Political rollercoaster

Bottom Line

Voters and investors alike have been strapped to a dizzying election rollercoaster over the past four months, with prospective results swinging wildly from favoring Republican candidates in June and July to Democrats in August and September and now back to Republicans in October. The fiscal policies espoused by the two parties – on key issues such as taxes, regulation, immigration, and energy, among many others – are vastly different, resulting in increased financial market volatility and uncertainty. Early voting has already started, and with less than two weeks before election day on November 5, we’re bracing for any last-second surprises that could potentially roil financial markets yet again. 

Political pendulum Republican prospects soared after President Biden’s disastrous debate performance on June 27, the first failed assassination attempt on President Trump’s life in Butler, Pa. on July 15, and a successful Republican National Convention in Wisconsin in mid-July. 

Biden’s weighted-average approval rating plunged to a dismal 37% at that time, fueling deep concern among Democrats that Trump and the Republican party would orchestrate an election landslide. So, Biden dropped out of the race on July 21, and Democrats substituted Vice President Kamala Harris at the top of the ticket. Thanks to her unprecedented coronation – without the bruising gauntlet of a primary campaign -- the Democratic National Convention in Chicago in mid-August was an enormous success, reinvigorating the party’s energy and optimism. The enthusiasm continued to rise in the aftermath of Harris’ strong debate performance against Trump on September 10, which propelled Democrats back into the lead in the race for the White House. 

But Harris’ polling bounce has faded over the past six weeks. The vice-presidential debate on October 1 between her running mate, Gov. Tim Walz, and Sen. J.D. Vance, who is Trump’s running mate, did not go particularly well for Walz. Moreover, voters are frustrated with Harris’ lack of policy detail and her decision to avoid potentially difficult press conferences and unscripted interviews with journalists from unfriendly networks.

Consequently, Trump has regained a modest lead in the national polls and in all seven of the key swing states, albeit within the margin of error. So, the race is now essentially a coin flip, although Polymarket has Trump expanding his probability of victory to about 63% to 37% for Harris in the betting markets. 

Down-ballot impact We continue to believe that the Senate is likely to flip back into Republican control, largely due to state-specific races in West Virgina and Montana, regardless of the presidency. But control of the House of Representatives is likely to follow the race for the White House, as 80% of us have voted straight tickets over the past 30 years. Consequently, the odds of a Republican sweep have increased to 43%, while the odds of a split government (with Democratic control of the presidency and the House) at 24%, both of which are market-friendly outcomes. The odds of a Democratic sweep are now at 14%.

Volatility rising, financial markets uncertain The volatility index (VIX) has doubled from 10 to 20 over the past three months, reflecting increased investor uncertainty. Benchmark 10-year Treasury yields have similarly risen from 3.60% to 4.25% since mid-September, which translates into a target P/E of about 17.8 times in the Fed model. But the S&P 500 has largely ignored these cautious signals, soaring by 15% from its August 5 intra-day low to last week’s 46th record high of the year at 5,878, trading at an elevated price/earnings ratio of 21.4 times next year’s estimated earnings of $275. So, with stock valuations stretched by about 20%, we still expect some modest consolidation due to election-related uncertainty. 

Issues matter for voters and investors The key fiscal policy issues are economic growth (including the federal debt & deficit), inflation, and immigration (which includes border security and crime), on which Trump enjoys comfortable leads. The most important social issue is abortion rights, on which Harris enjoys a sizable advantage, particularly among women voters. 

Macro matters The National Bureau of Economic Research (NBER) declared the COVID recession over in April 2020, with GDP growth soaring by 35.2% and 4.4% in the third and fourth quarters of 2020 and by 5.6% in the first quarter of 2021, respectively, on a quarter-over-quarter annualized basis. 

The unemployment rate (U-3) peaked at 14.8% in April 2020 and plunged to 6.4% by January 2021, on its way to a 53-year low of 3.4% in January 2023. It has since risen to 4.1% over the past 20 months, triggering the Sahm Rule in each of the past three months through September. 

Nominal CPI inflation was at 1.4% in January 2021 when President Biden took office, half the previous 40-year average of 2.8%. Over the next 17 months, however, inflation spiked to a 41-year high of 9.1% in June 2022, due, in part, to excessive and unnecessary fiscal stimulus, according to the Federal Reserve’s White Paper published at its annual monetary policy symposium in August 2022. Inflation has since retreated to 2.4% in September 2024, as the Fed hiked interest rates up to a 20-year high at 5.5% and shrunk its balance sheet from $9 trillion to $7 trillion. 

Voters want change While Harris is promoting herself as the candidate of change, promising to implement better fiscal policies, she was also Biden’s vice president. So, part of Harris’ recent fading popularity may be that perhaps voters are holding her accountable for Biden’s poor fiscal policy record. In a recent media interview, Harris said that she couldn’t think of anything that she would do differently from Biden’s policies.

Extend the 2017 tax cuts The centerpiece of Trump’s fiscal policy plans is to extend and make permanent the corporate and individual tax cuts he put in place in 2017, which Harris argues would widen the federal debt and deficit by as much as $5 trillion over a decade. But her analysis is likely static, and possibly doesn’t consider the dynamic increase in economic activity, corporate spending, employment and wages that could result in an increase in tax revenues, rather than a reduction. 

Harris’ tax plan, in sharp contrast, is to increase the tax rate on corporations and high net worth individuals, arguing that the rich are not paying their “fair share.” But according to the IRS, the top 10% of taxpayers in 2021 (the most recent data available) who earn $170,000 or more already pay 76% of the total taxes in the US. The bottom half of taxpayers (who earn $50,000 or less) only pay 2% of the total taxes. So the current tax code is already very progressive.

Because the top 20% of taxpayers account for 40% of all consumer spending, and because consumer spending accounts for 70% of GDP growth, raising tax rates on top earners too sharply runs the risk of slowing the economy, perhaps into recession. 

When Trump reduced corporate tax rates from 35% (which were the highest in the developed world) to 21% (which is the global corporate average) in 2017, that unleased $2.5 trillion in repatriated assets back into the US from overseas, three-quarters of which companies used to purchase new equipment, build new plants, hire more employees, and raise worker compensation. The balance was spent on share repurchases and dividend increases, which benefited financial markets. Harris plans to increase corporate tax rates back up to 28% or higher, which could potentially reverse this positive trend.