This article was first published in Institutional Investor on 24th October 2024 here.
With less than two weeks to go in the US election cycle, investors have keen interest in how the new administration and its policies will affect asset markets. Institutional Investor recently sat down with Christian Dery, Head of Macro Strategy at Capital Fund Management (CFM), to discuss his outlook for the US election and asset market risks and opportunities under various electoral outcomes. The following interview has been edited for clarity.
As we enter the final weeks of the 2024 campaign, how do you view the potential outcomes and their effects on public policy and the US economy?
We see several scenarios for the November 5 election.
First, there’s a Republican or Democratic sweep, in which the prevailing party captures the presidency and both houses of Congress. Recent data from prediction markets estimates a GOP sweep at about 39% and a Democratic sweep at about 18%. Regardless of which party is in power, we anticipate that fiscal stimulus and the nation’s fiscal addiction to deficit spending will continue. The question, of course, is how fiscal stimulus will be spent and what its impact on the economy will be.
In the event of a Republican sweep, baseline policy proposals are expected to increase the deficit by roughly $500 billion, or 2% of GDP. A centerpiece of the Republicans’ proposed fiscal stimulus is additional tax cuts for corporates and individuals. The proposed policies are highly stimulative to the economy, inflationary, and market-friendly.
In contrast, Democratic fiscal proposals are expected to maintain federal spending at roughly 6% of GDP. In the event of a Democratic sweep, taxes will rise for corporations and the wealthiest households. We also expect more regulation of commercial activity and closer antitrust scrutiny, imposing additional costs on corporations. The Democratic platform is focused on redistribution of wealth, with higher taxes funding spending initiatives. Higher corporate taxes will hit earnings, higher individual taxes will weigh on spending, and this will increase the probability of recession in the near term.
A Democratic sweep is less likely than a Republican sweep, partly due to the staggered voting system in the Senate. Only twelve Senate seats are competitive this year. The Democrats need to win nine of the twelve Senate seats along with the presidency, which would allow the VP to cast the tie-breaking vote.
The second scenario is a split Congress, where the House and Senate are under different party control. We see this as the most likely outcome and also less disruptive to the economy and asset markets. Who’s going to win the presidency? The race is a dead heat and is determined by the outcome in seven swing states. As of today, Harris is polling within the margin of error in most of them.
What is important from a near-term investment point of view is this: tariffs and immigration go through the executive branch and the presidency, while fiscal policy – that is, taxation and spending – goes through Congress. Trump has proposed increasing tariffs on China, existing trade partners, and countries that de-dollarize. These proposals have negative implications for assets that are sensitive to trade and tariffs, notably emerging market FX and equity markets that are trading partners with the United States.
Q: Which voter groups do you think are most likely to tip the election one way or the other?
The presidency is going to be determined by undecided voters in seven swing states. As of today, the race is a dead heat with Harris now within the margin of error in most swing states. The outcome of the presidency is an even bet and is particularly hard to predict.
For portfolios, investors should be prepared for various scenarios and understand their exposures to different outcomes. CFM is a systematic manager. We run scalable, diversified, liquid strategies that have low correlation with broad markets. We have a large number of dynamic models that adapt as the market evolves. These models are designed to capture a wide array of diversified, statistically meaningful relationships at multiple time scales. The goal is to strike a balance with no concentrated exposure to a particular outcome.
Q: Setting aside each party’s campaign activity and messaging, what other factors do you think will contribute to the outcome of the election?
In hindsight, a few narratives will be used to explain why one party prevailed over the other. However, the reality is that an election is a complex set of interactions that determine the outcome. With the election fast approaching, both parties will use emerging developments to score political points and attempt to sway remaining undecided voters. The half-life of these attempts will be short, given the fast media cycle and with only a a few weeks to go before the event.
At this point, we are pricing a split Congress and a toss-up for the presidency. Elections tend to have small sample properties, but we are able to detect statistical regularities arising from the behavior of market participants around important market events. We also recognize that models may miss crucial information.
