How the election outcome may influence investors and markets

Throughout this year, investors have been fixated by the impact of the COVID-19 pandemic on the economy and the policy response to it. By comparison, markets have not reacted to polls that show Democratic presidential nominee Joe Biden with a large lead nationally over President Trump and the possibility of a “blue wave” sweep of Congress. 

At first blush, this is surprising considering that the outcome could be a game-changer from the economic policies pursued by Trump and congressional Republicans. However, one possibility is that investors are not convinced that the polls are accurate.

According to a CNN report, the performance of the stock market has a reliable track record of predicting election outcomes: When the S&P 500 Index falls in the three months leading to the presidential election, the incumbent president has lost the election 88 percent of the time. This time, the market is virtually unchanged over the last three months, which suggests investors think the outcome is too close to call.

If Trump pulls off another upset victory, many observers believe the stock market will rally because it would ensure policy continuity, especially as regards the likelihood of future tax cuts. However, Trump’s reelection probably would not have as large of a market impact as his election did four years ago, when he was given little chance of winning. 

By comparison, there is a disparity of views about how the stock market would react to a Biden win. One reason is that Biden’s fiscal plan calls for both increased government spending and increased taxes for corporations and households earning more than $400,000 annually.

Another consideration is that the legislation that is ultimately enacted will hinge on whether Democrats gain control of both houses of Congress. In this regard, investors will be focusing on the results for the U.S. Senate as well as the presidency.

Those who see a market sell-off believe investors will react negatively to the prospect of increased taxes. Biden’s plan calls for the Tax Cuts and Jobs Act to be repealed and for the corporate tax rate to be boosted from 21 percent to 28 percent. This is estimated to reduce earnings-per-share of S&P 500 companies by 5 percent – 9 percent depending on whether it is fully implemented or pared down. 

In addition, one risk is there could be a near doubling of the tax rate on capital gains and dividend income from 24 percent to 43 percent. If so, investors could take capital gains before year’s end. 

The counter argument is that the impact of tax hikes is likely to be temporary, and investors ultimately will focus on the effect that stepped-up government spending will have on the economy. Economists at Goldman Sachs, for example, indicated that a Biden win and blue wave would likely prompt them to upgrade their forecasts for the U.S. economy. They believe it would increase the probability of a fiscal stimulus package of at least $2 trillion being enacted in early 2021, which would then be followed by increased spending on infrastructure, green energy, health care and education.

The worst outcome for the markets is widely considered to be a contested election that drags on for weeks. The last time this happened was the Bush v. Gore contest in 2000, in which the outcome took five weeks to determine. During that spell there were numerous recounts and court rulings that added to market volatility, and the S&P 500 Index fell by nearly 8 percent. If anything, the outcome this time could be more contentious and volatile, especially if Trump is unwilling to accept the final verdict.

Finally, weighing all of these possibilities, what should a prudent investor do once the outcome of the election is known?

I stand by the recommendations I gave four years ago. First, don’t overreact to the announcement of a winner. Recall that many people believed a Trump victory in 2016 would cause the stock market to plummet, and the initial market response was a nearly 900-point drop in the Dow Jones Industrial Average. It was then followed by a massive rally that lasted into 2018 as investors anticipated tax cuts and deregulation would generate stronger economic growth.

Second, focus on the likely economic policies that will be enacted and recognize that the devil is often in the details. At this juncture, it is too early to know what legislation will be forthcoming and what will be pared down or bypassed. That’s why the outcome of the congressional elections matter so much.

Third, stay objective and park your politics at the door when investing. While the stock market reacted favorably to the prospect of tax cuts and deregulation four years ago, the ensuing trade war with China contributed to heightened market volatility. In the end, people are more likely to make better investment decisions if they are flexible and open to a range of possibilities than if they are rigid in their beliefs about what will happen.    

Nicholas Sargen is an economic consultant and is affiliated with the University of Virginia Darden School of Business. He is the author of “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”