US elections: Investors can find an advantage in volatility

October 26, 2020 06:00
Photo: Reuters

Financial markets could remain volatile as we head towards US elections in November – particularly with the prospect of a contested result. The build-up to a US election is typically characterised by market volatility, and this year it has been exacerbated by the Covid-19 pandemic. In addition, any legal or constitutional challenges to the election result would likely add to market uncertainty.

How should investors view the run-up to the US elections, particularly in the context of Covid-19?

Historically, the months before US elections have been volatile for the markets, and this year may be no different. The pre-election period comes during a global pandemic that has already caused tremendous swings. In February, the S&P 500 Index reached all-time highs before Covid-19 triggered a 34% drawdown. The S&P then rebounded nearly 60% before a correction in September. We expect some form of this volatility to continue until the election results are known. Market performance will also largely be driven by virus trends, which continue to remain precarious heading into autumn.

However, if infection rates improve, an effective vaccine comes online next year and the global economy continues to recover, the market outlook for the US and elsewhere could improve notably. So investors may want to use periods of market volatility in the coming months as a tactical opportunity to add to their positions in stocks and other risk assets.

A few sectors have powered stock markets’ tentative recovery so far. Will that continue, and what does it mean for investors?

We’ve been expecting market participation to broaden – meaning more segments should do well beyond the “Covid winners” of technology, consumer discretionary and healthcare. A steadily reopening economy, more fiscal stimulus and favourable developments in the fight against Covid-19 would help speed this rotation. In the US, the value cyclical sectors of industrials, financials and energy have been beaten up this year while growth sectors have soared – but this may shift somewhat in the next six to 12 months. For example, consider that both major presidential candidates are proposing strong infrastructure-spending packages. That seems to be positive for industrials and manufacturing no matter who wins.

Broader participation also applies to other regions globally. Europe has attractive opportunities in value cyclicals in the healthcare and financial sectors, as well as parts of the energy sector. And China offers exposure to secular growth stories – particularly in growth technologies such as artificial intelligence and 5G communications. The US dollar has also weakened this year, which could help non-US assets.

What does US low interest rate mean for inflation?

The Federal Reserve has made it clear that it will not raise rates for some time – potentially until the end of 2023. Low rates are keeping investors on the hunt for income, and some are being forced to invest in riskier assets to meet return and yield targets. The Fed has also announced a shift in its inflation-targeting policy, indicating that it will allow inflation to temporarily overshoot its 2% target to balance the nearly 10 years that inflation hasn’t met that goal. This scenario – low rates, ongoing monetary and fiscal stimulus, and the potential for economic growth to accelerate – could push up inflation expectations in the coming years. But in the near term, rising economic growth and normalising inflation should provide a good backdrop for stocks and other risk assets.

If Mr Biden is elected president, how could that affect the financial services industry and regulations?

Mr Biden’s policy proposals call for higher corporate taxes, capital gains taxes and taxes on wealthy individuals. He would also roll back some of the recent financial-sector deregulation measures. Taken together, these policies could hurt corporate earnings, especially for those sectors that benefited the most from tax cuts and deregulation – financials in particular – as well as large multinational companies with overseas operations, including technology and healthcare firms. However, tax hikes may not be an immediate priority for Mr Biden while the US is recovering from recession, and he plans to use the proceeds from any tax increases to invest in growth areas such as renewable energy. Mr Trump, meanwhile, wants to maintain the status quo: he would like to preserve his tax cuts and deregulation measures, and perhaps even make his recent payroll tax cuts permanent. Overall, however, the implementation of either candidate’s plans will depend on which party controls the US Congress after the elections.

Investors should keep an eye on the main risks

In the near term, we think the two primary risks are a resurgent coronavirus and the election result being contested in the courts. These factors would likely create uncertainty for markets, compounded by traditionally volatile September and October months. But the election result will eventually be decided, and as of now it appears that 2021 could bring one or more viable vaccines. So if these risks are resolved, and if consumer activity around the globe improves, financial markets could perform well – particularly against a backdrop of low rates and ongoing fiscal and monetary stimulus measures.

Investors may face volatility in the near term, but they could use periods of consolidation – market pullbacks or sideways movement – as tactical opportunities to add risk to portfolios, or to further diversify their portfolios. We see the potential for a broader range of sectors and regions to participate in the market’s upside over the next 12-month period. Europe and China are regions to watch, as are industrials and select parts of the financials and energy complex – particularly clean energy.

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U.S. Investment Strategist, Allianz Global Investors