Two Key Observations and a Caveat on the 2020 Election | Lord Abbett
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Institutional Perspectives

Why investors should avoid assumptions about the effect of presidential elections on the market.

Read time: 4 minutes

Given the stark differences between the two candidates in November’s U.S. presidential election, investors are right to consider its likely implications. In this Market View, we touch on two key observations from Lord Abbett investment professionals and offer a caveat about overly simple assumptions regarding its likely impact.

Observation 1: Markets Are Pricing in an Uncertainty Premium

As strongly as markets have performed since the pandemic-related turmoil in March, they are still pricing in an uncertainty premium, according to Kewjin Yuoh, Lord Abbett Partner & Portfolio Manager. “Any presidential election presents investors with event risk, and this may result in market volatility,” Yuoh said.

The risk that an unexpected event will affect asset values was especially evident in 2016. In the run-up to the election, the S&P 500® Index declined approximately 4% in the two months prior to the November 8 election. The CBOE Volatility Index (VIX), a measure of implied volatility, climbed steadily over the same period. With the election of President Donald Trump, the volatility continued, though it was short-lived.

Of course, investors may not be rattled much by ups and downs ahead of this year’s election, given their recent experience. We believe the VIX is unlikely to approach the level seen in March 2020.

 

Figure 1. Volatility May Rise as the Election Approaches

CBOE Volatility Index, January 4, 2016 – August 5, 2016

Source: Yahoo Finance. Data as of August 5, 2020. The CBOE Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Of course, the extent of the risk surrounding the November election may also depend on other considerations, including valuations and economic conditions, said Yuoh. But expect some volatility in the run-up to the election, and possibly in its wake, regardless of the outcome.

Observation 2:  It Appears Unlikely that Tax Rates Will Go Down

The two parties have traditionally taken different approaches to tax policy, but given the federal government’s extraordinary fiscal deficits resulting from the Coronavirus Aid, Relief, and Economic Security (CARES) Act and other spending, tax cuts are probably off the table, regardless of November’s outcome. While President Trump may want to leave tax rates unchanged, a win for Joe Biden would probably mean increases of some kind, according to Dan Solender, Lord Abbett Partner & Director. “Given the size of the deficit, it’s hard to imagine that tax rates could come down, even if that's what the Trump Administration wants, because the deficit's so big it has to be financed some way.”

Tax policy could also have particular implications for the municipal bond market, Solender said. Higher federal tax rates on upper-income earners could further boost demand for municipal bonds. This has been one impact of the cap on the federal deductibility of state and local taxes that took effect in 2018 as a result of the Tax Cut and Jobs Act of 2017. Since then, wealthier residents, especially in high tax states such as New York, New Jersey, and California, have been particularly motivated to purchase municipal bonds as a way of reducing their higher federal tax liability. “Additionally, corporate tax rates were reduced with the 2018 tax bill and that reduced municipal demand for banks and insurance companies,” said Solender. “If corporate tax rates go back up, that could bring that demand back and provide more support for the municipal bond market to perform well.” 

A Caveat: Impacts of Presidential Elections on the Market Are Unpredictable

Many investors believe that markets like divided government. The theory is that with each party in charge of part of the government, big changes in policy to the right or left are unlikely. “While this has some intuitive appeal, there is no support for this in the data,” said Giulio Martini, Lord Abbett Partner & Director of Strategic Asset Allocation. A divided government hasn’t been associated with better stock market returns, either before or after elections.

Regardless of whether government is unified by Party or split, stock market returns in the 12-, six-, and three-month periods prior to the presidential election tend to be below average. The year after presidential elections has also tended to have sub-par returns (See Figure 2).

The effect of the winning party and of the extent of the win are inconsistent. When an election results in a continuation of divided government, returns in the first three months exceed those that occur when one party takes control. But 12 months after the election, this effect largely disappears.

While this may suggest that politics is unimportant, it is more likely that stock market performance is influenced by many factors, making it difficult to parse out the effect of a presidential election. If these factors are not controlled for, then the impact of politics alone on the market can’t be discerned.

On the other hand, in off-year elections a pattern has been more evident. Stocks have tended to produce low returns in the year leading up to the election but strong returns afterwards. “The data suggests that while politics matters, it matters in a very complicated way,” said Martini. “And it can be difficult to isolate its impact from the other factors.”

 

Figure 2. A Look at Market Returns Before and After Elections

Real (inflation-adjusted) Price Return in select periods around U.S. Federal Elections, 1948-2016

Source: Lord Abbett analysis of Bloomberg data tracking S&P 500 price returns from 1948 through November 2017.

 

Summing Up

Presidential elections present investors with event risk, and given the unusual circumstances surrounding this year’s contest, investors should expect volatility to rise as November 3 approaches.  While the two candidates represent broadly different approaches on a wide range of issues, one area where they may end up in a similar place is with respect to the direction of tax rates. Given the size of the federal budget deficit and total debt, it seems unlikely they will go down. While they also may not go up if President Trump is re-elected, an increase is likely if he loses. Regardless of this year’s outcome, investors would be unwise to make large bets on either possibility. History suggests that while elections affect market performance, other factors obscure the effect of a presidential election, so its impact is ambiguous.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. All investments involve risks, including the loss of principal invested.

This material is provided for general and educational purposes only. The examples provided are for illustra­tive purposes only, and are not indicative of any particular investor situation.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The CARES (Coronavirus Aid, Relief, and Economic Security) Act is a $2 trillion stimulus passed by the U.S. Congress in March 2020, to blunt the impact of an economic downturn set in motion by the global coronavirus pandemic.

The CBOE Volatility Index, or VIX, is a real-time market index created by the Chicago Board Options Exchange that represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors' sentiments.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. 

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

Note to European Investors: This communication is issued in the United Kingdom and distributed throughout Europe by Lord Abbett UK Ltd., a Private Limited Company registered in England and Wales under company number 10804287 with its registered office at Tallis House, 2 Tallis Street, Temple, London, United Kingdom, EC4Y 0AB. Lord Abbett UK Ltd (FRN 783356) is an Appointed Representative of Duff & Phelps Securities Ltd. (FRN 466588) which is authorised and regulated by the Financial Conduct Authority.

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