Pence Perspective | Q4. 2020
Bottom Line Up Front:
At the beginning of the year, there was a broad consensus on Wall Street that a Biden presidency was the largest looming risk to equity markets and existing valuations. Over the last month the market has taken a decidedly different tone. As former-Vice President Joe Biden’s general ballot lead has expanded – now sitting at eight points in the Real Clear Politics Average as of October 26 – markets have rallied around the likelihood of a “Blue Wave” and the prospect that has for forthcoming stimulus as well as a more orderly election process due to the magnitude of Biden’s lead. For markets, the most important part of the election is that it will be uncontested and over.
We do not share the view of a landslide election. We cannot predict the winner but we do not see this as an overwhelming Blue Wave – it will likely be closer than most think. The President of the United States is chosen via the Electoral College which meets on December 14, not the popular vote, and in the states that matter the race is much closer than it is on a national general ballot. President Trump’s approval rating is one point higher today than it was at the end of January 2017, he possesses an excited and steady base, and a majority of the swing states are within the margin of error for a two-candidate election.
Market performance over the last few months has been highly correlated to progress on talks for another round of fiscal stimulus. Given the emerging consensus view that a Blue Wave would result in more spending and less gridlock, a close election without a clear, indisputable result likely means a volatile market. Therefore, we have been proceeding with caution and think it is best to be prepared for either outcome and some volatility in the process.
It is important to remember that if Covid-19 didn’t stop the U.S. consumer, it’s hard to imagine the president could either. No matter who he is. People don’t shop in the red aisle or the blue aisle, they shop in the human aisle. Despite historic drops in retail activity, retail sales were above Pre-Pandemic levels just four months after the shutdown. A Joe Biden presidency is broadly viewed as a bigger boost to fiscal spending while a Donald Trump presidency would be more supportive of existing valuations in equity markets. Both candidates are generally supportive of growth just with different methodologies of doing so.
Markets and Economy
Markets have been driven by record levels of stimulus, a historically accommodative Federal Reserve, and Covid-19 being less destructive for S&P 500
corporate performance than anticipated. Second quarter earnings season largely came in better than expected with 62% of companies beating sales estimates and 83% surpassing earnings expectations. As a result, analyst expectations for profits in the third and fourth quarters have risen substantially – the third quarter has been
revised to a -18.4% decline, better than the -21% expected decline expected at the end of September, while the market anticipates a return to profit growth by the first quarter of 2021.
The early stage of the recovery has been much more robust than expected, leading the Federal Reserve (Fed) and International Monetary Fund (IMF) to upgrade their forecasts for domestic growth this year. Corporate profits didn’t drop as much as forecast and there have been a number of economic datasets that have displayed “V-shaped” recoveries such as retail sales and most aspects of housing – home sales, homebuilder confidence, and housing starts are all at or near record levels thanks to historically low interest rates, while a robust stock market pushed American household net worth up by $7.6 trillion in the second quarter to a new record. Manufacturing has shown robust strength, very much in contrast with traditional recessionary dynamics. Even more surprisingly, despite losing as many as 22 million jobs at the peak of the pandemic, average credit scores in the United States are higher today than they were a year ago as individuals largely used stimulus to pay down debt or save. Americans reduced non-mortgage debt at a 6.6% annual rate in the second quarter, and including mortgage debt total household non-financial debt grew just 0.5%, the lowest rate since 2012.
Other indicators haven’t had as robust of a recovery. Jobless claims are still very historically elevated and a growing share of the workforce has been unemployed for more than 27 weeks. Job additions have also moderated significantly in recent months with a rising proportion of permanent layoffs, although 11.4 million jobs were added between May and September. As we proceed into the winter months and Covid-19 cases continue to rise that moderation is likely to continue as certain sectors such as travel and hospitality continue to sit on the sidelines.
It has become increasingly clear that as the CARES act stimulus fades, the pace of the recovery is beginning to stall as well. According to a late August survey by the NFIB, one in five small businesses said they would have to close their doors if economic conditions don’t improve in the next six months. A majority of PPP borrowers it surveyed, or 84%, said they have now used the entirety of loans they received earlier, and 44% said they would apply or reapply for a second PPP loan if one becomes available. We believe another round of stimulus is required to bridge the recovery.
As individuals used their stimulus checks and the enhanced unemployment benefits expired without a renewal, the fiscal environment deteriorated over August and September. The median unemployment recipient, as tracked by the JPMorgan Chase Institute, had spent two-thirds of the savings accumulated during the previous four months. Incomes in August fell 2.7%, and the savings rate declined to 14% – still very elevated historically, but substantially below the savings levels in the early stages of the pandemic.
