An Election Endgame Investing Strategy

With the election just one month away and uncertainty increasing due to the President’s coronavirus diagnosis, investors may be tempted to focus on what markets are signaling about the election outcome. 

Generally, low long-term rates this close to an election typically point to a status quo result or divided government. However, the U.S. stock market (along with polling data), seems to be telegraphing increasing odds of Democrats gaining control of the White House and both chambers of Congress, which would raise the odds of substantive policy reforms. Indeed, stock sectors that could be affected by such policy change, such as financials, carbon-based energy and pockets of healthcare and technology, have recently underperformed.

Market volatility, as I covered recently, may depend mainly on how long before the November election outcome becomes clear. The margin of victory will dictate the timing of final results and for how long. Morgan Stanley & Co.’s public policy strategists believe that a margin of victory of less than 3% could delay final results by as much as several weeks.

Ultimately, such short-term observations could just be noise. Instead, investors may want to tune in to a key long-term signal. Given where we are in the business cycle, which we find to be a more meaningful market driver than politics, I expect the yield curve, an economic indicator based on the bond market, to steepen post-election, as long-term rates rise while short-term rates stay anchored by Federal Reserve policy. I believe that will happen regardless of who gets voted into office.

A steeper yield curve signals expectations of a stronger economy ahead and we maintain high confidence in a V-shaped recovery. Employment gains, while slowing, remain positive, the housing market is robust, and manufacturing readings have surprised to the upside. A second wave of coronavirus infections in the U.S. could occur, but better treatment protocols have helped to reduce mortality rates, while progress on various vaccines continues. We don’t expect widespread economic shutdowns to resume.

Clarity on the election, ongoing economic growth, passage of a fiscal stimulus bill (which we still see as likely next year) and distribution of a vaccine could all be catalysts for rising long-term rates.

Plus, a technical factor points to higher long-term yields ahead: Falling foreign demand for U.S. long duration bonds, even amid soaring Treasury issuance. This adverse supply-demand dynamic also could contribute to eventual yield-curve steepening.

Since bond prices move inversely to rates, a steeper yield curve can cause declines in long-term government bonds and lead to gains in some sectors, such as financials, that tend to post higher profits when the gap between short-term and long-term rates is wider.

Here’s my advice: Shorter term tactical investors should watch polling margins heading into the election. Wider polls suggest a quicker election resolution, which could be a catalyst for yield curve steepening. Longer term strategic investors should consider positioning their portfolios now to take advantage of the reflationary scenario we see coming in 2021. We believe opportunities in U.S. financials, small-capitalization stocks, value cyclicals and international stocks are plentiful.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 5, 2020, “Election Uncertainty and Steeper Yield Curves.” Ask your Financial Advisor for a copy of this report, our recent US Policy Pulse reports on Election 2020, or find an advisor. Listen to the audiocast based on this report.