ElectionWatchInvestment implications of the 2020 US elections

15 January 2020Chief Investment Office GWMInvestment Research

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Democratic

debate reaction

See ElectionBrief: Sparks don’t

fly in Iowa debate for coverage

of the 14 January debate.

Do policy proposals really matter?

With less than a year to go until the next election, we believe voters will begin to focus attention on the policy priorities espoused by the remaining can-didates still vying for the Democratic nomination. The pending impeachment trial of President Donald Trump will dominate media coverage through the end of the month, but a serious assessment of the candidates’ proposals is likely to follow. Given the deep divide between the two parties’ competing policy agendas, investors often wonder how they might impact markets. But before we can address this question, we need to consider a few things.

First, we need to narrow the scope of what consti-tutes a material issue. Every political campaign is littered with a host of ideas that enthusiastic—and dare we say naïve—staffers parry back and forth like shuttlecocks. But only a few are ever given se-rious consideration by the eventual candidates and party leaders. So we need to focus only on those

proposals that are likely to make the transition be-yond campaign rhetoric.

It strikes us that each and every policy proposal must matter in some way to someone, or else it would never have surfaced in the first place. But as investors, we are interested only in those that are likely to affect portfolio outcomes—those that reach what we define as the “macro impactful“ threshold, with the potential to affect the real economy and influence market valuations.

Finally, it’s important to keep in mind that while any new administration enters office with a very clear set of policy goals, exogenous factors often alter the policy course those elected officials pursue. For ex-ample, the attacks of 9/11 prompted a radical shift in the Bush administration’s policy agenda, while the global financial crisis imposed constraints upon the Obama administration during its first term.

ErratumDue to an editing mistake, an earlier version of this report was published misidentifying Jimmy Carter’s challenger in 1980. It is Ted Kennedy. This version corrects the error.

This report has been prepared by UBS Financial Services Inc. Please see important disclaimer on page 7.

2ElectionWatch 2020 | Do policy proposals really matter? | ubs.com/electionwatch

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What really matters

Academic studies and industry research suggest that “macro impactful” policy choices fall into four very broad categories: fiscal policy, monetary policy, reg-ulatory policy, and trade policy.1 Legislative changes to the tax code constitute the most important method of implementing fiscal policy, but the tra-jectory and composition of discretionary expendi-tures, and the size of the budget deficit—over which both parties appear less apprehensive—are also important. Democratic candidates do appear eager to reverse some provisions of the Tax Cuts and Jobs Act. The ability to do so will be an uphill battle and will depend on the composition of Congress.

As far as monetary policy is concerned, the re-sponsiveness of central bankers to both cyclical events and structural changes to the economy will affect financial markets. The absence of a consis-tent approach to cyclical changes could prompt market participants to incorporate higher risk pre-miums into asset prices, but overly strict adherence to a predetermined set of policy rules poses a big-ger risk. As we discuss on page 6, we believe the Federal Reserve is prepared to adjust monetary policy as necessary to prolong the economic ex-pansion (see “Election myths”).

There are four key sectors where regulatory policy changes affect both the real economy and financial markets: environmental, financial, healthcare, and energy. Regulatory activism—and the interpretation and enforcement of existing regulations—is one area where a candidate’s policies do matter a great deal because the executive branch of government retains broad discretion.

Recent experience shows that trade also can have a material impact on both the economy and finan-cial markets. This could range from the execution of (or withdrawal from) trade accords to a willing-ness to impose punitive tariffs or import quotas on certain goods and services. Here again, US presi-dents have broad authority to dictate trade policy. But as we discussed in prior ElectionWatch reports, both parties now share a common concern over unrestricted free trade.

The cumulative effects of these policy choices are translated into the real economy primarily through their impact on domestic growth dynamics, shifts in inflation expectations, dueling investment in-centives, fluctuations in foreign exchange rates, and changes to real interest rates. These, in turn, will influence financial markets by potentially alter-ing both future return expectations and current risk premiums.

