Investment Implications for a Pandemic Election

The US election is another variable for investors to grapple with in the context of the global pandemic. Let us not forget that the global GDP collapsed in the second quarter as a result of COVID-19 and contracted at a pace even more severe than during the 2008 financial crisis. The unknown path of the virus, the resultant stay-at-home orders and the risk of reinfection have all exerted severe pressure on almost every aspect of the global economy.

However, global central banks carried out massive monetary stimulus to support the orderly functioning of markets, in the process creating liquidity and calming anxious investors. We cannot underestimate the crucial nature of the rapid central bank response and the emergency fiscal stimulus in the United States (US) and other major economies around the world. Undoubtedly, these quick actions put cash in the hands of the neediest, allowed businesses to make payroll and consequently helped to avoid worst-case economic outcomes from the pandemic-induced shutdown.

For the past several months, countries around the globe have been moving toward a process of gradual reopening – and the economy is responding. Simona Mocuta, SSGA’s senior economist, coined the term “relay recovery” to describe the recuperation of the economy and the evolution in support required to take it to the next phase. The first leg of support was led by global policymakers and the second leg, the present, is being led by local reopening decisions and the resumption of business activity.

We are encouraged to see that consumer spending and industrial production have been improving around the globe and have been faster in areas where the COVID-19 virus is relatively well controlled. Although the recovery is certainly patchy, the economy is finding a slow path forward.

Next Phase Would Ultimately Require a Medical Solution

The next phase and the ultimate resumption of a more normal economic cycle will require the third supporting condition – a medical solution to the pandemic, which may not be ready until well into 2021. Nonetheless, we see near-term economic momentum developing with mild, if any, inflation as consumers and businesses adjust to the overhang of the virus.

Even before the pandemic, several structural forces were converging to keep the interest rates “lower for longer”. In addition, given extended valuations and questions about whether future earnings would deliver, many investors were reevaluating both the level and the nature of their equity allocations as well as expressing concerns about the length of the economic cycle. As a result, we could see a sharp interest in assets that offered a measure of diversification. These core trends are unlikely to be reversed no matter the outcome of the election.

The US election adds a degree of event risk since a quick resolution is not expected. In addition, dramatic policy changes may be in the offing. Markets are pricing in some risk of a disputed election and resultant volatility in the weeks beyond the election day. We think this is a rational investor response given the critical importance of the swing states (those that could be reasonably won by either candidate) and the potential for a contested election.

Since the Bush-Gore 2000 election, results in a handful of swing states have been determining victory or defeat in the national election, typically by tight margins. At the same time, elections for three or four of 100 seats will set the control of the Senate. The ultimate outcome of these elections is extremely difficult to predict. Therefore, we do not think either party can legitimately claim victory the morning after election day, especially if the outcome is based on narrow victories in two or three states.

Election Implications

While election uncertainty is high, we think it is prudent to prepare for a Biden administration and consider the sector implications stemming from his policy proposals. Backed by a Democratic Senate, Joe Biden should move forward with his agenda including reforming corporate and personal taxes, allocating US$2 trillion of new spending on clean energy and widening access to the Affordable Care Act. The increase in spending would favor fossil-fuel-light technologies, infrastructure and health care stocks (even if the government would restrict drug prices). Non-US equities as well as industrials and dividend-paying companies appeal to us as well.

If Mr. Biden wins but the Republicans hold the Senate, the new administration could still achieve its agenda albeit at a smaller scale. We would still favor fossil-fuel light companies and those with rich dividends, but the health care sector would see a much smaller boost.

Regardless of the sector implications, we expect short-run volatility in the broad market until a clear winner emerges. In an average election, market volatility tends to increase as voting day nears and then quickly resolves once a clear winner emerges. Once investors have a reasonable prediction of the ultimate winner, volatility tends to fade.

The 2000 Bush-Gore election, when results were not available for over a month, is the precedent for the 2020 election. Today, polls are tight, and each party is prepared to legally challenge the results in swing states. Consequently, state officials will be understandably reluctant to certify results until the voters’ choice is clear. The market anticipates volatility as evidenced by the forward VIX curve, which shows an elevation in implied volatility in October, November and early December and a moderation only in January. For sure, markets are expecting volatility and we concur with this prognosis.

Investment Implications

Another way to look at investor expectations is through our Market Regime Indicator, which helps us to monitor whether investors overall are in a risk-seeking or risk-avoiding mood. Critical inputs to the model are implied volatility in currencies, implied volatility in equities and spreads on risky debt. This proprietary metric more recently backed-off the March and April crisis levels to the upper end of a normal risk regime. In other words, although risk sentiment improved, it remained modestly elevated compared with the longer-term trend.

Considering macroeconomic and market environments, we are broadly neutral in our active asset allocation (on a directional basis) and prefer to take relative-value positions from a six to nine-month time horizon. In equities, we are overweight US large cap companies at the expense of US small caps. Large cap stocks enjoy strong earnings and sales expectations and until very recently had a strong momentum tailwind. However, we are underweight real estate investment trusts given the impact of COVID-19 on the lodging, office space and retail sectors. We also are a bit overweight in European and emerging market stocks.

From a relative value fixed income perspective, we are underweight core bonds, recognizing low yields on government securities, in favor of investment grade credit and high yield bonds. We like the stability of coupon income in a low yield environment and are encouraged by the improving macroeconomic backdrop. One caution on high yield, however. Be mindful of exposure to energy credits since the presidential campaigns take distinct views on future fossil fuel policies. Details on our current positions may be found here.

Policy issues on Environmental, Social, and Corporate Governance (ESG) and equality in retirement plans’ tax structure simmer below the headlines. We expect to hear more from policymakers on the use of ESG in retirement plans during the year ahead. Reaction to the Department of Labor’s proposal has been very negative since it effectively precludes the inclusion of ESG funds in retirement plans due to, among other barriers, significant new governance procedures and documentation requirements. Many industry experts were surprised at the restrictive proposal, noting that it was at odds with the more permissive guidance on private equity.¹ A Biden administration may be more receptive to ESG since it may become one aspect of a larger focus on climate change initiatives.

More likely, a Biden administration coupled with a Democratic Senate would enact tax increases on highly compensated employees to pursue income equality in retirement plans. Several items are under discussion, including changing the tax treatment of defined contribution plans from a tax deferral to a tax credit system. This idea had little traction in the past but now opens the door for other tax increases for highly compensated employees – for example, capping benefits, limiting catch-up contributions, reducing compensation limits or prohibiting Roth conversions – i.e., moving all or part of the balance of a traditional IRA into a Roth IRA. We will be monitoring proposals for plan design under a possible Biden administration.

Actions for Investors

Considering all the economic, pandemic and election-related uncertainties, our advice to investors is to separate the immediate risk of market volatility from longer-term implications. Specifically, some investors will want to take protective action or raise liquidity in the next 90 days, and some will want to focus on the medium- to long-term view. As we see it, both perspectives are valuable and are in the best interest of plan participants.

If volatility or liquidity is an issue for your portfolio as the year-end approaches, we think Treasuries will provide good liquidity as well as act as a good tail-risk hedge. Gold, defensive currency pairs and cash equitization may also be good strategies in the very short run. With the long term in mind, we believe the considerations described in Figure 1 are important to evaluate. We welcome the chance to discuss these issues in your context.