January 8, 2021

As of this morning, the results of the Georgia runoff elections to determine control of the US Senate have not been finalized. The vote count shows that the Democrats have secured at least one of the two seats. The prediction markets are placing over a 95% chance of Democrats winning both seats. Although the counting process is still underway, in today’s note we provide the implications of the Democrats taking control of the government on the economy as well as the equity and fixed income markets should the prediction markets prove correct.

Key Takeaways

  • Scope for increased fiscal support provides upside to our first half economic outlook, though in the medium term some of the boost may be offset by slightly higher taxes and regulations. Given we are still in a pandemic, the near-term focus of the Biden administration is likely to remain on supporting the economic recovery.
  • The election results hold implications for markets but like our economic view, our overall outlook does not change materially. One of our key mantras over the past year has been “Elections matter, but should not be viewed in a vacuum.” History has shown that other factors matter more, such as the economic cycle, monetary policy, and earnings—each of which remains supportive irrespective of which party controls the Senate.
  • However, this outcome would provide further support to our November upgrade of US Small Caps, which tend to be more leveraged to the economy and are our preferred way to participate in the reflation trade, as well as our Industrials and Materials sector overweights.
  • While we may witness a near-term overreaction in US yields to the upside, we believe the Fed will not tolerate substantially higher rates. We continue to view the 10-Year US Treasury yield’s move into the 1.0-1.25% range as a tactical opportunity. Fiscal stimulus supports maintaining our overweight to investment grade and high yield credit.

Economy

While control of the Senate is important, the magnitude of control is more important for large policy shifts and budget matters. Therefore, we do not view a razor-thin majority as drastically changing the economic landscape. We continue to see the economy as being in the early stages of a self-reinforcing recovery. From a short-term perspective, a Democratic sweep is likely to lead to an increase in the size and scope of fiscal support. This additional stimulus provides upside potential to our economic forecast for the first half of the year as the vaccine rollout continues. That said, in the medium term, some of the boost to the economy from the fiscal stimulus is likely to be offset by the potential for slightly higher taxes as well as increased regulation in some sectors, including health care, energy, financials and technology.

The Covid-19 pandemic is ongoing, and we anticipate that the Biden administration, including prospective US Treasury Secretary Janet Yellen, along with the Federal Reserve (Fed), will focus more on keeping the recovery on track before focusing on tax increases. Further, such a small majority in the Senate and for that matter the House, suggests a lower likelihood of sweeping tax changes (i.e., undoing the 2017 Tax Cuts and Jobs Act). But the legislature could enact smaller targeted moves, such as a 3.8% Net Investment Income Tax imposed by the Affordable Care Act, or slightly higher tax rates on high-income earners as well as a slight uptick for corporate taxes. That said, the recovery will likely remain the top near-term focus of the administration.

Equities

The election results hold implications for markets, but like our economic view, our overall outlook does not change materially. One of our key mantras over the past year has been “Elections matter but should not be viewed in a vacuum.” History has shown that other factors matter more, such as the economic cycle, monetary policy and earnings—each of which remain supportive irrespective of which party controls the Senate. Further, the Covid-19 vaccine rollout will continue to exert one of the largest effects on the economy and markets. Our work continues to suggest that we are in a multi-year bull market, supported by an economy in the early stages of a recovery. We are moving to a more moderate phase of the bull market after the initial snapback rally, and we expect periodic setbacks. However, our work suggests that the primary trend remains higher.

Importantly, markets have shown positive returns under various political control scenarios in Washington. Historically, a Democratic Congress and Democratic President has been the most common occurrence (chart below). The last time we saw this configuration was in 2009 to 2010. The S&P 500 rose almost 40% during this period. However, other factors besides government policy impacted returns as markets were coming out of the global financial crisis and rebounding from depressed levels.

As mentioned, there is scope for slightly higher taxes eventually. On an individual level, tax policy can have significant and varied consequences. However, from a market perspective, the data in aggregate suggests other factors have often overwhelmed tax policy. For example, despite a tax increase in 2013, stocks rose more than 30%. The market was supported by below average valuations and a significant rise in monetary stimulus as the Fed’s balance sheet ramped up.

Conversely, in 2018, despite tax cuts, stocks faltered by about 4%. Starting valuations coming into the year were well above average and at a cycle high; at the same time, monetary policy was becoming more restrictive as the Fed started to unwind its balance sheet and raise short-term rates on fears the economy was overheating.

That said, a Democratic sweep will have some impact. Over the course of the year, we expect a tug-of-war between greater fiscal stimulus and the prospect for higher tax rates. We also anticipate concerns of higher interest rates and the impact on stock valuation multiples to inject volatility into markets.

In the near-term, the expectation of more fiscal stimulus is likely to continue to support more economically-sensitive areas of the market. This would add further support to our November upgrade of US Small Caps, which tend to be more leveraged to the economy and are our preferred way to participate in the reflation trade. (Small caps have sharply outperformed the S&P 500 and large cap value since we increased the position.)

Likewise, industrials and materials, sectors which we remain overweight, should benefit from increased fiscal spending, including a potential infrastructure package. Slightly higher interest rates and a near-term uptick in the economy should also be a positive for financials, which have been steadily improving in our work over recent months. Technology is still an overweight in our work but is likely to see some near-term profit taking on concerns related to increased regulation, higher taxes and interest rates, as well as a rotation to more cyclical areas of the markets.

Fixed Income

Under more traditional market conditions, a double-victory by Democrats would likely hold greater implications for US yields from anticipated greater government spending via further fiscal stimulus measures and infrastructure investments. In a vacuum, these initiatives wield the power to boost inflation and growth expectations, which, in turn, typically create upward pressure on US yields. Furthermore, the US government will need to add to its debt issuance plans in 2021 and beyond to fund its higher expenses. The resulting jump in US debt supply creates another catalyst for higher yields to entice commensurate market demand. However, in the throes of a global pandemic, the current fixed income environment is anything but traditional. The Fed’s extremely accommodative policy stance and record-low yields across the globe provide significant counterweights to the potentially bearish effects of last night’s election.

The fallout from the pandemic has pulled inflation and employment levels well short of the Fed’s dual mandate. In support of achieving its objectives, the Fed is committed to low rates for a long time via near-zero policy rates and massive purchases of US Treasuries. Therefore, we believe the Fed will heavily exert its influence on the US yield curve in the year ahead to preserve loose monetary conditions.

While we may witness a near-term overreaction in US yields to the upside—we are seeing the 10-year US Treasury yield touch 1% for the first time since March 2020 and the yield curve steepen to multi-year highs—we believe the Fed will not tolerate substantially higher yields given the uncertainty surrounding the virus and the path of the economic recovery. Additionally, foreign yields remain at extremely low levels, well below those available in the US. As domestic yields move higher, demand intensifies among yield-starved investors overseas, thereby impeding their ascent. With almost $18 trillion in foreign debt offering negative yields, we expect foreign demand to remain intact. These two factors should dampen the near-term upward yield bias. We continue to view the 10-year US Treasury yield’s move into the 1.0-1.25% range as a tactical opportunity to extend duration in fixed income portfolios that have drifted well below their duration target or for those investors waiting for more favorable yield opportunities. Our overweight to investment grade and high yield credit should benefit from the prospect of greater federal support for the economy and further tighten corporate credit spreads.

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