Why investors should avoid assumptions about the effect of presidential elections on the market
Two Key Observations and a Caveat on the 2020 Election
Observation 1: Markets Are Pricing in an Uncertainty Premium
As strongly as markets have performed since the pandemic-related turmoil in March, they are still pricing in an uncertainty premium, according to Kewjin Yuoh, Lord Abbett Partner & Portfolio Manager. “Any presidential election presents investors with event risk, and this may result in market volatility,” Yuoh said.
The risk that an unexpected event will affect asset values was especially evident in 2016. In the run-up to the election, the S&P 500® Index declined approximately 4% in the two months prior to the November 8 election. The CBOE Volatility Index (VIX), a measure of implied volatility, climbed steadily over the same period. With the election of President Donald Trump, the volatility continued, though it was short-lived.
Of course, investors may not be rattled much by ups and downs ahead of this year’s election, given their recent experience. We believe the VIX is unlikely to approach the level seen in March 2020.
Figure 1. Volatility May Rise as the Election Approaches
Of course, the extent of the risk surrounding the November election may also depend on other considerations, including valuations and economic conditions, said Yuoh. But expect some volatility in the run-up to the election, and possibly in its wake, regardless of the outcome.
Observation 2: It Appears Unlikely that Tax Rates Will Go Down
The two parties have traditionally taken different approaches to tax policy, but given the federal government’s extraordinary fiscal deficits resulting from the Coronavirus Aid, Relief, and Economic Security (CARES) Act and other spending, tax cuts are probably off the table, regardless of November’s outcome. While President Trump may want to leave tax rates unchanged, a win for Joe Biden would probably mean increases of some kind, according to Dan Solender, Lord Abbett Partner & Director. “Given the size of the deficit, it’s hard to imagine that tax rates could come down, even if that's what the Trump Administration wants, because the deficit's so big it has to be financed some way.”
Tax policy could also have particular implications for the municipal bond market, Solender said. Higher federal tax rates on upper-income earners could further boost demand for municipal bonds. This has been one impact of the cap on the federal deductibility of state and local taxes that took effect in 2018 as a result of the Tax Cut and Jobs Act of 2017. Since then, wealthier residents, especially in high tax states such as New York, New Jersey, and California, have been particularly motivated to purchase municipal bonds as a way of reducing their higher federal tax liability. “Additionally, corporate tax rates were reduced with the 2018 tax bill and that reduced municipal demand for banks and insurance companies,” said Solender. “If corporate tax rates go back up, that could bring that demand back and provide more support for the municipal bond market to perform well.”
A Caveat: Impacts of Presidential Elections on the Market Are Unpredictable
Many investors believe that markets like divided government. The theory is that with each party in charge of part of the government, big changes in policy to the right or left are unlikely. “While this has some intuitive appeal, there is no support for this in the data,” said Giulio Martini, Lord Abbett Partner & Director of Strategic Asset Allocation. A divided government hasn’t been associated with better stock market returns, either before or after elections.
Regardless of whether government is unified by Party or split, stock market returns in the 12-, six-, and three-month periods prior to the presidential election tend to be below average. The year after presidential elections has also tended to have sub-par returns (See Figure 2).
Figure 2. A Look at Market Returns Before and After Elections
Summing Up
Presidential elections present investors with event risk, and given the unusual circumstances surrounding this year’s contest, investors should expect volatility to rise as November 3 approaches. While the two candidates represent broadly different approaches on a wide range of issues, one area where they may end up in a similar place is with respect to the direction of tax rates. Given the size of the federal budget deficit and total debt, it seems unlikely they will go down. While they also may not go up if President Trump is re-elected, an increase is likely if he loses. Regardless of this year’s outcome, investors would be unwise to make large bets on either possibility. History suggests that while elections affect market performance, other factors obscure the effect of a presidential election, so its impact is ambiguous.
Source: Lord Abbett
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