All of this is occurring at a point in time where new Covid-19 cases are rising, both domestically and globally. As of October 20, 42 states have a 7-day average new cases number in excess of their 14-day average, indicating an acceleration in new positive cases. Both of the United States and the European Union including the United Kingdom have surpassed previous record daily case numbers, resulting in Ireland reinstituting a 6-week lockdown, while the United Kingdom, Spain, France, and Italy have all introduced measured restrictions as hospitalizations rise.
While the theme up to this point has largely been “Stimulus vs Virus” – that more stimulus has been pumped into the economy than damage done to it – this has notably shifted. It is our opinion that if we don’t move quick enough there could be more virus than stimulus in the economy. With the fiscal effects of stimulus progressively disappearing and Covid-19 cases growing quickly worldwide, the spotlight has been on the likelihood of another round of stimulus in order to kick start an economy that’s beginning to stall. This is a large part in why markets have been so driven by talks on stimulus.
Wall Street’s Expectations of a Biden Presidency
Wall Street has also shifted in terms of their outlook of a Biden administration on corporate profitability and domestic growth. A Blue Wave is now widely considered a bull case for equities as the Democrats largely support a substantially larger stimulus bill than Republicans as a base case, with much broader and less targeted spending in addition to a full repeal of SALT tax limitations. With control over the House and Senate passing legislature becomes much more straight forward and markets have largely operated on the hopes of more stimulus since May.
While Vice President Biden has announced intentions to raise the corporate tax rate to 28%, up from 21% currently, he has not publicly clarified a position on the tariffs. However, considering the majority of Wall Street banks are expecting somewhere between a softening of the tariffs and a full repeal, we believe a change in policy is likely. Goldman Sachs, for instance, is modeling a 28% corporate tax rate – which would reduce 2021 profits by about 9% – but also expects a full repeal of the tariffs within the first year of a Biden Administration, resulting in a modestly positive effect on earnings. There are question marks around the popularity of such a move considering more than two-thirds of Americans have a negative view on China. A Trump win would likely result in a more hardline China stance which would be a negative to Wall Street.
The Maps & Issues
Given the reliance that markets have had on existing stimulus and how correlated index performance has been on day to day progress for another round of fiscal measures, investors have increasingly focused on the likelihood of a Joe Biden victory. The way the map is currently structured, if Donald Trump wins all of the toss up states but Biden comes out on top in the states currently “Leaning Democratic” Biden would win the election. A Biden presidency, coupled with a blue Senate, likely means larger levels of stimulus and fewer roadblocks towards enactment in a period where time is really of the essence.
Prior to the onset of the Covid-19 pandemic Donald Trump had a roughly 57% chance of retaining the presidency according to PredictIt. As of October 26, that stands around 41% while FiveThirtyEight has Trump at a roughly 12% chance according to their statistical model. Former Vice President Biden’s general ballot lead, while lower than at previous points in the cycle, is outperforming Hillary Clinton’s lead by about four points relative to this time in 2016.
President Trump won in 2016 largely by overperforming the polls in the states that perennially matter such as Florida and Ohio while flipping Wisconsin, Michigan, and Pennsylvania – all of which hadn’t voted for a Republican since at least 1992. His hopes of a victory largely hinge on his ability to do that again.
For this election, there are two issues: The Economy and Coronavirus. For individuals who have the virus as their top issue, Joe Biden is their overwhelming candidate. For others who view the economy as more important, Donald Trump is the favorite but by a smaller margin than Biden’s on Covid-19.
Five times this year, The Wall Street Journal/NBC News poll has asked voters who they think would be better at handling the economy, Mr. Trump or Democrat Joe Biden. Five times they have named the president, by margins ranging from seven to 11 percentage points. Plenty of Americans, in short, appear to buy the president’s argument that the economy was in fine shape before the coronavirus hit, and that it isn’t his fault it has plunged since then.
However, for recent elections “It’s the Economy, Stupid” has had substantially less pull for voters than in previous cycles. In 2018, voters overwhelmingly said they thought Republicans would do a better job with the economy, yet the party lost 41 seats in the House that year.
For most voters, if Covid-19 is not their top issue it is a close second. Voters are viewing Covid-19 and the economy in largely the same vein; that it’s difficult to get the economy back to a pre-pandemic normality while we are still in the midst of said pandemic. Joe Biden leads nationally on virtually every issue other than the economy such as health care, climate change, race relations, and an ability to unite the country.
However, the President is not elected via the popular vote and, in our view, this is an election that is going to be all about the margins. There are 10 states that matter in this election, and new Covid-19 infections as a share of population are at or near all-time highs in four of them – with Wisconsin being in the midst of one of the worst epidemics in the country, reporting numbers just mildly below the peaks of Florida and Arizona in July. Wisconsin was a major flip for Trump in 2016, so a current Covid-19 outbreak of this scale is a negative for his chances there.
