In this quarter’s Chat with the CIO, Eric P. Leve and Frank Marcoux, Senior Vice President, work to navigate the rocky path leading to November’s elections with a focus on the potential investment implications.
September 30, 2020
Eric P. Leve, CFA: First off, shall we agree to keep this to the topics that best serve investors and concentrate on the implications of the pandemic and the upcoming election on the markets and the economy, rather than the politics?
Frank Marcoux, CFA: You bet. While presidents can lead the way on many areas of policy, the economy and the markets tend to work in a much broader ecosystem. And, in fact, the last 50 years have been markedly different than those before. Prior to WWII, ownership of the White House and both houses of Congress was the norm, paving the way for major legislative action like trust-busting, the pro-business 1920s, New Deal, Eisenhower infrastructure, New Frontier, and the Great Society. Now, a cohesive government is more the exception than the rule. This is particularly true over the last 20 years, where the narrower majorities in both houses have meant more gridlock.
Eric: But the data I’ve seen show that the markets are mostly indifferent to politics. The presidency has been largely shared by parties over the past 120 years. Democrats and Republicans have had 56 and 64 years in office, respectively, and it’s been pretty even. Stock market returns under Democrats have been slightly better than under Republicans, but not by leaps and bounds. And the U.S. is different than most every other country... our presidents must contend with the broad powers afforded to the states as well as the authorities of Congress and the Supreme Court.
And yet, there’s been a dangerous evolution under presidents Obama and Trump to expand the use of executive orders, increasing presidential power, and—in some cases—rapidly-changing federal policy. Even though Republicans have traditionally exhibited a tighter hold on the purse strings than the Democrats, COVID changed that dynamic dramatically. These inflated spending rates are likely to continue under either political party until the economy gains firmer footing, and possibly until we have a safe, reliable vaccine and/or the mortality rate due to the virus accelerates its decline.
Frank: The real concern I see here is the potential for market volatility related to the election process itself. Both parties have made claims that could lead their supporters to question the election’s outcome and COVID has created an incredibly-distorted dynamic. Irrespective of the eventual result, this could lead a candidate to prematurely declare victory on election night, beginning a process akin to—but likely worse than—2000. The problem is exacerbated by the variety of voting procedures across the country and the long-term underfunding that has made the U.S. Postal Service potentially ill-prepared for such a test. This may prove a greater test than the 2000 election when the Supreme Court’s decision led to Al Gore’s concession and resolution by the meeting of the Electoral College. In a worst-case scenario, resolution this time could extend into the new year.
Eric: There is nothing straightforward about the current situation within our borders. And, unfortunately, our position as a global leader is in flux as well. The dominance of the U.S. appears to be waning after 70 years.
The international system abhors vacuums and, if the U.S. continues to meaningfully withdraw from three crucial regions—including the Middle East, Europe, and East Asia—those vacuums will be filled by other players. The most likely entrants are China, Russia, and Europe; of these, only Europe is likely to play a constructive role in the international order.
Frank: Eric, are you suggesting that the U.S. will lose its role as global hegemon?
Eric: No, just that our influence might shrink around the edges. Engagement with global and regional partners like NATO and the World Health Organization is critical. Over the past several years we have seen central banks across the globe increasingly hold more euros, gold, and even the Chinese renminbi as part of their reserves. This will likely be a negative for the U.S. dollar at the margin, but most of the world’s trade and financial transactions still remain dollar-denominated.
The real concern I see here is the potential for market volatility related to the election process itself.
Frank: Fair enough. So, let’s turn to the effect on the economy. In February, the economy was already losing steam after enjoying the longest recovery in U.S. history. Unemployment was at unprecedented lows but jobs gains were weakening. Additionally, economic growth was becoming more unevenly distributed with highest growth in the Far West, Rocky Mountain, and Southwest states while the Plains and the Great Lakes regions lagged.
Eric: And then, as we all know now, the COVID crisis provoked one of the largest fiscal responses in history. The CARES Act enacted in late March, and the unemployment benefits from its Paycheck Protection Program, supported consumer spending through the summer. Yet, those programs have been expiring. Fulsome and appropriate follow-up measures are of grave importance not only to the economy but our citizens. Lives are truly at stake.
Going back to my earlier comment about spending and fiscal stimulus, by May, the ratio of federal debt to our country’s Gross Domestic Product (GDP) had nearly reached post-WWII levels. Now, current projections show that the continued coronavirus spending, dwindling GDP, and shrinking tax-revenues will cause the federal debt held by the public to exceed 100% of GDP in the next fiscal year.
Frank: Interestingly, it’s the government’s monetary policies that have contributed positively. The Federal programs to purchase Treasuries, mortgage-backed securities, and corporate bonds were announced on March 23rd. While the announcement occurred several days before the passage of the CARES Act, it convinced investors that the Federal Reserve (the Fed) was going to keep interest rates low for a long time, bolstering stock valuations.
Eric: Even though some investors are still sidelining their cash, those in search of yield are finding that stocks have continued to be compelling compared to bonds. Dividend yields from stocks have remained stable, while bond yields have exhibited a secular decline. U.S. stocks’ dividends offer more income relative to bonds than at any time since 1958. Following on the same theme, economic uncertainty and low real interest rates may provide a tailwind for gold.
Frank: Thinking further on the markets, I’d expect that a post-COVID world means a tepid, long-term recovery along with a number of new challenges and investors must be prepared to reexamine their assumptions. Large cap stocks have generally become the “safety trade,” but there is a credible case that Tech and Health Care may be leaders for the long-run. Furthermore, small cap U.S. stocks are in the cheapest decile compared to large cap over past 20 years. While no one knows how or when the pricing on small and large caps will converge, I believe exposure to smaller cap stocks should be a positive.
Eric: And, a similar statement can be made about international stocks. Based on any of the major indicators, whether it’s trailing earnings, forward earnings, or book value, international companies are also in the cheapest decile over the past 20 years.
So, let’s bring these trains of thought together Frank, and highlight some of the investment themes. From elections to the markets and the economy, what can we expect based on the campaign rhetoric?
Frank: While there are certainly some major differences, there are several sectors that may benefit regardless of the eventual winner. One area where presidential candidates Trump and Biden agree is infrastructure. Every election features massive infrastructure spending as a campaign promise, and this may just be the time it comes to fruition. The importance of 5G wireless connectivity, electrical grids, and water cannot be denied. These necessary endeavors are also by definition local, and would broadly support job creation in a time where municipal finances are otherwise strained.
At the end of the day, massive monetary stimulus will continue regardless of the November Presidential election and the ultimate result whenever that comes.
Eric: Internationally, a Biden victory would likely increase engagement with global partners, which may restore some bilateral trading arrangements. These negotiations will be critical for either winner, as a new unified political will in Europe could make it a credible challenger to the U.S. for governments’ foreign reserves.
At the end of the day, massive monetary stimulus will continue regardless of the November Presidential election and the ultimate result whenever that comes. The subsequent deficits may eventually constrain any 2020 winner from further aggressive fiscal policy.
With no shortage of uncertainty, investors will be well served to remain disciplined. September reminded us that technology stocks aren’t bulletproof and broad diversification among equities—especially to those areas that have underperformed in recent years—will likely serve investors well. What I do know is that I appreciate the thoughtful, disciplined wisdom of my Bailard colleagues and our collective ability to entertain passionate discourse. Until next time, Frank!