August 24, 2020

Elections Matter, but Other Factors Matter More

It is an election year, and emotions are running high. Investor angst regarding how the election outcome will impact financial markets is palpable. Elections play a role and often add to market volatility; however, an objective review of the historical data indicates that Washington’s perceived influence on market returns may be overstated.

From an investment perspective, we are not suggesting a change in government control does not matter. We are, however, positing that the election is just one of the many factors that influence investments. Elections should not be viewed in a vacuum. The business cycle matters, as do valuations, geopolitics, monetary policy, and other factors, such as the path of the coronavirus.

Taxes and Market Impact

Still, one of the common concerns voiced by some investors recently is the potential of higher taxes’ impact on the stock market should a shift in government control occur in Washington. 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.

Indeed, markets have, counterintuitively, produced better returns, on average, and been more consistently positive in years in which taxes have risen. Again, this does not mean that raising taxes is a positive for the stock market; however, history suggests other factors play a larger role in stock returns.
For instance, despite the top marginal personal tax rate averaging above 90% as well as an elevated corporate tax rate in the 1950s, the US stock market had its best performing decade of the past 70 years, aided by a post-WWII economic boom and very low stock market valuations entering the decade. Conversely, despite having among the lowest average tax rates of the past 50 years, the 2000s generated the worst stock market returns and economic growth in the modern era. The first decade of the 21st century was beset by the aftermath of the bursting of the technology bubble, record high valuation levels and the 2008 global financial crisis.

In a more recent example, despite a tax increase in 2013, the S&P 500 rose more than 30% that year. The market was supported by below-average valuations and a significant rise in monetary stimulus as the Federal Reserve’s (Fed) balance sheet ramped up.

Conversely, in 2018, despite tax cuts, stocks declined by more than 4%. Starting market valuations coming into 2018 were elevated at the same time monetary policy was becoming restrictive as the Fed started to unwind its balance sheet and raise short-term interest rates on fears the economy was overheating. This weighed on the market.

Sectors and Elections

Another area where a lot of ink is often spilled ahead of elections is which segments of the market will do best under one candidate or another. However, despite a consensus view often contrasting the large difference the impact of a Democratic or Republican president would have on various segments of the market, the top two sectors (technology and consumer discretionary) and bottom two sectors (energy and financials) have been the same under the last two presidents. Small caps also underperformed large caps under each. This speaks to secular forces and fundamental factors influencing market returns beyond Washington.

Bottom Line

We strongly caution against mixing portfolios and politics. We are not suggesting whoever is in the White House does not matter. Nor are we implying that there is a lack of potential for market downside; that is always the case. We are, however, suggesting the election is just one of the many factors that influence market returns. Importantly, while policy can certainly hinder or help the economy, businesses are dynamic and will adjust once they understand the rules. Historically, there have been opportunities and risks while each party was in power. Moreover, in the coming year(s), the path of the coronavirus and progress toward vaccines and treatments will likely have a more significant impact on the performance of the economy, markets and sectors than the election outcome.

Accordingly, until the weight of the evidence in our work shifts, our overall positioning stance remains intact. We maintain an equity tilt relative to fixed income, especially with government bond yields hovering close to all-time lows. Within equities, we hold a US bias, where earnings trends remain stronger compared to much of the globe. Yields are set to stay low, but high quality fixed income should continue to serve its role as a portfolio stabilizer. Although credit spreads have tightened substantially, investment grade and high yield bonds should remain supported by the Fed and investors’ search for yield.