Fate of the markets lies with the Fed more than the White House

In more normal times investors would have spent last week digesting opinion polls and poring over the closing statements from the candidates to be the next US president. Instead, the pandemic remained centre stage as concerns over rising infection rates and renewed restrictions on activity sent markets into a tailspin. The election was supposed to be the defining event of 2020. Like everything else this year, it too has become overshadowed by the virus.

Before last week’s virus-related sell-off, investors had begun to focus on the idea that the election would deliver a so-called “blue wave”, which not only sweeps Joe Biden to the White House but also delivers the Democrats a majority in the Senate and thus control of Congress. Should this materialise, the conventional wisdom is that it would pave the way for a large fiscal stimulus, which in turn would reflate the US economy. The conventional wisdom also holds that this would be positive for equity markets but negative for the dollar (since inflation expectations would also rise).

Maybe. But the experience of 2016 suggests that investors should be careful about taking strong positions on political outcomes and, worse, mechanically translating those to market outcomes. Back then, the consensus was that Trump was unlikely to win, but if he were to prevail then his rhetoric on trade and “carnage in America” would spell disaster for equity markets. We all know what happened next.

With this in mind, three points are worth stressing. First, at the risk of stating the obvious, there is a big difference between the Democrats winning the White House and the Democrats winning the White House and control of Congress. Given how tight the race will be in several states, and indications of a large turnout, we may have to wait until later in the week to get a clearer idea of the political landscape. Even then, the close nature of the election raises the prospect of a protracted legal dispute over the result. Despite all of this, one thing that’s unlikely to happen, even in the event of a “blue wave”, is that Democrats win a filibuster-proof majority in the Senate. Expectations for a huge stimulus package may need to be dialled down.

Second, whatever the outcome of the election next week, there is a risk of exaggerating the implications for the economy and financial markets. Despite their protestations to the contrary, presidents do not tend to have a significant bearing on domestic growth. There is, for example, little evidence that President Trump’s programme of deregulation has boosted economic growth. Meanwhile, although the tone of the debate on trade and international relations would likely soften under a Biden administration, the underlying sources of tension would remain. This is particularly true in the case of China; irrespective of who is in the White House, US-China decoupling is likely to continue over the coming years.

Third, so far as financial markets are concerned, the actions of the Fed are often at least as important as those of the White House. Cuts to corporation tax have played a role in propelling the US stock market under President Trump, but a critical component has been a loosening of monetary policy that has pushed real interest rates to multi-decade lows. In this respect, the question is not so much whether or by how much fiscal policy will be loosened under the next president, but the extent to which this will be accommodated by the Fed.

As it happens, we believe the Fed will continue to pursue policies that keep real rates in negative territory as the US economy continues its slow recovery from the pandemic shock, in which case equity markets should perform well under either a Biden or Trump administration over the coming years. But the key point is that this would be because of actions at the Fed, not the White House. Investors would do well to keep this in mind as the results roll in on election night.