“If you mix your politics with investment decisions, you’re making a big mistake.” – Warren Buffet
As a newly elected U.S. president prepares to move into the Oval Office early in the new year, much discussion continues around the potential impact that the impending change will have on equity markets going forward. As of this morning (less than a day after the vote) it appears that Donald Trump has been elected to serve a second term and will become the next President of the United States. Nonetheless, a newly elected President’s capacity to implement policy, often perceived as a source of risk by investors, will depend on his/her ability to garner sufficient support in the House of Representatives and the Senate, particularly in the absence of a single party sweep. This is the system of U.S. checks and balances at play. Although Republicans have also won a majority of seats in the Senate, the final vote count for control of the House of Representatives is not yet complete (even if Republicans are currently in the lead and could win control here as well). However, in the long run, evidence clearly shows that the choice of president, Republican or Democrat, has little impact on long-term equity outcomes. The lead-up to the vote and the period immediately following election results often produce increased market volatility; however, bottom-up fundamental drivers, including going-in valuation levels and the ability to compound earnings over time, are superior determinants of equity returns in the long run.
Fiscal, Trade and Immigration Policies
As President-elect Trump prepares for a second term in the White House, it is widely believed that his administration will adopt a decidedly different approach than the prior administration, particularly in key areas such as fiscal policy, trade and immigration. It is expected that a Trump White House will likely extend 2017 tax cuts, enact a further reduction to the current 21% corporate tax rate and restore key state and local personal tax breaks that benefit middle-to-high-income earners. On the trade front, the new Trump administration will likely seek to impose a range of new tariffs on China as well as other key trading partners. Nonetheless, the new President should be viewed as being relatively more pro-business while championing a more favourable regulatory environment going forward. Trump will also pursue stricter immigration policies including increased spending on immigration enforcement.
Possible Market Impact
In the short term, the Trump presidency may stimulate economic growth through tax cuts and deficit spending, while tariffs would also provide a lift to protected domestic industries. However, these measures will likely increase the U.S. national debt over time, driven by successive annual fiscal shortfalls. Over the long term, investors should expect that these measures could lead to lower economic growth – as the combination of an increasing debt burden, a more constrained labour supply and trade tariffs would produce incremental inflationary pressures as well as potentially higher interest rates.
What does history tell us about politics and equity market returns?
Over most time periods, the evidence clearly shows that stocks rise over the long term, irrespective of the political party occupying the Oval Office.
Source: Yardeni Research (https://yardeni.com/charts/sp-500-presidential-cycles/)
Although a Republican or Democratic sweep would likely result in a greater number of policy changes, history has shown that markets have traded higher under either scenario, even if annualized returns have diverged somewhat – averaging 12.9% for a Republican sweep vs. 9.0% under a Democratic sweep.1 Market returns under most other partisan permutations are also positive – with perhaps, most notably, a Republican or Democratic presidential win in combination with a divided congress yielding similar average annualized returns of 13.7% and 13.6%, respectively, since 1933.
What about fundamentals?
Factors such as the state of the economy, inflation rates and Fed policy provide the backdrop against which stocks can compound earnings over time. Equity markets advance over the long term, in large part because of the trajectory in underlying earnings and the valuation levels they command – not because of political outcomes. The chart below illustrates the strong, upward-sloping relationship between forward earnings and the index level for the S&P 500 over the past 30 years.
Source: Yardeni Research (https://yardeni.com/charts/sp-500-earnings-the-economy/)
Current valuation levels are also an important driver of expected returns, with the S&P 500 forward earnings multiple displaying an inverse historical relationship with index returns. Today’s multiple of nearly 22x suggests underwhelming return potential going forward – something investors should place greater emphasis on when compared to the potential short-term impact of election results.
Source: J.P. Morgan
Key Takeaways
First, equities generally rise over the long term. Investors should carefully weigh the potential opportunity cost of altering their equity exposure and long-term investment plans against perceived risks posed by the politics of the day. Second, policy change is difficult to achieve in the U.S. given the system of checks and balances. History shows that U.S. equity markets can perform well in the period following a status quo election outcome, where a single party does not control both the executive and legislative branches of government. Although still to be determined, yesterday’s final election outcome could produce such a scenario – thus reducing perceived risks around policy change. Lastly, fundamentals drive long-term equity outcomes. A franchise’s ability to compound earnings over time and its current valuation are superior determining factors for equity returns in the long run.