Here at CFM, we meet regularly at our Market Risk Committee to discuss forward-looking risks and how they can impact our portfolios. This involves scenario and factor analysis to detect any imbalances in our portfolios that are not captured by existing models. We discuss all types of emerging risk, including geopolitical, liquidity, and event risks such as elections. Ideally, we are able to codify these insights into our models. While we do not override signals, on rare occasions we can reduce risk to mitigate unintended biases.
Q: How do you see a Democratic or Republican victory affecting equity markets, both in the immediate short term and over the next four years?
A Republican or Democratic sweep has important market implications because the policy platforms of the two parties are different.
A Republican sweep is likely to be stimulative and market-friendly. Post-election price evolution should follow the 2016 analogue. Trump is proposing cutting corporate taxes to 15%, extending individual tax cuts, and reducing regulatory burdens. His baseline proposal adds 2% to the deficit and provides significant stimulus.
A Democratic sweep is stimulative via fiscal policy, but the Democrats are likely to implement redistributive policies. Corporate taxes will rise to 28%, which will weigh on earnings per share (EPS). Tax cuts for the affluent will expire. Regulation will increase, including scrutiny of monopolies, mergers, and overall market regulation. On balance, this scenario is negative for markets.
Regardless of the outcome, aggressive fiscal policy eventually becomes a political issue. In all scenarios – sweep or split – the fiscal spigot stays open. Bill Clinton ran on an austerity platform in the 1990s when the deficit as a percentage of GDP was 5%. At one point, there was talk of extinguishing the entire US debt given the trajectory of receipts to the government versus spending. He raised taxes and cut spending to contain the deficit – an austerity platform. The word ‘austerity’ is non-existent in either party’s political platform.
The fiscal expansion proposed by either party is inflationary and likely to overheat the economy. As a result, austerity will have to happen in the future. It is simply inevitable. I suspect this could happen in the next few years as deficits balloon and inflation remains firm. This also binds the Federal Reserve to a more hawkish stance.
Q: You mentioned fiscal addiction earlier. What scenarios do you foresee for government spending and its impact on markets?
Fiscal addiction is the most important change this cycle. I agree with the idea that this cycle is income-led, not credit-led. It resembles the 1960s with a strong fiscal impulse and firm inflation. Wage growth is running at 5%, and service-price inflation is at 4.5%.
Yes, the Federal Reserve has made excellent progress on taming inflation, but we have this large fiscal impulse in the background, which brings up the old idea of money velocity – that is, one person’s spending is another person’s income. A large fiscal expansion puts more money in the system and is more directly linked to spending in the real economy.
To get inflation back to target, a combination of less spending, higher interest rates, and alleviation of supply constraints is required. Looking at the baseline fiscal spending of both parties, it is hard to accept that it will not be stimulative and inflationary.
Again, the spending happens irrespective of the party in power. Fiscal largesse is America’s new addiction. Ultimately, there is a cost to be paid, and a future administration will have to deal with ballooning deficits and inflation via austerity measures, similar to Clinton’s austerity platform in the 1990s.
Q: How do you view the GOP’s interest in using tariffs and trade restrictions as a source of federal revenue in lieu of taxes? How might this strategy affect markets?
The Republicans believe tariffs can fund spending, while the Democrats believe taxes can fund spending.
Tariffs can be effective, but they are an inefficient policy tool. Allow me to make a few observations: First, under a tariff system, the foreign exchange of trading partners weakens to adjust to the tariff, reducing its effectiveness. Second, trading partners are likely to retaliate. Tariffs on trading partners lead to counter-tariffs, chosen strategically on important sectors to maximize the impact on exporters. Third, trade restrictions are difficult to police. There are many ways to circumvent tariffs, for example through intermediate production. That is, China sets up a factory in a friendly country to export products, which are then re-exported. Finally, tariffs increase the cost of imported intermediate goods for manufacturers. Steel is a good example, as it is used as an input in many production processes. China has economies of scale in steel production and produces it at the lowest cost. The net effect is inflationary as tariffs increase the price for firms importing steel.