Policy over party

Given what’s at stake, it’s not surprising that can-didates are mapping out divergent policy paths and garnering more attention. With such seem-ingly stark choices, one might expect the market to exhibit a clear preference for one party over an-other. History suggests it‘s not so simple.

Studies have found that the range of market out-comes varies widely regardless of the winning can-didate’s party affiliation. One may conclude that markets tend to do better under Democratic leader-ship,2 while another holds that markets react more favorably when a Republican wins the presidency3 (especially in closely contested elections). We are mindful that statistics can be misleading without necessary context. As we illustrate on page 5, sim-ply adjusting the number of elections included in a study or deciding whether to exempt the 2008 election in the wake of the Great Recession can sig-nificantly affect the results (see “Election myths”).

Investors should therefore focus their attention on the “macro impactful” policy priorities of the can-didates rather than on party affiliation. Fiscal and regulatory policy proposals, in particular, deserve close scrutiny as they will exert the biggest influ-ence on market outcomes.

1Baker, Scott R., Bloom, Nicholas, Davis, Stephen J., and Kost, Kyle J.; March 2019. “Policy News and Stock Market Volatility,” NBER Working Paper Series, National Bureau of Economic Research; Working Paper 25720.2Santa-Clara, Pedro and Valkanov, Rossen; October 2003. “The Presidential Puzzle: Political Cycles and the Stock Market,” The Journal of Finance, Vol. LVIII, no 5.3Snowberg, Erik, Wolfers, Justin and Zitzewitz, Eric; March 2006. “Partisan Impacts on the Economy: Evidence from Prediction Markets and Close Elections,” NBER Working Paper Series, National Bureau of Economic Research; Working Paper 12073.

Did you know? 72% of incumbent presidential candidates have won reelection since 1948.

For more on this topic, see “The incumbency advantage” from our May 2019 report, ElectionWatch 2020: Off to the races.

3ElectionWatch 2020 | Do policy proposals really matter? | ubs.com/electionwatch

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At a glance Policy likelihood Investment view

Corporate taxes

The Trump administration lowered corporate taxes with the 2017 Tax Cuts and Jobs Act, but a Democratic administration would likely attempt to increase taxes.

If Trump is reelected, corporate taxes will likely remain the same—with an effort to make the cuts permanent. Democrats would try to raise additional revenue, but passing legislation could be difficult without a large majority in Congress.

Although hurdles exist, debates on the topic could raise volatility as Democratic proposals could cut earnings by up to 7%. We remain constructive on US equities but always recommend diversifying across regions to protect against local risks.

Redistribution

While President Trump has proposed additional middle class tax cuts, a Democratic candidate would look to increase taxes on the wealthy. Democrats have also proposed changes to policies around minimum wage and social security.

Wealth tax proposals are unlikely to pass Congress, although estate taxes and capital gains taxes for high earners could be raised. Higher top tax rates and increases to the federal minimum wage are likely with a Democratic president.

When tax planning, maximizing flexibility can be more effective than trying to predict future tax rates. Investors can diversify savings across a mix of taxable, tax-deferred, and tax-exempt accounts.

Health reform

While President Trump has weakened the Affordable Care Act, Democrats would likely look to preserve or expand public healthcare coverage. Both President Trump and Democratic candidates support drug pricing reform.

While “Medicare for All” would be difficult to pass, an expansion of public healthcare coverage would be more likely under Democrats. Some form of drug pricing restriction is possible under either administration.

Debates over coverage and drug pricing will likely spark volatility in the healthcare sector. Any disruption to private insurance markets and limiting the pricing power of healthcare companies could hurt the sector, although some legislative risk is included in current valuations. Investors should remain diversified across sectors.