All in all, in our view, the absolutely key states to watch are Pennsylvania, Arizona, Florida, as well as – to an extent – Georgia and North Carolina which have both emerged as potential toss ups despite solidly Republican electoral histories. Pennsylvania is likely the key to an electoral victory and Joe Biden’s lead there has narrowed in recent days.
As of Oct 21, Joe Biden leads by about four points in the Real Clear Politics (RCP) Average for Pennsylvania, down from a high of seven points on Oct 12. In the six
top battlegrounds, Donald Trump is actually polling better with Joe Biden today than he was with Hillary Clinton at the same juncture in 2016 which does quite a bit of damage to the view of a landslide Biden victory.
And while Trump still has resounding support from the farmers, leading Biden by 73 points nationally, Trump’s base of support in other areas has shifted. While he has lost support with Whites (especially in Women, and non-college educated), his support among minorities has shifted substantially. According to FiveThirtyEight, he has gained 11 points in Black support, nationally, while his support among Hispanics has increased by around 14 points. In states like Florida, where about 20% of the electorate is Hispanic, this is incredibly important. An NBC/Marist poll in September found Donald Trump leading Joe Biden in that category. In 2016, Hillary Clinton’s lead with Hispanics in Florida was 27 points. This also matters in states like Arizona, which Trump narrowly carried, and Nevada, which Hillary Clinton won by a little over 2 points in 2016. Nevada had one of the more onerous and drawn out lockdowns relative the nation, and the rebound has lagged which has emerged as a potential swing to the Trump campaign.
All in all, however, what really matters is the performance of the Democrats in the Senate as that is where legislation is written and passed. A Joe Biden Presidency loses much of its bull case for markets if the Republicans maintain a majority in the Senate and therefore control the extent to which a President Biden can push through his agenda. The Democrats currently have 47 seats in the chamber and the Cook Political Report favors them to regain the majority which has eluded them since the 2014 midterms, but the margins matter.
Looking at the map in terms of net approval rating shows a deep deficit to overcome for the Republicans in order to maintain the majority. 10 of the 23 seats that Republicans have up for re-election are in states with a net disapproval of Trump, with 7 considered a toss-up. Maine and Colorado are likely pickups for the Democrats, while Arizona Senator Martha McSally lost her election in 2018 and looks like another possible pickup. On the Democratic side, only Sen. Doug Jones (D., AL) is a state with a positive view of Trump and looks a near certainty for a flip, while Sen. Gary Peters (D., MI) has recently emerged as a worry for Democrats.
Put this way, it demonstrates the importance of a strong showing in Arizona, North Carolina, and Georgia as a loss there for Trump would likely mean a loss of both the Presidency and the Senate majority. Lindsey Graham’s seat in South Carolina has emerged as a toss-up after having one of the more hypocritical statements regarding the nomination of Amy Coney Barrett and is another seat to watch, but we view a defeat there as unlikely.
All in all, it’s not too difficult to envision a scenario where the election results in a net-pickup of 2-3 seats for the Democrats – getting them to a majority including the Vice President or just short of a majority. For the balance of markets that are increasingly focused on stimulus, the size of this majority is incredibly important as policy differences between Republicans and Democrats in the Senate are greater than the differences between the presidential candidates. A 3-4 seat majority for the Democrats likely means a stimulus bill somewhere between $2.5 – $3.0 trillion, while a smaller majority would likely lead to more targeted measures closer to the $500 billion – $1.0 trillion number signaled by Senate Republicans. Additionally, the smaller a potential majority, the more reliant a Biden administration becomes on more moderate Senators in the caucus like Joe Manchin (D., WV) and Kyrsten Sinema (D., AZ), which could alter policy from what was conveyed in the Democratic Platform as was seen in the attempted Affordable Care Act repeal in 2017.
The most substantial Biden policies – a reversal of the 2017 Tax Cuts and Jobs Act (TCJA) for corporations and individuals making more than $400,000 in income and an increase in the Capital Gains rate for individuals with more than $1,000,000 in income – can be passed through the “reconciliation” process meaning a 51-vote majority is all that is required.
Other Democrat policy objectives, such as an infrastructure plan structured around green energy, a $15 minimum wage by 2026, $10,000 in student debt forgiven per borrower, and budgetary reprioritizations would still be subject to a filibuster – meaning a 60-vote majority would be required in order to pass legislation. An elimination of the legislative filibuster has been a significant topic in this regard, a possibility that progressively diminishes the smaller the Democratic majority is. A survey by the Wall Street Journal of all 47 members of the Democratic caucus found at least five lawmakers who currently oppose such a move, potentially enough to stop the filibuster from being killed outright.
