scenario, we would expect investment-grade (IG) debt to outperform high-yield bonds, as a strong USD could continue to support foreign inflows into IG, whereas high-yield spreads are more susceptible to a less stimulative environment.
2. Biden presidency, Democratic Senate
This is the most reflationary outcome, as spending would likely be highest under such a scenario.
- Currencies: The USD would likely trade weaker in this scenario, given the expected increase in government debt. EM currencies, which tend to outperform against a weak USD backdrop, would be among the biggest beneficiaries.
- Nominal and real interest rates: Inflation expectations are likely to rise as the market prices in substantial fiscal stimulus, a weaker USD, and potentially higher oil prices. While we would expect nominal rates to rise, we’d anticipate a so-called “bear flattener” (i.e., 10-year rates rise more than 30-year rates), as the market might price in a lower structural growth rate from higher taxes and potentially unproductive government spending. This would mean real rates would likely stay low as well.
- Credit: In the short term, credit should fare well because it would price in a stimulatory environment; high yield and bank loans should outperform IG, as reflation disproportionately benefits companies with high debt levels. Longer term, it’s less clear how equity and credit markets would respond to higher corporate tax rates and less business-friendly policies. As our colleague Connor Fitzgerald observed in his June 8 blog post, the US equity market has become more “bond-like” over the years. As such, we have found a strong correlation between US equity performance and changes in long corporate real yields. Following a Democratic sweep, real yields might rise and credit spreads might widen, which has historically coincided with negative equity performance.
3. Biden presidency, split Congress
A Biden victory with a split Congress would likely mean higher spending than under Trump, but somewhat constrained by a Republican Senate. Stimulus would largely be focused on areas where the two parties could find common ground (i.e., infrastructure).
- Currencies: We would not expect much of a reaction from the USD under this “middle-ground” scenario.
- Nominal and real interest rates: Nominal rates could rise and yield curves could steepen on higher inflation expectations and the removal of election-related uncertainty. Real rates might also rise (although less than nominal rates), as infrastructure spending tends to be the most productive form of government spending.
- Credit: Credit markets would likely respond favorably to this outcome, as they tend to prefer split government over single-party domination.
We will follow up before the end of the year with another blog post outlining our post-election thoughts, including updated market views if necessary. Until then, hold onto your hats — the final countdown to the election (and perhaps its aftermath as well) should be interesting, to say the least!