Sector regulation (technology, communication, and financial)

Both President Trump and Democratic candidates have increased scrutiny on technology giants amid antitrust and data privacy concerns. Within the financial sector, President Trump's regulatory appointees have eased Dodd-Frank Act rules somewhat, while Democrats would likely look to reverse more industry-friendly regulatory interpretations.

Regardless of the administration, breaking up tech companies is unlikely in the near term as antitrust cases can take a long time to be resolved. Exact financial regulatory proposals are still unclear. However, Democrat calls for breaking up big banks are not likely to lead to legislative changes.

Investors should prepare for greater volatility in election-sensitive sectors. The potential threats of increased regulation and breaking up larger companies would raise compliance costs and constrain profitability. Investors should remain diversified across equity sectors and hedge concerns by investing in companies with exposure to longer-term trends such as digital transformation.

Environmental policy

The Trump administration has loosened environmental regulations, while Democratic candidates would almost certainly strengthen them.

While the ambitious proposal called the Green New Deal is unlikely to pass with a divided Congress, a Democrat in the White House could take measures to increase environmental regulation by executive order. President Trump would be likely to continue to loosen regulation.

Companies connected to clean energy, clean air, carbon reduction, and energy efficiency could benefit from regulatory action taken by a Democratic administration and could offer a hedge against the risk of more burdensome environmental legislation for the carbon-based energy sector.

Trade policy

A reelected President Trump would likely continue his aggresive trade tactics. Democratic candidates are unlikely to adopt a more conciliatory approach.

Both President Trump and Democratic candidates are likely to maintain a hard stance on trade during negotiations with China. Democrats may take softer positions with allies, such as the EU.

Investors should continue to diversify globally and favor companies that are less trade- and investment-dependent.

Framing the key issues

In case you missed it: In our Year Ahead 2020 report, we outlined six key issues for investors wonder-ing “What does the US election mean for my portfolio?” We explore these factors below.

4ElectionWatch 2020 | Do policy proposals really matter? | ubs.com/electionwatch

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The 2020 countdown

The Iowa caucuses are 19 days away

The next Democratic debate is 23 days away

The last Democratic debate was on 14 January (read our reaction)

This report was published on 15 January

Super Tuesday is 48 days away

The Democratic National Convention is 180 days away

The Republican National Convention is 222 days away

Election Day is 293 days away

The election in graphics

Who’s who in the race

Candidate photos: Alexander Tamargo / Contributor, Getty Images (Pete Buttigieg); John Shearer / Contributor, Getty Images (Bill de Blasio); NBC NewsWire / Contributor, Getty Images (Mike Gravel); MSNBC / Contributor, Getty Images (Tom Steyer); John Lamparski / Contributor, Getty Images (Bill Weld); David Liv-ingston / Contributor, Getty Images (Marianne Williamson); Joshua Lott / Contributor, Getty Images (Andrew Yang); Wikipedia (all other candidates)

Democrat (running) Democrat (withdrew) Republican (running) Republican (withdrew)

Donald Trump

Joe Walsh

Bill Weld

Mark Sanford

Republican

John Delaney

Tulsi Gabbard

Kirsten Gillibrand

Mike Gravel

Kamala Harris

John Hickenlooper

Amy Klobuchar

Jay Inslee

Wayne Messam

Seth Moulton

Richard Ojeda

Beto O’Rourke

Deval Patrick

Tim Ryan

Bernie Sanders

Joe Sestak

Tom Steyer

Eric Swalwell

Elizabeth Warren

Marianne Williamson

Andrew Yang

Bill de Blasio

Michael Bennet

Michael Bloomberg

Cory Booker

Steve Bullock

Pete Buttigieg

Julián Castro

Joe Biden

Democrat

5ElectionWatch 2020 | Do policy proposals really matter? | ubs.com/electionwatch

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US equity markets

Myth: The presidential election campaign brings uncertainty, hampering market returns during elec-tion years.

Reality: US equities typically perform well in the fourth year of an incumbent’s presidential term.