Trade imbalances play a role here, too. By some estimates, the Chinese current account surplus is running at a record pace. The Democrats recently increased tariffs on China, aligned with Trump’s proposed baseline. It remains to be seen whether tariffs will close these imbalances. That said, the tariffs shine a light on uncompetitive trade practices. China’s industrial policy effectively subsidizes strategic manufacturing industries. In many cases, these subsidies allow Chinese factories to produce below the cost of production, making it difficult for trade partners to compete.
Q: Similarly, what are your thoughts on the Democrats’ eagerness to raise taxes on corporations and the wealthiest households? Again, how might this strategy affect markets
The Democrats would require a sweep of both Houses of Congress to enact their baseline proposals to raise taxes on corporations and the wealthy. In the near term, these policy proposals have a negative effect on markets, as higher taxes will weigh on EPS, and closer regulatory scrutiny is likely to increase compliance and operating costs for American companies.
The Democrats’ platform is redistributive from corporations and wealthy taxpayers. In that sense, it is less stimulative than the Republican platform and increases the odds of a US recession.
Let’s not forget that the word “austerity” is absent in any of these platforms. The Democrats’ baseline policy calls for federal spending that keeps the deficit at about 6% of GDP, which is likely to rise over time. I think my point on the need for austerity measures eventually holds. Whichever party governs will eventually have to cut spending and get ballooning deficits under control. At some point, the market will start to price in this scenario, potentially forcing the government to act.
Q: Do you think the election will have a substantive effect on Federal Reserve policy and interest rates? If so, what might we expect?
The Federal Reserve is an apolitical institution and independent. It responds to evolving conditions in responsible ways. If an election outcome proves to be too stimulative and inflationary, then the Federal Reserve will shift to tighter monetary policy.
The Republican sweep scenario increases the chance of a hawkish response given how stimulative the GOP’s proposals are. We are still talking about a lower bound of 6% in deficits, and this is likely to grow in any election outcome. If you believe that fiscal policy is inflationary, there is a risk the Federal Reserve will have to shift to a more hawkish stance.
We received a set of projections at the September FOMC – this is the famous “dot plot.” The Committee has the policy rate reaching terminal in two years. Currently, the market discounts that arrival to terminal in 16 months. The discounted pricing implies a soft landing for the US economy. Inflation reaccelerating is priced as a tail risk. It will be interesting to see how conditions evolve relative to pricing and whether the Federal Reserve and market pricing are correctly discounting future conditions.
Q: As you look at equity markets today, what other factors do you think pose major risks to the current bull market?
Outside of election risk, I think the two greatest risks to equities are a reacceleration of inflation and a reality check on the outperformance of US equities, specifically the technology sector. The outperformance of US technology shares has led to unprecedented levels of concentration in the sector in both US indices and as a percentage of global equity market capitalization. Non-US investors are recycling savings into US assets, with foreign equity ownership reaching roughly 40%. Part of the recent outperformance of US technology shares is the result of excitement around generative AI. The problem is that generative AI requires an enormous amount of capex to build the required compute for training and inference. This is very different from the hyper-scaling properties of software with zero marginal cost. As a result, the balance sheets of the large technology incumbents will change as they significantly increase spending and capex to compete in generative AI. If these companies fail to show a roadmap to scale and profitability, the market will start punishing these stocks for high spending rates with no obvious killer use cases. This represents a significant risk for the generative AI theme.
DISCLAIMER
All opinions and estimates included in this document constitute judgments of CFM as at the date of this document and are subject to change without notice. Future evidence and actual results could differ materially from those set forth, contemplated by or underlying these statements. CFM does not give any representation or warranty as to the reliability or accuracy of the information contained in this document. CFM accepts no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. This article does not constitute an offer or solicitation to subscribe for any security or interest.
