Investment strategy bulletin  

16/09/2016

US elections 2016: more status quo than system reboot

November 2016 elections: state of play. Following two highly volatile primary races, the amount of uncertainty around the US presidential election in November has been unusually elevated. But as the dust has begun to settle, clarity has increased with polls showing a wide lead for Hillary Clinton. Both poll data and other sources, such as prediction or betting markets, suggest that the Democratic nominee is now considered the strong favorite to win the Presidency. Election forecast models such as Nate Silver’s FiveThirtyEight model (which has a strong track record in past elections - unlike individual polls) suggest a probability in the range of 75-80% at the time of writing.

While the race for the White House may be the most consequential, it is not the only important one. Both the Senate and the House of Congress are in play: in the Senate, Republicans hold an 8-seat majority, but will be defending 24 seats, as opposed to just 10 for Democrats. Democrats therefore need a pick-up of 5 seats (or 4 assuming they win the Presidency) to take back the majority. A tight race is to be expected, in which the Democrats stand a decent chance of gaining control.

The House is much more likely to stay Republican: currently split 246-188, the Republican share of seats is the largest since the 1920s. Democrats would need a 30-seat swing to win back the House, a fairly hard task especially considering the unfavourable drawing of Congressional districts. Prediction markets place this probability at just below 20%.

SCENARIO 1: A CLINTON WIN (BASE CASE)
The most likely outcome is therefore one where Hillary Clinton becomes President but the government remains divided, with the GOP managing to hold on to its majority in the House, possibly even in the Senate. We see a Clinton victory as a status quo development. The resultant policy framework would be similar to President Obama’s and the goal of preserving policies already in place such as Dodd-Frank or Affordable Care Act would be an important part of the new administration’s agenda. A Republican-controlled House would prevent aggressive reform proposals from becoming policy. Recent experience has shown how a divided and increasingly polarized government tends to result in stalemate.

Secretary Clinton’s most ambitious plans for a large-scale infrastructure investment program and any expectations for a major dose of stimulus are therefore likely to be disappointed. But with the US economy having recovered a great deal of its lost output and getting increasingly close to full employment, no signs of an urgent need for fiscal stimulus are evident.

After the sharp tightening that took place over 2011-2014, fiscal policy in the US has recently turned marginally expansionary. Together with still accommodative monetary policy, this supports our outlook for continued economic expansion despite the already fairly mature state of the cycle.

In fact, the economic outlook may turn out to be somewhat better than pure “status quo”. Room for compromise could be found on the corporate tax reform issue, given bipartisan support for the idea. A plan similar to that proposed by President Obama, allowing US corporates to repatriate foreign earnings (currently kept overseas in order to avoid a 35% tax rate) taxed at a one-off concessionary rate. The plan envisioned using the proceeds from this repatriation holiday (estimated at just under USD 250 bn) to fund infrastructure investment. Secretary Clinton is likely to aim for a similar compromise, given her stated goal of boosting infrastructure spending.

In the event of a decisive Clinton victory, especially in the case that the Democrats manage to get control of one or both chambers of Congress, a more predictable policy environment would emerge. A united government eliminates the risk of episodes like a debt-ceiling fight and would potentially allow the Democratic administration to put in place a fiscal response if an economic slowdown were to occur – a critical risk-management tool at a time of interest rates just above zero.

SCENARIO 2: A DONALD TRUMP WIN (UNLIKELY, BUT POSSIBLE)
In contrast with the policy-continuation scenario of a Hillary Clinton presidency described above, a Donald Trump presidency (likely to also mean continued GOP control of Congress and Senate) would come with a significant amount of uncertainty - for the US, but possibly also for the rest of the world. Campaign statements in favour of partially defaulting on the national debt or of withdrawing US support for its military allies offer strong evidence that policy predictability would be considerably lower. While market participants have been able to discount such concerns as long as a Trump win remains a remote scenario, this may well change if this assumption gets challenged. A natural market reaction to such an increase in policy uncertainty would be a sharp rise in risk premia.

The most prominent items in the economic agenda of the Republican nominee are the proposed barriers on immigration and trade, as well as large-scale tax cuts (in the order of just below USD 1 trillion per year). Assuming the US economy no longer suffers from significant demand deficiency and is now relatively close to full employment (a view that the Fed also appears to hold) tax cuts of such scale could cause the economy to overheat, triggering an inflation overshoot and sharp interest rates increases. Reduced labour supply would result in a tough adjustment process as employers suddenly face labour shortages and are forced to push wages up. Meanwhile, an aggressive US stance on trade including imposing tariffs would increase the prices of imports, adding to inflationary pressures. A combination of higher inflation, higher rates, and risk aversion caused by a “trade war” environment can be expected to slow down the economy.

Finally, while Hillary Clinton seems likely to re-appoint Janet Yellen as Fed Chair given the Democratic support for current Fed policies and for Yellen’s appointment in 2014, Donald Trump’s stated intention is to replace Yellen when her term ends in February 2018. Republican objections to the Fed’s easing stance were evident in the Senate vote (only 11 Republican senators voted for Yellen’s appointment versus 33 against or abstaining). The preferred candidate is thus likely to be more in line with the current Republican party mainstream, which tends to be critical of policies such as quantitative easing and in favour of earlier and faster rate hikes. We expect that a Fed Chair candidate holding such views would cause the markets to reprice the US interest rates term structure significantly higher from current levels. A more hawkishly-inclined Fed combined with inflationary pressures and overheating risks for the US economy would present a potent mix, threatening to generate significant dollar appreciation.


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