Every January, the financial press is awash with forecasts of the future performance of US equity markets. In presidential election years, the predic-tions are often accompanied by commentary on whether the prospect of a Democratic or Republi-can victory will affect stock valuations in the run-up to the election. We examined results from the last 23 presidential elections and reached two conclu-sions. First, there is a demonstrable correlation be-tween the last year of a presidential cycle and posi-tive results for the US equity market (see Figure 1a).

Second, available data can be adjusted with relative ease to generate a conclusion that favors one party over another (see Figure 1b). For those interested in this topic, please refer to our 14 November 2019 re-port, Are election years good or bad for investors?

The reason for the equity market’s historical strength is actually rather prosaic. Incumbent presi-dents are more likely to introduce fiscal policies aimed at enhancing their prospects for reelection.4 Higher budget deficits and an uptick in inflation often follow, which forces the next (or reelected) president to adopt more conservative policies that can restrain the rate of economic growth in the early years of the following administration. Since 1928, there have been only four instances where equity returns are not positive in the fourth year of a presidential election cycle.

While we expect stock market volatility to rise this year as policy proposals from both parties receive more media coverage, we believe the prospects for positive returns for the S&P 500 are high. Those market returns are unlikely to replicate the ones posted in 2019, but if history is any guide, inves-tors with a diversified portfolio of stocks should be able to weather the inevitable turbulence.

Figure 1a

Election year

Incumbent president

Individual elected

S&P 500 Index total returns

Historical US presidential election results

2016 Obama Trump 12.0%

2012 Obama Obama 16.0%

2008 Bush W. Obama -37.0%

2004 Bush W. Bush W. 10.9%

2000 Clinton Bush W. -9.1%

1996 Clinton Clinton 22.9%

1992 Bush H.W. Clinton 7.6%

1988 Reagan Bush H.W. 16.6%

1984 Reagan Reagan 6.3%

1980 Carter Reagan 32.5%

1976 Ford Carter 23.9%

1972 Nixon Nixon 19.0%

1968 Johnson Nixon 11.0%

1964 Johnson Johnson 16.4%

1960 Eisenhower Kennedy 0.5%

1956 Eisenhower Eisenhower 6.5%

1952 Truman Eisenhower 18.2%

1948 Truman Truman 5.4%

1944 Roosevelt Roosevelt 19.5%

1940 Roosevelt Roosevelt -9.6%

1936 Roosevelt Roosevelt 33.7%

1932 Hoover Roosevelt -14.8%

1928 Coolidge Hoover 37.9%

Election myths: Debunking election beliefs

4Gil-Alana, Luis and Mudida et al, Mapping US Presidential Terms with SP500 Index: Time Series Analysis Approach, 2019.

Figure 1b

US presidential election results

Average return

Average return (excl. 2008)

S&P 500 Index total returns in election years (1928–2016)

A Republican was elected 14.70% 14.70%

A Democrat was elected 7.05% 11.06%

All election years 10.71% 12.88%

S&P 500 Index total returns in election years (1948–2016)

A Republican was elected 12.38% 12.38%

A Democrat was elected 6.96% 13.24%

All election years from 1948 9.97% 12.74%

S&P 500 Index total returns in election years (1960–2016)

A Republican was elected 12.39% 12.39%

A Democrat was elected 7.19% 14.56%

All election years from 1960 9.97% 13.32%

Note: S&P 500 total returns include dividendsSource: Bloomberg, UBS, as of 2 January 2020

6ElectionWatch 2020 | Do policy proposals really matter? | ubs.com/electionwatch

Monetary policy

Myth: The Federal Reserve places monetary policy on hold during presidential election years.

Reality: The Fed has not hesitated to modify mon-etary policy in presidential election years.

