With the U.S. Presidential Election less than a week away, we have received several phone calls asking what happens to the stock market, if “Fill in the Name” is elected President. We thought we would share our thoughts on some of the likely outcomes.
It appears there are three likely outcomes (in no particular order):
- A Democratic President and a Republican Congress
- A Democratic President and a Split Congress
- A Republican President and a Republican Congress
In all three of those scenarios, the Dow Jones Industrial Average should continue higher (based on historical precedence as the table below shows).
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DJIA Real Performance vs. Presidential and Congressional Combinations |
|
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When U.S. Government has a: |
% Gain/Annum |
| Democratic President, Republican Congress | 4.78% |
| Democratic President, Split Congress | 7.99% |
| Republican President, Republican Congress | 6.85% |
| Democratic President, Democratic Congress | 2.96% |
| Republican President, Split Congress | -6.05% |
| Republican President, Democratic Congress | -2.05% |
| Concept courtesy Ned Davis Research | |
It should also be noted, that the U.S. stock market typically rallies into the year-end of Presidential Election Years as the angst of the election lifts. While we understand that during the political season, the level of concern rises, we remain optimistic towards the near and intermediate term outlook for the U.S. stock markets.
The U.S. Economy
Over the last seven years, the U.S. economy has been driven by three main forces—1) a surge in demand for automobiles, 2) an increase in demand for housing, and 3) expansion in U.S. energy production. Today, it appears auto demand has peaked and will not be the driver of excess economic growth it once was. Housing demand also appears to be slowing and has entered a more normal track based on demographics. Finally, U.S. energy production has gone through a typical “Boom to Bust” commodity cycle and has now entered a steady state of modest expansion based on economic demand for oil and natural gas. Therefore, we see economic growth that continues but at a very modest pace.
The Federal Reserve needs to see the economy continue to move forward for an extended period to be able to normalize interest rates. Historically during economic recessions, the Federal Reserve has cut interest rates on average 5%. With Fed Funds Rates currently at 0.25%, the Federal Reserve could not respond in a traditional manner if the U.S. economy were to falter. So with a slow growing economy, the Federal Reserve will need to manage the delicate balance of raising rates while not stunting economic growth. As a result, they will continue to move extremely slowly and cautiously with any rate increases over the next few years.
With this dilemma as the backdrop, the Federal Reserve would like to move toward a more normal interest rate environment. This means they would like to gradually raise short-term interest rates. To put this in perspective, the Federal Reserve has only increased interest rates once so far in this cycle and that was last December when they moved from “0” on short term interest rates to 0.25%. The market is expecting another 0.25% increase in December. A 25 basis point move every twelve months is about as gradual as one can get.
At this pace, the Federal Reserve will most likely be keeping interest rates below the rate of economic growth and inflation for an extended period, perhaps many years, while trying to achieve normalization. What this means for savers and fixed income investors is that they will receive a rate of return that is below the cost of living.
For fixed income investors we prefer investments in Treasury Inflation Protected Securities, High Quality Municipal Bonds (for investors in the top tax brackets), and opportunistically using Corporate Bonds. At this time, we would avoid international bonds.
Equity Markets
We are moderately optimistic toward the equity markets. Our view is supported by the three following reasons:
- U.S. corporations have been in an earnings recession since the third quarter of 2014; that is to say that overall U.S. corporate earnings have been in decline. We are now seeing the first signs of U.S. corporate earnings acceleration which should bode well for rally into year end and perhaps through 2017.
- Much of this improvement has come from more value-oriented cyclical industries such as Financials, Industrials, and Energy. An improvement in cyclical industries usually signals an increase in economic growth.
- We are also seeing improvement in markets outside the U.S. This improvement is being led by emerging markets, which historically have been a leading indicator of improving global growth. This should help both the U.S. economy and U.S. equity markets.
Regardless of who is in the White House or which political party controls the House or the Senate, we believe there is bipartisan support to accomplish at least a few things early on in a new administration.
Both Republicans and Democrats seem to be willing to address the U.S. corporate tax code. Currently, there is more than $2 Trillion sitting overseas that American Corporations are effectively blocked from bringing back to the U.S. due to our punitive tax code. According to Tim Cook, CEO of Apple, the effective tax rate for a U.S. Multinational Company to bring home foreign earnings is just north of 40% when one considers both State and Federal taxes. Whether corporations spend it on research and development, plant and equipment, dividends to shareholders, or expanding jobs at home, there is only upside for the U.S. economy if this money can be repatriated back to the U.S. economy.
Further, it would not be surprising to see a bi-partisan agreement on a corporate profit repatriation plan with the tax revenue generated from that plan used for much needed U.S. infrastructure spending. There seems to be bipartisan agreement to move towards rebuilding our infrastructure. Infrastructure projects tend to be long-lived multiyear undertakings and a thoughtful approach to this issue could provide the underpinnings for sustained economic growth. This could serve as a boon to the U.S. economy and jobs.
The one concern that continues to bother us is the stretched valuations of the U.S. equity markets. Much of this overvaluation has been driven by the exhaustive search for yield as the Federal Reserve policies of maintaining extremely low interest rates over the past seven years has driven many savers into riskier investments such as high dividend paying stocks.
This search for yield phenomena has driven prices of historically “conservative” equity sectors, such as Utilities, Real Estate, and Consumer Staples, to extremely overvalued levels. While more cyclical sectors, such as Financials, Industrials, Energy, Materials and specific areas in Health Care are inexpensive. Therefore, in a way, it has become a bifurcated market when it comes to valuation—where historically “conservative” areas are overvalued and represent higher than normal risk and historically “cyclical” areas are undervalued and represent lower than normal risk.
Summary
We believe that interest rates will move gradually higher. However, this move will continue to be slow since the Federal Reserve will not want to do anything that could negatively affect the U.S. economy. Therefore, even though utilities and other high yielding sectors of the markets are overvalued, they are unlikely to be severely impacted, given the likely gradual pace of rate increases. However, the stretch in valuations may limit upside potential. Conversely, more cyclical segments of the market with better valuations should outperform. This outperformance could be even more pronounced if economic growth were to accelerate.
IMPORTANT DISCLOSURES
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Riggs), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Riggs. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Riggs is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Riggs’s current written disclosure statement discussing our advisory services and fees is available upon request. If you are a Riggs client, please remember to contact Riggs, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services.
Our expectations after the U.S. election is that the U.S. stock market should rally as the uncertainty of the election is lifted. For any incoming President, the need to score early “wins” becomes important and we believe there may be opportunity for bi-partisan approaches toward reinvestment in U.S. infrastructure and revising the U.S. Corporate Tax Code to allow U.S. Corporations to bring home profits earned overseas. Both of these areas should help U.S. economic expansion, and, in turn, the U.S. equity markets. On the Fixed Income side, we are likely to see the Federal Reserve move rates higher but at a very slow pace.