US 2020: The COVID Election – Part III

This is the third installment of our mini-series on the US elections. The first part took into account market risks that may arise from a disputed US election, while the second part reviewed competing policy platforms and their implications for asset allocation. Although we concluded that equity investing would overall become more challenging under a Biden administration, we also suggested that there would be some winners from his public investment plans. In this third part, we would like to provide an overview of equity sectors that would lend themselves better to the policies of a Democratic government.

Key Policy Drivers

First, it is important to note that most tax plans are broadly negative. Above all, plans to increase the statutory corporate tax rate, raise the tax on foreign earnings (Global Intangible Low-Taxed Income) and set a minimum corporate tax rate are all headwinds to earnings. On top of that, plans to raise personal tax income on the wealthiest Americans (higher capital gains taxes on million-dollar plus capital income and raising payroll tax threshold on households earning over US$400,000) could further drain capital out of financial markets.

Second, there is likely to be a determination to boost earnings and bargaining power of labor. The most glaring area is the expectation of an increased federal minimum wage, but there would be other measures that could prove to be costly to labor-dependent industries as well.

Third, the degree of margin erosion that a rollback of the policies of Trump administration can cause is less quantified. There could be broad disruption from new regulatory appointees, changes in fiduciary powers, new consumer protection powers and an overarching push to promote climate change mitigation. Add in the aim to reduce income and racial inequalities, and it is clear that the regulatory landscape will be uneven. Individual companies and industries could be affected in varying magnitudes, resulting in some interesting investment opportunities.

Fourth, a Biden administration would be more determined to promote public investment. US infrastructure remains starkly underfunded and the post-COVID-19 economic shock should facilitate the political case for government spending to boost the economy’s recovery. In his pre-COVID-19 platform, Joe Biden had already foreseen an annual boost of roughly US$500 bn, focusing on healthcare, transport, housing and education (especially early education and childcare).

Mr. Biden has now added a substantial front-loaded proposal to enhance government spending on R&D (half of which is to be directed toward clean energy) as well as US-focused procurement of products, materials and services. In this approach, only the defense industry would be a net loser of government spending.

As Figure 1 shows, assuming Mr. Biden can channel one third of those plans into the first two years, it would materially lift government investments compared with that of the previous decade.

Sector Overview

Tax changes would negatively impact corporate earnings across the market, reversing some of the benefits to earnings per share seen since 2016. Furthermore, without the incentive to repatriate cash, companies could keep cash earnt outside the United States (US) abroad with a knock-on impact on the rate of dividends and share buybacks (the sectors that saw the highest increases in buyback activity in 2018 after the Tax Cuts and Jobs Act were Materials, Utilities and Technology). However, public spending and climate-friendly policies could be beneficial offsetting factors to tax increases.

Compared with the last presidential election, two sectors may experience less scrutiny, namely Healthcare and Financials. First, Healthcare has been at the fulcrum of political debate for years and has been exposed to changing insurance plans as well as desires to manage pricing and prescription processes. During the current election campaign, a pandemic is still raging, and therefore the country is reliant on healthcare provisions and supplies. A full economic recovery depends on an effective vaccine – not only development but also manufacturing and distribution.

Historic fears of political repercussions are reflected in the underweight positioning of institutional investors in US Healthcare and net outflows from the sector pre and post past election dates (Figure 2). However, given the sector’s stable earnings growth and lower risk to business models, we believe there could be an attractive opportunity this time around.

Financials benefited significantly from the Trump administration’s deregulation and appointment of industry-friendly policymakers. We do not expect as much focus in this campaign: a tax rise would hit earnings and consumer-facing products may incur margin shrinkage. Substantially tighter financial regulation in the coming years, however, is unlikely given the regulatory changes post the Global Financial Crisis that remain in place.

The proposed green policies present a switch proposition. Mr. Biden’s plans could benefit Utilities in terms of their transition toward cleaner electricity generation. This could mirror large European electricity providers that have enjoyed re-ratings on the back of their leadership in energy transition. By contrast, the already pressurized Energy sector could be hit by these fiscal policies even as low oil prices are offering no relief to their profit and loss accounts.

The cyclical groupings of Industrials and Materials are traditional beneficiaries of infrastructure spending. Whilst the latter will have to contend with lower defense orders for aerospace equipment, the miners and construction material companies in the Materials sector are well placed for new building projects.

Meanwhile there could be mixed results for Consumer Discretionary businesses including retailers, hoteliers and leisure companies. With a fillip to the consumer balance sheet under Mr. Biden, there may be upside from consumer spending, but many of the corporates are large employers of lowly paid workers. The outlook may not be as rosy as after the last Democratic win, when large investor inflows followed.

By contrast, Technology has a relatively low labor/capital mix and would be less affected by employee wage hikes. This sector stands out for its secular growth opportunities, but these could be tempered near term by tax changes and a more determined stance on antitrust enforcement.

Investment Implications

Overall, US and global equities could see a rise in volatility over coming months until markets can reasonably forecast an outcome. Such an uncertain environment could lend itself to taking a selective approach to investment. During the 2016 election, we witnessed a dramatic widening of dispersion of returns between sectors and a sharp rise in interest for sector exchange-traded funds as a means of positioning against various political outcomes.

While all the sectors will face mixed implications across different industries, we look favorably on Healthcare, Materials and Utilities as being well placed to navigate any political transition in the US.

In addition to the pandemic, social justice themes will be a significant feature in coming years. The priority would be criminal justice reform to lessen police abuse and reduce the disproportionate sentencing of black youth. It goes without saying that the investment implications of the Black Lives Matter movement cannot be overemphasized. Such a major societal change will inevitably drive investment decisions and corporate governance in the coming years.

Together with the increased environmental focus, this focus on social justice is likely to accelerate environmental, social and corporate governance parameters in the US to that already seen in Europe. Among sectors, Utilities are better positioned in relative terms to take advantage of this new trend.

The authors are grateful to Anthi Tsouvali and State Street Global Markets for contributing to the article.