Investment strategy bulletin  

12/10/2016

US presidential election: potential market impacts

US election.JPGIn what has been a particularly political year, the forthcoming US presidential election is now drawing much of the market attention. Indeed, following the UK’s unexpected vote in favour of “Brexit”, investors seem more concerned about the re-emergence of protectionism around the globe, and the likely consequences that such a development would have on financial markets.

In a previous bulletin, we exposed why a Clinton victory is our base case scenario.  The first two debates and ensuing polls gave Mrs Clinton a significant advantage over Donald Trump. These developments continue to support our stance. Nevertheless, as the voting process cannot be anticipated with accuracy, the consequences of a potential Republican victory should be considered.

The disruptive nature of a potential Trump presidency makes it crucial from a portfolio positioning standpoint, as it could imply the end of well-entrenched trends such as yield-chasing and emerging market stabilisation depending on his ability to pass his most radical proposals.

SCENARIO 1: A CLINTON VICTORY (BASE CASE)
Former Secretary Clinton’s campaign suggests a bolstering and expansion of Obamacare, minimum wage legislation and a continued focus on renewable energy and drilling restrictions, which would weigh on pharmaceuticals, consumer discretionary (restaurant/retail), energy (shale industry in particular) and utilities (higher carbon emission and efficiency standards). Albeit already somewhat priced-in, as evidenced by relative sector performance, these pressures should strengthen if Clinton is actually elected.

One of Clinton’s key policy ambitions is a large-scale infrastructure program. However, as highlighted in our previous bulletin, a Clinton victory would  likely come with a divided government. Expectations regarding the final size of such a program thus stand to be disappointed. In addition, it should be at least partly funded by a higher tax rate on high income brackets and estates, in an attempt to limit the impact on the US public deficit.

As for inflation, some pressure might arise from the introduction of a minimum wage. Although, here again, political division will likely prevent broad-based application of such legislation, a gradual implementation at the federal and state level cannot be excluded. All things being equal, we think that a Clinton victory might support inflation break-even and nominal rates, but not to the extent of generating a significant trend in the Treasury market.

All told, with a Clinton victory remaining our and the market’s base case, and pointing to policy continuity vis-à-vis the current Obama administration, we expect no major implications in terms of market direction. Rather, the few trades that did start to price in a Trump victory would reverse. For instance, the rally in US dollar against Mexican peso – the clearest reflection of rising Trump risk – rolled over after the first debate. Another episode of rising Trump polls would offer a better entry point to investors who would like to bet on a Clinton victory.

SCENARIO 2: A TRUMP VICTORY
First and foremost, a Trump victory would translate into higher risk premiums, in the US but also more broadly, given the uncertainties surrounding his political program and the larger policy changes involved. The likelihood that a Trump victory be associated with Republicans holding on to their majority in both the Senate and the House would facilitate adoption of his main policy positions. Against this backdrop, Treasuries are likely to initially benefit from safe haven flows.

Medium-term though, once the dust settles, there are many aspects of the Trump program that should drive US yields higher, notably a larger  public deficit (with infrastructure investments and tax cuts not funded by a rise in revenues), the appointment of a more hawkish Fed Chairman to replace Janet Yellen, and upward pressure on wages and imported inflation due to immigration and trade barriers. The inflation break-even rate should thus rise more significantly than in our base case scenario. More generally, a higher public deficit and the increased uncertainty on monetary policy should imply a normalisation of the term premium, and, in turn, a steepening of the yield curve.

Trade policy, the field of candidate Trump’s most radical proposals, will be key to foreign exchange markets. There is much debate as what Trump would actually do if elected. That said, the US President does have broad-based authority under existing statutes to unilaterally impose significant barriers on international trade. Larger fiscal stimulus, repatriation and protectionism should support the US dollar, particularly against the Mexican peso and the renminbi. Indeed, Mexico and China were explicitly targeted by the Republican candidate when he suggested dramatic changes in trade agreements, with imports tariffs of  respectively 35% and 45% mentioned. Volatility and losses on these currencies should be exacerbated – China might retaliate by ending its intervention in the currency markets – and are likely to spread, at least partly, to the rest of the emerging space.

In equity markets, following an initial bout of volatility, a reduction of the corporate tax rate (from 35% to 15%) would be supportive. Sector-wise, the main themes of the Trump campaign suggest outperformance of big pharma (repeal Obamacare), financials (dismantle Dodd-Frank), materials (impose tariffs on Chinese steel and invest in infrastructure), traditional energy (support energy production and deregulate exports) and information technology (offer a repatriation holiday on foreign earnings). Expectations of a boost to the domestic economy, albeit short-lived, should lead to an outperformance of the US equities, especially relative to emerging markets.

For credit, higher financing costs are likely to be somewhat offset by the corporate tax cut. Despite high leverage, coverage of interest expense should thus remain sufficient to avoid a surge in defaults.

Finally, within the commodity complex, gold might initially benefit from investor interest as part of a risk-off episode, but the precious metal should then be capped by the rise in US interest rates. As for oil prices, the opposite positions of the two candidates on the shale industry (with Clinton arguing for greater regulation and Trump offering little support to renewable sources of energy) make for very divergent prospective US production. The US being the “swing” producer, oil prices would likely be lower in the case of a Trump presidency that incentivizes shale investment.

In conclusion, while a Clinton victory would not markedly change current market trends, a Trump victory would call into question the two most important forces currently driving financial markets. Higher nominal rates and a steeper yield curve would challenge the viability of the yield-chasing approach. And a rise in protectionism would hamper the stabilisation of the emerging markets complex, just as these economies are beginning to recover. The importance of the outcome of the US presidential election should thus not be underestimated.



 

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