How US elections work and the impact on markets

First a little US politics 101.

The president:

The US President is elected every 4 years and can serve a maximum of 2 consecutive terms, so current President Barack Obama is not able to stand again and Hilary Clinton (Democrats) will stand against Donald Trump (Republicans).

Each US state gets a set number of electoral votes to allocate to the presidential candidate who gets the most votes in their state. The states allocate their electoral votes on a winner-takes-all basis (except Nebraska and Maine, who pro rata them). There are 538 electoral votes up for grabs and a candidate needs at least 270 of them to be elected president.

Electoral votes are not proportionate to population, so, for example, Montana has a population of one million and 3 electoral votes, compared with California with 37 million people and 55 electoral votes – so 37 times more people but only 18 times more electoral votes, making Montana’s votes theoretically twice as valuable as those of California. It is therefore possible to become president without winning the majority of votes.

The congress:

Congress is made up of two chambers: the Senate and the House. They have power over the budget (taxation and government spending) and over creating laws.

• Senate: 100 seats – the 50 States each have 2 senators who serve a 6-year term (votes are staggered so c. one-third of senators are elected every 2 years).
• House of Representatives: 435 seats with each state getting allocated seats in proportion to their population (with a minimum of 1 per state). Representatives serve 2-year terms.

New laws generally pass through the House for approval and then the Senate (60% required for approval) before being signed into law by the President (who has veto power).

Figure 1: Current US Congress

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Source: Wikipedia

The polls:

Political polls, as aggregated by RealClearPolitics, reflect a tight race for the popular vote. Hilary Clinton is currently ahead by around 2% (though these numbers are volatile and tend to move around with each new scandal).

Figure 2: Aggregate polls for the popular vote

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Source: RealClearPolitics, Bloomberg

Typically the presidential race is decided by a third of the states – the so called “Battleground” states, with the other two thirds of states usually fairly predictable in their party support. As a result, a better indication of the likely outcome is based on the polling in the “Battleground” states.

Figure 3: The ‘battleground’ states

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Source: RealClearPolitics poll averages on November 2 2016, Bloomberg

These polls suggest Clinton will be the most likely victor, but a swing in a state like Colorado (where Clinton is only ahead by ~2%) could hand the victory to Trump.

The impact

Most of the media focus is on who will be president, but in practice the economic impact of the victorious candidate’s new policies is dependent on fiscal and legislative changes getting through Congress where the House is likely to remain in the control of the Republicans.

Figure 4: The senate race

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Source: RealClearPolitics poll averages on November 2 2016, Bloomberg

The Senate (where one-third of the seats are up for grabs next week) could see the Democrats gain control. The Senate race will likely be close and it’s unlikely that either party will reach the 60 seats required to force through legislative changes without opposition support. So, for at least the next 2 years until the next congressional elections, implementing major legislative or fiscal changes will likely be extremely challenging and, as such, the main impact of these elections is likely to come from sentiment changes.

Impact on markets

The US represents around 25% of global GDP, so what happens in its economy is very relevant to the global economy. The US represents an even bigger share of financial markets, with US-listed companies representing around 40% of the market cap of global listed equities and bonds issued by US government institutions and US corporations represent around 40% of the notional value of global bonds. The US dollar is also generally considered the world’s reserve currency, so the cliché that “if the US markets sneeze, the world markets catch a cold” very much holds true.

While the composition of the US Congress post-elections is likely to limit the direct impact on the US economy from legislative and fiscal changes, uncertainty around policy direction can limit activity and create a second-order drag on economic activity. Arguably the recent market weakness has already factored that into asset prices. Uncertainty can also increase volatility in security prices.

Although the implementation of each candidate’s policies is likely to be challenging, sentiment could impact asset prices, particularly in sectors that have been the focus of campaigning:

• Rates: While the president will have no control over monetary policy, fiscal policy can create a second order effect in rate markets. Trump is most likely to have an impact here, if elected, by creating a larger budget deficit through reduced taxation and increased government spending. The increased US deficit and increasing supply of US Treasuries issued to fund that additional deficit should both push bond yields higher. (Generally bad for bonds, emerging market [EM] currencies, high dividend yield stocks, real estate investment trusts [REITs] etc.).
• Financials: A Clinton victory would likely be bad for US banks as a result of increased regulation, this would also apply to so-called “shadow banks” – money market funds, insurance companies, hedge funds, private equity etc. who also engage in lending. Clinton also wants to introduce a tax for high-frequency trading. Changes to taxation for US individuals invested in private equity funds from the “carried interest” gains is something that’s being pushed by both candidates, but Clinton’s proposed tax hikes are much more punitive than Trump’s and would likely create fund-raising challenges for Private Equity managers.
• Healthcare: Clinton wants to increase the government’s spending on government healthcare (Obamacare) while Trump wants to do away with it. Health insurance providers who facilitate Obamacare have generally found it very unprofitable. High drug prices have got a lot of negative press from both campaigns, though mostly Clinton’s – legislation to address this is very unlikely, although negative media coverage could be an overhang for pharmaceutical companies under a Clinton administration.
• Fiscal spending: Both candidates want to increase fiscal spending – the focus of Clinton’s spending is predominantly healthcare and human services, while Trump is more likely to spend on infrastructure (which should benefit the construction, industrial and materials sectors), though it should be noted that the Republicans that control the House are generally opposed to increased government spending.
• Foreign policy: Trump is clearly the bigger risk to US foreign policy. He’s been very outspoken on Mexican immigration as well as on moving outsourced manufacturing jobs back to the US. Both candidates are keen to review trade agreements, with Trump determined to renegotiate most of them fairly aggressively. A Trump victory is likely to create a few jitters for the largest US trading partners (China, Mexico and Canada).

Figure 5: US international trading partners

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Source: Bloomberg, Anchor Capital

Conclusion

A Trump victory is likely to introduce more volatility into the markets, because it’s a marginally less likely outcome and there is more uncertainty around his policies. Arguably the lacklustre returns we have seen from the markets are already front-loading some of this – participants don’t want to be caught off-sides like they were with Brexit. This volatility should abate within a few weeks as the markets come to the realisation that the implementation of significant legislative and fiscal change is likely to be challenging given the make up of Congress (and Trump’s lack of support from some within his own party).

The impact on the real economy should be limited, but uncertainty will likely weigh on markets for a few weeks and potentially longer in the areas mentioned above, where Trump has indicated a wish to make changes (Mexico, Canada, bonds) but that could create buying opportunities as we get more clarity on what will realistically change.

A Clinton victory should be more of a relief for markets, which could even rally on the news, though its unlikely to be significant and banks and pharmaceutical companies in particular could be pushed lower by negative sentiment and uncertainty.

Ultimately, the most likely outcome is increased volatility in financial markets (particularly with a Trump victory), but very little longer-term impact to the real economy.

Peter Little, CFA, is a global fund manager at Anchor Capital.

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