Contrary to popular belief, the Fed has shown a will-ingness to adjust short-term rates either to restrain the rate of inflation or stimulate economic growth regardless of an impending presidential election. The Federal Open Market Committee (FOMC), which oversees open market operations, has failed to ad-just policy only once in the past 12 election cycles.

In that instance, just three years ago, the Fed’s re-luctance to raise short-term rates was attributable to concerns about a slowing Chinese economy, which threatened to impede global economic growth. Four years earlier, with the federal funds rate already at zero, the FOMC agreed to increase the Fed’s holdings of long-term securities, thereby injecting liquidity into the financial markets. That action, generally known as QE3, occurred in the months just prior to the presidential election.

Fed Chair Jerome Powell has been subjected to withering criticism by President Trump, who believes the Fed failed to act quickly enough to ease mone-tary policy in 2018. While the current political envi-ronment is particularly contentious, the Fed is better insulated than other institutions to withstand overt political pressure. Powell’s term in office as a Fed governor is fixed by statute. Monetary policy is managed by the FOMC, with the chair of that pol-icy-making body within the Fed being chosen by its own members. So while President Trump conceiv-ably could choose another member of the Board of Governors to serve as board chair, he might not suc-ceed in dislodging Powell as the chair of the FOMC.

While the FOMC decided to leave the fed funds tar-get rate unchanged at 1.5–1.75% at its December 2019 meeting, we are reluctant to conclude that the Fed was preoccupied by the impending presidential election. The statement accompanying the decision to remain “on hold” for the time being reaffirmed the committee’s intent to monitor global economic developments and labor market conditions in 2020. We expect the Fed to act as appropriate in 2020 and exhibit its time-honored independence.

The Iowa caucuses

Myth: The Iowa caucuses are important because the winner typically receives his or her party’s nomination for president.

Reality: The Iowa caucus results have a mediocre track record of choosing presidential nominees.

Political pundits are fond of saying that “Iowa isn’t first because it’s important. Rather, it’s important because it’s first.” In the wake of a disorderly 1968 national convention, the Democratic Party adopted guidelines to promote the use of primaries and caucuses to choose its presidential nominee. Iowa’s Democratic Party promptly decided to schedule its caucuses in late January,5 thereby moving the state to the front of the line and raising its profile as an early testing ground for presidential candidates.

The state’s reputation for rewarding upstart candi-dates was secured in 1976 when Jimmy Carter gar-nered the most candidate votes, placing second behind “uncommitted.” While seven of the past 10 Democratic candidates have won the Iowa caucus vote before being anointed as the party nominee, there have been some notable misses. Michael Du-kakis placed third in 1988, as did Bill Clinton four years later. Both went on to win the nomination. It is also important to note that the overall tally in-cludes one instance where a presidential incum-bent defeated a party challenger (Jimmy Carter over Ted Kennedy in 1980) and another in which the victor barely won the contest (Hillary Clinton over Bernie Sanders in 2016).

Meanwhile, the record for Iowa’s Republican voters is even worse. Only two of last seven GOP candi-dates in a contested caucus won their party’s nomi-nation after winning in Iowa. For example, Ronald Reagan lost the Iowa caucus vote in 1980, and John McCain placed fourth in 2008. For all of the media coverage Iowa enjoys in January, its record of choos-ing winners is lackluster.

PublisherUBS Financial Services Inc.CIO Global Wealth Management 1285 Avenue of the Americas8th FloorNew York, NY 10019

AuthorsMike Ryan Tom McLoughlin

ContributorsBrian RoseBryan Kamau

Contributors outside CIOJohn SavercoolShane Lieberman

EditorAbe De-Ramos

Project management John ColluraMatt SiegelSimran Chahal

Report designCheryl Seligman

Cover photoGetty Images

5The Iowa caucus is scheduled for 3 February this year.

Fun fact: Theodore Roosevelt was the first president to refer to the Executive Mansion as the White House.

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7ElectionWatch 2020 | Do policy proposals really matter? | ubs.com/electionwatch

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