With a week to go until the US presidential election, will Joe Biden’s lead in the polls be enough to convince investors that Donal Trump is poised for defeat?
Many think not. After all, the polls notoriously got it wrong four years ago when Trump beat Hillary Clinton.
As Sean Markowicz, Global Strategist, Schroders explains, it is for this reason there has been a heightened interest in alternative methods of forecasting the outcome of the election and why many are turning to financial markets for guidance.
However, markets are sending mixed signals, suggesting the result may be another close contest:
The stock market indicator vs election betting odds
The stock market has a strong track record of correctly “predicting” the outcome of presidential elections. Whenever US equities were up in the three months leading up to election day, the incumbent party won and whenever they were down, the incumbent party lost.
Since 1932, this methodology has correctly predicted the winner 86% of the time, or 19 of the last 22 presidential elections. So with the S&P 500 Index up around 4% since August, markets seem to be pricing in a Trump victory.
Up and until mid-September, US equities have moved roughly in tandem with Trump’s re-election odds, as measured by election betting markets. The problem now is that these two indicators have started to move in opposite directions (i.e. equities up and Trumps’ re-election odds down), as shown in the chart below.
Stock prices could be predicting a Trump win, but betting markets seem less convinced:
Past performance is not a guide to future performance and may not be repeated
Source: Datastream Refinitiv, RealClearPolitics, Measuring Worth and Schroders. Data to 23 October 2020. Notes: dotted lines refer to average price change of Dow Jones Average from 31 July to 2 November of every election year from 1932 to 1964 and S&P 500 Index from 1968 to 2016. Period covers 22 presidential elections, 13 in which incumbent party won and 9 in which they lost.
In fact, as at 27 October, Trump’s chance of winning re-election stood at just 35%. So what is going on? How can we reconcile these two measures?
One possible explanation is that Biden’s widening lead in the polls has reduced the possibility of a contested election, which is perceived as more negative for stocks (at least in the short run) than fears of higher taxes or regulation under a Biden presidency.
At the same time, stock prices do not just give a possible indication of who might win the presidency, but also the state of the economy, which has been recovering from the fallout of Covid-19.
Another possibility is that the betting markets have placed too much confidence in a decisive win against Trump. In 2016, betting exchanges assigned Clinton an 80% chance of winning the presidency.
In comparison, the stock market was down 3.5% in the three months preceding the election, meaning equity investors had actually predicted that Clinton would lose.
The “Biden trade” has started to outperform
Although the stock market may be indicating a Trump win, beneath the surface, it is sending mixed signals.
Stocks that are expected to benefit under Biden have surged as his lead in the polls has widened.
Below are some examples of recent market rotations that have occurred.
Small vs large caps: Since the outbreak of Covid-19, US small-caps (small companies) have trailed their larger peers. However, since September, small caps have outperformed by 4.4%, as Biden’s chances of taking the White House have increased (see chart below).
One explanation for this shift is that analysts expect a larger fiscal stimulus package under Biden and potentially higher economic growth as well. Such a scenario should benefit small caps because they tend to be more economically sensitive compared to large caps.
Emerging markets (EM) vs US equities: EM equity performance has suffered immensely as a result of recent US-China trade tensions. But under a Biden administration analysts expect relations to be less fractious and for alliances to be restored with America’s allies.
This improvement in international relations and its positive effect on global trade activity should support EM equities. With EM equities up 5.9% versus the US since the beginning of September, investors may be pricing in this outcome.
Value vs growth: Value stocks have taken a huge beating this year, as investors have sought refuge in fast-growing technology stocks. However, following a major sell-off in tech in September, value has started to gain the upper hand. But will this last?
Many investors expect the Big Tech stocks that have powered the market rally this year to come under stricter regulatory scrutiny under a Democratic president.
Meanwhile, banking stocks, which represent a large component of value indices, should profit from a stronger economy, especially if accompanied by higher interest rates.
The issue is that banks are likely to face a tougher regulatory regime under the Democrats as well. It remains unclear whether one will outweigh the other.
Past performance is not a guide to future performance and may not be repeated
Source: Datastream Refinitiv, MSCI and Schroders. Data to 27 October 2020.
So which election-predicting indicator is right? Unfortunately, there is no silver bullet and with markets sending mixed signals, it seems the election may prove to be very close.
Regardless of who wins, however, history tells us that, in the long run, neither political party is better or worse for your investments.
Presidents do not operate inside a vacuum and there are many other factors that can influence markets such as valuations, interest rates and inflation, among other things.
It is generally held that investors should avoid knee jerk reactions once the winner is declared.
Important Information
Any references to securities, sectors, regions and/or countries are for illustrative purposes only.
This information is not an offer, solicitation or recommendation to buy or sell any financial instrument or to adopt any investment strategy.
Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions.
