Politics Create Drama, But It’s Fundamentals that Drive Markets
“It ain’t over till it’s over.”
“It’s like déjà vu all over again.”
“When you come to the fork in the road, take it.”
“The future ain’t what it used to be.”
I simply couldn’t choose among the various Yogi-isms above as the quote to include in this month’s investment commentary to describe the results of the 2020 presidential campaign and what lies before us on the political front. So, I just listed all of them that I thought fit well. One thing is for sure on election night: one went to bed saying…“It ain’t quite over yet.” On the morning following the election, uncertainty remained.
After appearing for a bit that it could be a number of days or even weeks before we would have closure on who won the White House, Joe Biden was finally named as the president-elect over the weekend. It looks like the GOP will likely retain the Senate, or at least as though the Democrat’s path to take control back in that chamber has significantly narrowed. Regarding the House, the Democrats will clearly maintain leadership, albeit their majority lead was slightly diminished. While investors have wrung their hands these past several months over a diverse set of possible election outcomes, as of this writing, it appears that gridlock or split government is likely and not surprisingly is being cheered by the market.
Part of the reason we have continued to maintain a cautious view on the stock market over the short term has been investors’ concerns about the potential election results, including the possible impact of a contested election. This has been one of the three main “wall of worry” items we have highlighted regarding our respect for near-term risks and our expectation for heightened volatility as we move to close out the year. The other two key headline risks we see out there include:
- The pace of COVID spread that we experience in the United States and Europe as everyone moves back indoors for the winter months
- The outcome of debated legislative proposals for additional fiscal stimulus to see us through a likely short-lived economic pause on the heels of a robust Q3 v-shaped recovery…such stimulus would be helpful prior to the likely introduction of a COVID vaccine in early 2021.
We believe these risks can be effectively managed. With the election results largely tabulated, we can remove perceptions of worst-case financial risks on that front. We continue to maintain our 3500 S&P 500 price target by mid-2021 and are biased to increase it and to see the S&P 500 hit new highs by calendar year-end next year. Certainly with the recent news of progress at certain healthcare companies in developing an effective COVID-19 vaccine in the near term, we are increasingly inclined to take our target up, but still feel it a bit premature to do so with the limited data that has been released and studied. In this commentary, I will focus on the election and our take on its impact on the market since it is so front and center at this juncture.
The bottom line is that, while politics can be fascinating and capture not just headlines but so much of our attention, it truly is fundamentals—trends in the economy and in earnings—that drive markets in the intermediate and longer term. While we recognize there is nuance to this election that feels unprecedented in nature, we do not believe this inspires some sort of unprecedented or extended economic risk. We see a positive trend in the fundamentals at present…hence our continued constructive view and market outlook over the coming 12-15 months. In fact, most all elections elicit fear of major policy change and potential worst-case outcomes, only to be resolved with better-than-feared economic impact and healthy market returns…despite some unusual aspects to this voting season, we expect a similar resolution to such fears about this election in 2020.
There’s Pessimism and Angst Surrounding Most All Election Outcomes…No Difference Here in 2020
The table below illustrates that annualized returns during most all various White House administrations have been solidly positive going back to 1980. This includes such presidents as Reagan, Bush Sr., Clinton, Bush Jr., Obama, and Trump. All suffered multiple criticisms (not unlike what we are witnessing today) during their campaigns that their stance on policy and issues would invite disaster, yet investors enjoyed solid double-digit annualized returns during their terms. Only under George W. Bush (Bush Jr.) were returns negative and that can be linked to the horrible economic and earnings backdrop as opposed to government policy or political leadership at the time. This suggests that it is the stage in the economic and market cycle that correlates highly with market results, not political leadership.
Data Supports Premise that Fundamentals Not Political Leadership Drive Returns
In this same vein, we find it quite remarkable that historical annualized market returns are virtually identical under various scenarios of political leadership. As shown below, annualized market returns are roughly 10% whether we have unified government in this country and one party controls all chambers OR we have split leadership and a divided Congress; that is the data.
Fears of Negative Economic Impact of a Biden Presidency Seem Overdone to Us
We remain positive in our outlook. While it’s a low in probability in our mind that Democrats will also control the Senate (We still have to wait for the results of January 2021 run-off elections associated with the two Georgia Senate seats in play to determine final political party representation in this chamber.), in our research, we conclude that the negative impact on S&P 500 earnings from Biden policies should be far less than advertised.
The chart below highlights that, absolutely, earnings would decline by double-digit levels if Biden’s published tax policy is approved and employed but what is ignored here is that if one includes offsets, such as the stimulative infrastructure spending and softer tariff policies that he also advocates, the net impact on earnings is negligible. Our view, therefore, is that any immediate reflexive pullback under this sweep scenario could be followed by reasonably swift recovery once investors absorbed this far more attractive net impact picture and better-than-feared more comprehensive data. That said, if the January Georgia Senatorial run-off votes tilt toward the GOP candidates as we expect, the Republicans will maintain majority in the Senate, thus making tax hikes and significant change in tax policy unlikely.
Source: J.P. Morgan US Equity Strategy & Global Quantitative Research
For the data lovers out there, you may find it interesting that cumulative stock market returns under blue sweep leadership periods have approximated 56% versus only 35% during red sweep periods…those during which the GOP controlled all chambers1. This is not a political statement; just fact.
What Would Cause Us to Change Our View
So, our base case is that, regardless of which party holds the White House, we may likely have a divided Congress and therefore split leadership…gridlock is a market-friendly state, as indicated from the data above. So, gridlock is good for investors, from our perspective.
There are several low-probability scenarios that would get us to adjust our view and become more pessimistic in outlook. If election results were delayed for an extended period of time, this could increase consumer, corporate CEO and investor uncertainty and lead to lower economic activity. How could such delays in the final call occur? First, the Trump campaign is filing lawsuits to contest election results in various states…if there is significant litigation that requires the Supreme Court to intervene, this would cause angst. We don’t fear this case so much, because the Supreme Court decision should be fairly swift if such intervention became necessary…similar to the 2000 “hanging chad” chapter and decision. In that period, the market had a single-digit pullback before moving higher, despite the fact that we were in the midst of the aftermath of a tech bubble. That is illustrative of manageable risk.
The final result here seems to be far better than feared and certainly far from the extreme scenarios that were being discussed going into election night. In fact, the gridlock that comes with split leadership and that reduces risk of tax increases, coupled with a president-elect who favors bipartisan infrastructure spending, and a track record of collaboration between Biden and Senate majority leader Mitch McConnell on major legislation…this all could lead to a very market friendly cocktail on the political and fiscal policy front.
In conclusion, we maintain conviction that it is fundamental trends in earnings and the economy that determine the path of the market. The chart below encourages optimism in this context as earnings expectations for the next 12 months continue to recover and rise.
Various economic metrics ranging from GDP, surveys taken by manufacturing and service companies, housing and auto data, to small-business optimism support an improving earnings picture. Our base case incorporates a continued, albeit moderating, improvement in the data and an election outcome that is delayed but deferred only for a reasonable time period. We believe this to be a supportive backdrop for healthy market returns over the next 12 months and maintain our “hold your ground view” in the midst of the current political uncertainty.
1“Yardeni Research Morning Briefing: And the Winner Is…?”
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.
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