From here on, the election will matter

Our call to go overweight stocks in January 2023, and to stay there ever since, has relied heavily on our view of a very positive fundamental backdrop: reasonable economic growth, solid earnings growth, inflation down from peak levels but sticky and a Fed largely on hold. Much of the 20% run-up in stocks last year, and the 12% so far this year, has hinged on most of the market coming around to our view, and we’ve enjoyed the ride, for sure. The question is now, “What next?” We think it’s the political cycle.

With the election cycle entering its last five months, markets will be spending more time trying to assess and discount the various options before them, meaning Trump or Biden. Although over the long haul, who the president is has mattered a lot less than staying fully invested (see sidebar), over the short term, government policy can impact markets and especially specific sectors. Increasingly, it looks like this year's election might matter more than usual, for two key reasons. First, because the House and Senate races are so close, it seems likely that whoever wins the presidency will probably carry both. Second, the economic policy differences between the two candidates are stark, especially on key market issues like tax policy, regulation and trade.

As with all other big issues that can potentially define a market turning point, Federated Hermes has developed a framework to help us and our clients process election information and determine its impact on stocks.  Our preliminary conclusion is a Republican sweep is the most likely outcome, for now, and that should be supportive of our call to remain long stocks—and particularly for the market to broaden out beyond tech stocks towards small caps, financials, utilities and energy. Here’s how we see it:

1. Winner probably takes all With key Senate and House races very tight, it seems likely that whoever wins the top of the ticket will help their respective party take Congress, meaning likely to be reasonably successful legislating their policy. This alone should make this presidential election more meaningful than usual to markets.
2. A big shift in tax policy is all but guaranteed by the election outcome Unlike almost all previous elections, this will most assuredly impact tax policy within the first year. That’s because most of the Trump tax cuts from 2018—which reduced taxes broadly on all income brackets, small businesses, corporates and investors—automatically roll back in 2025 to their previous higher levels, unless policy action is taken. (Technically, the corporate tax rate cuts are permanent, but Biden has said he wants to raise them in any case.) Biden’s team seems determined not to take action, allowing the cuts to lapse; Trump, the opposite. In our view, the Republicans did a poor job in 2018 describing the positive, supply-side driven impacts of their tax cut program, which were designed to promote growth by letting consumers hold onto more of their incomes, giving corporates more incentive to invest in the U.S. economy, allowing small businesses to retain and invest a larger share of their earnings, and allowing investors to retain a higher share of their returns on risky investments such as stocks. Despite the dire warnings of some economists and the Congressional Budget Office, the Trump tax cuts did not cut government revenues but expanded them, as the government took a smaller share of a much bigger pie. As of 2023, federal government tax revenues had grown by $1.15 trillion since the tax cuts were put in place, against the CBO’s estimate of $880 billion by that year. The reversal of the tax cuts would likely negatively impact economic growth, and especially would affect negatively small businesses, which are often subject to ordinary income tax regimes. In this respect, a second Biden term would be negative for our market broadening-out thesis.
3. Approach to regulation favors large caps under Biden, small caps under Trump With business leaders around the country raising the topic of regulatory excess under Biden’s White House, the “hidden tax” of regulatory overreach is likely to be on the market’s radar screens. The Biden administration has unleashed a fury of government regulations. While designed to achieve progressive policy outcomes, they have a cost associated with them at the margin that many believe exceeds the benefits of those outcomes. According to the American Action Forum, Team Biden’s regulations have even exceeded President Obama’s in terms of cost and estimated paperwork hours needed for compliance. By contrast, the cost of the new regulations released in Trump’s presidency was about a quarter of Biden’s, in terms of estimated paperwork hours, and even less when fully costed out in dollars. Generally, the costs of complying with government regulations tends to be fixed, and therefore smaller companies are more negatively impacted than larger ones. So from this perspective as well, a second term for Team Biden would likely be less favorable for small caps than a Trump presidency.
4. Old economy sectors likely to do better under Trump Broadly, a second Trump presidency would be less likely to pursue as aggressively as Biden’s the efforts to subsidize alternative energies, as well as the chip/tech sector. Based on his first term, Trump’s trade and regulatory policies likely would at the margin be favorable for old economy companies in banking, energy, utilities and materials. Of course, there are many other factors at play, but at the margin, a second Biden term probably favors growth stocks, and a Trump term, value stocks.
5. Trade policy might be a wash Probably the least market-friendly outcome of a second Trump presidency would be trade. Markets don’t like uncertainty, and Trump’s tendency to use tariffs as a negotiating tool was unnerving for many. A repeat would be less welcome by markets. On the other hand, relations with China have not gotten any better under team Biden, and even he has now begun to use the “tariff card.” So frankly, trade policy is probably shifting from a clear Biden advantage to something more of a wash.
6. Inflation ‘policy’ probably favors Trump Inflation matters less for stocks than for bonds, as stocks are partly hedged through their earnings, which correlate over time with nominal GDP. Still, higher inflation means higher rates, and if and when lower inflation readings allow the Fed to cut the fed funds rate, stocks broadly should be helped. In particular, small caps, which are longer duration assets and often more financed with debt, prefer lower rate regimes. Our present sticky inflation numbers have a variety of sources, including the labor shortage, excessive Fed stimulus well into the post-Covid recovery, and fiscal policy. The latter has been particularly harmful under Team Biden, given the $6.1 trillion in Federal stimulus programs since the election in 2020, even while the same has worked to constrain supply, especially in the energy space. To the extent Biden’s efforts to stimulate demand while constraining supply could be called an inflation “policy,” it too has hurt small caps disproportionately.

Our call for the market broadening out toward small caps, financials, energy and utilities is based on a variety of factors, especially cheaper valuations and better relative earnings growth ahead as the economic cycle stabilizes. This call also seems dependent in part on the election outcome. Of late, these stocks are starting to catch a bid, and we think that may be the market already beginning to sense a Republican sweep. Trump’s lead in the key battleground states is expanding, not contracting, and that’s before the polls start getting adjusted for likely voter turnout. Our guess is the latter should favor Trump, as Biden’s policies have left key constituencies of his coalition upset over any range of issues starting with inflation and economic progress, Mideast policy and the border. Trump, meanwhile, is holding big rallies in heretofore Democratic strongholds like New Jersey and New York.

For now, we are sticking with our call to remain long stocks and particularly to remain overweight small caps and Value. The U.S. has a positive economic backdrop, an expanding earnings cycle, a benign Fed and valuations broadly fair and outright cheap within the sectors of the market we like most. The election news is moving further in the direction of this call and presents another reason for optimism. With less than six months to the election, in the near term, political developments will matter more than usual. And there’s plenty of time between now and then for the likely election outcome to shift. So stay tuned.