Main Street vs. Wall Street
At this time, we cannot take a view on the election other than it will likely be close. For every national poll that shows a landslide for Biden, there are several details within that show significant regional variations and over the last 4 years in office the Trump campaign has shown a resounding ability to bounce back. As just one example, the President was impeached and emerged more popular.
After the Iowa, New Hampshire, and Nevada primaries Vice President Biden’s campaign was largely considered dead in the water. The campaign finished Iowa less than 1% away from being considered “non-viable”, received no delegates in New Hampshire, and lost Nevada to Bernie Sanders by a margin of nearly 30%. Iowa and Nevada are considered key states in this election, while Senator Kamala Harris never made it to the primary and ended her campaign without a delegate. Prior to South Carolina’s primary, “Electability” was an open question. Neither candidate brought an organic grass roots energy to their campaign and that is the fundamental difference between the Trump and Biden camps.
It is not difficult to envision a scenario where the election comes down to one or two states, and with the recent examples of universal mail-in voting elections going wrong there is every possibility that markets are not accurately pricing in what could very well be a messy election. In Nevada, Clark County conducted a universal mail-in primary where 223,000 ballots – about 20% – were returned undeliverable. A local election in New Jersey ended with 4 people being charged with voter fraud around mail in ballots, while a recent New York primary sent as many as 100,000 ballots with return envelopes imprinted with wrong names, making a verifiable signature impossible.
These are just a few examples of how states that have no previous experience operating universal mail-in elections are not prepared on such short notice. Covid-19 didn’t exist in any significant way prior to December of last year, and the average state still utilizes a benefits system that is 28 years old – which resulted in millions of people failing to receive benefits in the early stages of the pandemic. If an environment arises where the election likely comes down to just a handful of states with what are likely close margins, we would expect a volatile market. In the aftermath of Bush v Gore in 2000, the S&P 500 lost 12% from election day at the peak of the uncertainty.
We still believe equities are the place to be as current conditions are incredibly accommodative for stocks. Good news is considered a boon to growth projections and future valuations while bad news is considered to increase the likelihood and magnitude of further stimulus. The Federal Reserve has committed to a historically accommodative stance on interest rates until at least 2023. We expect a lower for longer interest rate environment, and the Congressional Budget Office (CBO) doesn’t expect the Fed to raise rates until 2026. It’s unlikely that risk adjusted returns lean in the way of fixed income anytime soon given the backstop around equity markets and high levels of investor sentiment.
Broadly, both candidates revolve around fiscal stimulus for the lower income segments of the country, which are the areas that need the most support in the midst of the pandemic. This is also a demographic that is proven to spend when they get a raise. Vice President Biden wants to raise the minimum wage and forgive $10,000 worth of student loans for borrowers. This would result in a 15% compound annual wage increase for federal minimum wage workers between now and 2026, while the student loan proposition would clear the debt of almost a third of borrowers. Biden’s proposed capital gains hike applies only to individuals making over $1 million in income, which represents just 0.1% of wage earners as tracked by the Social Security Administration.
Trump, on the other hand, wants to expand upon the 2017 TCJA to a 20% rate for corporations, authorize the individual tax breaks past 2025, and extend one-time forgiveness of the payroll tax for individuals making under $100,000. Both candidates are proposing pro-growth policies, both have infrastructure initiatives they would like to push, and neither candidate wants to raise taxes for the middle class and below. The average consumer doesn’t alter consumption based on the party in office, and the expanded unemployment benefits show that when you give the lower income demographics a raise, they disproportionately spend and support above trend growth.
We believe it will be a close election which could trigger volatility. Volatility, however, will give rise to opportunity as we will be better able to understand policy preference once the election is resolved. The common elements of both platforms support more disposable income for lower income Americans which means we will focus on looking for opportunities in sectors of the market likely to have relative strength regardless of the outcome.
For our clients with Strategic Asset Management (SAM) accounts where we manage with full discretion, depending on your individual situation, objectives and type of accounts. Due to the increase in expected volatility, we may increase cash or near cash equivalent positions as we evaluate both volatility and value. This gives us an opportunity to mitigate volatility and contested election and possibly to take advantage of clarity once an outcome is determined.
For our clients who hold brokerage accounts, if you are interested in a similar fee-based strategy, please contact your advisor.
If you are not yet a client and are interested in learning more about our services, please contact Milo Reyes at (949) 660-8777 extension 129 or Ramilo.Reyes@lpl.com to schedule an appointment.
We appreciate your trust and the opportunity to be of service.
All the best,