The U.S. Presidential Election: A Brexit Redux?

By any measure, this has been an unusual and highly contentious U.S. presidential election cycle. Many Americans will head to the polls next Tuesday feeling caught between a rock and a hard place, forced to choose between two of the most unpopular candidates to vie for the Oval Office in recent history.

Financial markets have become increasingly unsettled during the last week of the campaign. Stocks fell and safe haven assets such as Treasury Bonds and gold rallied as news broke that the FBI would continue its probe into Mrs. Clinton’s emails. Since then, stock markets have continued to sell off, and Mrs. Clinton’s once substantial lead appears to have evaporated. Many are drawing comparisons with the UK’s unexpected decision to “Brexit” the European Union, which roiled financial markets in late June.

So, if stock markets were able to recover their poise so quickly after Brexit, why do financial markets seem to be so suspicious about the longer-term impacts of a victory for Mr. Trump? Much of this presidential debate has been devoid of substantive and detailed policy recommendations by either candidate. Therefore, the future remains unusually vague so close to voting day, regardless of who wins. It has been especially difficult for capital markets to handicap the implications of a Trump presidency. His positions have been deliberately hazy and often contradictory, and he has surrounded himself with a team of advisers who emanate from outside the political mainstream. For markets, this spells uncertainty.

To add fuel to the fire, many worry a Trump election may lead to a sudden change in the direction of Federal Reserve policy. Central bank programs have dominated market movements since the Great Financial Crisis, and the Fed’s stance of driving interest rates down to unprecedented levels has helped propel stock markets higher with lower volatility. Deriding central bank actions as politically motivated, Mr. Trump has implied that he would consider appointing a more hawkish Federal Reserve chairperson when Mrs. Yellen’s term expires in 2018 (or even sooner). The Federal Reserve has strongly hinted it will raise interest rates in December, and markets are now rattled that there could be an unexpected change in the trajectory of this path.

Prior to this latest plot twist, investors were also concerned that an extreme outcome skewed in the other direction—a landslide victory from Mrs. Clinton leading to a Democratic reclamation of both the Senate and House—would mean carte blanche for the executive and legislative branches to gravitate toward the Bernie Sanders/Elizabeth Warren agenda of higher taxes and greater regulation.

In the near term, markets find themselves rooting for a tempered form of gridlock, where policy uncertainty does not cloud an overall assessment of future fundamentals. Over the long term, the market will be looking for signs of pro-growth initiatives, which are interpreted by many investors to be a reduction in taxes and regulation and an endorsement of free trade. While both candidates have voiced concerns about free trade, they differ substantially on the issue of taxes and regulation.

Some common ground does appear to exist on both candidates’ vaguer-than-usual agendas on the need for more expansionary fiscal policy to stimulate economic growth; both highlight infrastructure spending, and in the case of Mr. Trump, a reduction in taxes. The idea that fiscal deficits might begin to expand next year regardless of which candidate emerges as victor, along with growing awareness that global central banks are reaching the limits of their effectiveness, are providing a tailwind behind rising interest rates. The yield on the 10-year Treasury bond has risen by nearly 0.50% to 1.80% since its low in the immediate aftermath of Brexit.

For stock markets to continue to progress as long-term interest rates rise, corporate America’s earnings base needs to grow again. Against a backdrop of uneven but steady economic growth, a stabilization in oil and other commodity prices, and a narrowing of corporate credit spreads, there are tentative signs that growth might be occurring, breaking the “profits recession” of the last several quarters.

This election could provide ample opportunities to increase exposure to stocks in portfolios. We are poised to leverage our discipline; however, given the potential for a large adverse reaction to a Trump victory, we are waiting until after the election to execute.

In a broader sense, this U.S. presidential election has been a microcosm of a much larger, global theme: politics are increasingly a place for the “haves” to wage war on the “have nots,” rather than a battleground for those aligned with the more traditional left and right political spectrum. Brexit highlighted a gross underestimation of voters’ desire for change, and many see this theme carried through in the popularity of Mr. Trump’s campaign, which many dismissed as a farce right up until he seized the Republican nomination.

The candidates have been cast in this light regardless of their stated policies. As a recent “Buttonwood” article from The Economist pointed out, voters’ opinions of the candidates are inherently contradictory. Mr. Trump, the champion of the blue-collar nativist, could impose tariffs that would damage the purchasing power of the poor. Mrs. Clinton, often labeled as the “Wall Street candidate,” argues for stricter taxation across the board of those in the highest income bracket.

Our 2017 Capital Markets Forecast explores this theme in greater detail: addressing the rising tide of populist sentiment and identifying those countries that are making greater progress in escaping its contractionary grip. Policies which focus on productivity growth, structural reform, and entrepreneurialism offer ways to treat the underlying causes of voter angst by promoting the aforementioned pro-growth initiatives which are key to higher expected returns in the long run.

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