The US presidential election draws deep interest from investors around the world because of the size and importance of the US economy and the potential for the election to deliver significant changes in fiscal, trade, healthcare and regulatory policies, which, in turn, may have implications for corporate profits, consumer spending and financial markets. The 2020 election is particularly significant given the current political context. In 2017, President Trump and a Republican Congress delivered a massive tax cut, focused on corporate tax relief, and the administration also has broadly slashed regulations.
The real possibility of a blue wave (the Democratic Party winning back both the presidency and the Senate, while maintaining control of the House of Representatives) may result in at least a partial reversal of those policies (Figure 1). The margin of seats captured in any Democratic victory in both houses of Congress, however, will impact Democrats' ability to effect broad legislative change. Moreover, a new government may choose to tread carefully with respect to enacting large tax increases given the economy's fragile state. Finally, any negative economic impact from the reversal of corporate-friendly policies under a Biden administration could be offset by broad fiscal expansion skewed toward government spending, which might stimulate aggregate demand, and by a less confrontational stance on trade, which might reduce market risk premia. Should Republicans manage to retain control of the Senate, the corporate tax cuts would likely remain in place.
Figure 1: Democrats Now Favored to Control Both Houses of Congress
A Biden victory appears to be the favored outcome as indicated by the election betting markets, averages of state polls compiled by Realclearpolitics.com, and the forecasters at the Good Judgment Project, but no one should rule out the possibility of President Trump's reelection, with a Supreme Court confirmation battle offering the President a chance to reinvigorate his base.
Markets typically are able to quickly digest and price any risks associated with a new governing regime once the outcome of the election is clear, but the uncertainty in the run-up to an election typically results in increased volatility. Historically, after the election has past, we have seen a clearing of uncertainty, which creates a more constructive environment for stocks, as the outlines of the new administration's policies take shape.
The structure of the VIX futures curves anticipates a rise in volatility with a kink in the curve showing elevated implied volatility for the October-through-December contracts relative to the current spot price and longer-dated futures (Figure 2). The US Economic Policy Uncertainty Index typically rises 8.7% in the first 10 months of a presidential election year, before easing in the months afterward. This year, the same index has jumped 35%, even after falling 14% over the past two months (Figure 3).
Figure 2: Elevated Volatility Expected Around Election
Figure 3: Economic Policy Uncertainty Remains Elevated
Why has the uncertainty index increased so much? We have seen increased polarization in the US, with close presidential elections, Congress changing hands more frequently, and two presidential candidates winning elections without winning the popular vote. The pandemic has created additional uncertainty by increasing voter reliance on mail-in-balloting. Thus, there is increased probability of a delay in knowing the election results and of a contested outcome. With a large percentage of Democratic voters indicating they will vote by mail and Republican voters planning to vote in person, there may be no clear winner on election night. This heightens the risk of litigation and demands for election audits. Thus, there is the risk that uncertainty could drag on for weeks post-election. This extended period of uncertainty would keep markets volatile and increase the potential for a drawdown in risky assets until clarity emerges with regard to control of the presidency and Congress.
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