The U.S. stock market has rallied in the past several months. There are several drivers of that, but one possibility is that investors see the re-election chances of President Trump, who investors have always favored for his pro-business policies, moving higher.
To be sure, stocks have been on fire in the past few months for several reasons, most of which center on the fact that the economic recovery from the pandemic has been incredibly fast so far. Unemployment has fallen from above 15% to 10% in this period. Consumer spending has rebounded viciously. Second-quarter results showed a far less severe earnings decline year-over-year than expected across sectors, pointing to earnings momentum towards a full recovery in 2021. Much of the strong top-line results have been driven by fiscal and monetary stimulus. And while interest rates cannot fall much from here -- the benchmark lending rate effectively set by the Federal Reserve is 0% -- Congress can appropriate billions or even trillions of dollars more to be injected into the economy. Small businesses need cash. The speed of the recovery hinges on more fiscal stimulus, yet cyclical stocks rose Tuesday on backward looking economic data like a strong manufacturing reading for July. The speed of the recovery hinges on more fiscal stimulus, yet cyclical stocks rose Tuesday on backward looking economic data like a strong manufacturing reading for July. Trump has strengthened in the past few days, so stocks are currently ignoring a potential “fiscal cliff.” The election is indeed quite a factor.
Let’s take a step back.
From June 26 to now, the S&P 500 is up 15%, after it had fallen hard on account of a summer wave of virus infections and paused state reopenings. From June 23 to now, Trump’s reelection probability, according to polls aggregated by RealClear Politics, has increased. Senator Biden’s probability was at 51.5% and Trump’s was at 40.9% June 23, representing a spread of 10.26 percentage points. On September 1, the spread was at 6.2, in favor of Biden, who was at 49.6%. And we must watch the S&P 500 in its totality. Yes, cyclical value has underperformed, and the market has been powered by growth tech stocks, which compose more than 25% of the index’s market capitalization if one includes semiconductor stocks. But let’s not forget FAANG stocks are -- yes multinational -- but very U.S. focused. That makes their effective tax rates heavily influenced by a change in the U.S. corporate tax code. So all S&P 500 stocks should be in focus.
There is a clear correlation between the performance of the stock market and Trump’s chances of re-election. Some strategists were saying in April that the rebounding market came at a time during which Trump as losing ground to Biden, but at that time, investors could not ignore the Fed’s aggressive move to lower interest rates by a total of more than 50 basis points. They couldn’t ignore that Congress was more than willing to pour practically free money into households and small businesses. They couldn’t ignore that, if states reopened and the rate of increase in new daily virus cases decelerates, the stimulus would provide a bridge to a better economy.
But Trump promises even lower corporate taxes than what we have now, which would immediately boost earnings. Lower taxes on some cohorts of the population, which would boost consumer spending. Some investment strategists do point out that these changes can most likely only be incremental relative to the first bout of tax breaks. And Congress may be more comprised of Democrats. But if Biden does win -- especially if there is a blue wave in Congress -- corporate taxes could indeed go all the way up to 28% from 21% at present. And investors do not want to see taxes move up, even if part of the rationale is to pay off some of the now enormous government debt.
Sure, it’s possible that the Biden-related fears are of a larger magnitude than that of the Trump-related excitement (if that excitement indeed exists).
But one factor that pushes against the idea that the election is driving markets is that consumer analysts at Goldman Sachs point out that the average consumer company in its wide coverage universe would see net income fall by 6% under Biden’s proposed corporate tax policy. The effective tax rate would move to 24%. Considering the potential economic tailwinds investors are expecting -- or at least hoping for -- earnings may certainly not even fall at all. And RBC Capital markets analysts point out that consumer companies like McDonald’s (MCD) - Get McDonald's Corporation (MCD) Report and Starbucks (SBUX) - Get Starbucks Corporation Report, which have large presences overseas, are stocks to consider for the who want to avoid owning stocks heavily exposed to a Biden tax hike. Speaking of domestic-focused stocks, small caps, well-represented by the Russell 2,000, are up 14% since June 26. This reveals another positive correlation between Trump’s chances and stocks. Unsurprisingly, there’s yet another caveat; European stocks, currently less driven by politics, have risen nicely since end June, as the virus has faded.
Broadly speaking, U.S. stock valuations compared to interest rates are not sky-high. That’s been true since the massive correction in economically-sensitive stocks that began on June 8. The S&P 500’s equity risk premium -- or the average stock’s excess one-year earnings yield minus that of the safe 10-Year Treasury bond -- was almost 3.8% entering Tuesday. The long-term average risk premium for the index is a bit below 3.5%, depending on who you ask. The higher the risk premium, the cheaper the price of the stock.
So is it possible that investors are demanding such excess return on stocks in order to allow for the possibility of higher corporate taxes under a Biden presidency? Is it possible that stocks have rallied of late as Trump’s chances have improved? The answer is yes, it’s possible. But fund managers TheStreet has spoken with have also pointed out that valuations have been held back by the massive uncertainty regarding the speed of the recovery. Let’s not forget, the colder months of the year may bring a third wave of infections and massive lockdowns across the country again.
One of the biggest takeaways for investors for the near-term: expect some volatility.