US elections: looking into a Trump victory

Markets have reacted to his trade policy proposals, but implications are more far-reaching

Introduction
The upcoming US elections are gradually taking centre stage in investors’ discussions and risk assessments.
There is indeed a clear sense, to which we subscribe, that politics has become increasingly important for financial markets since the global financial crisis. The rise of anti-establishment parties and candidates has raised risk for financial markets in terms not only of the economic outlook, but of the quality of economic policy and the business environment, as exemplified by Brexit.
In the US, the presidential election contributes to that theme as the Republican candidate D. Trump has made disruptive proposals about fiscal policy, trade policy, monetary policy and foreign policy.
In this analysis, we consider the potential implications of the election’s outcome on financial assets. To that end, we build on the three scenarios laid out in previous research: a base case (Clinton wins but remains constrained by Congress) and two alternative scenarios (Trump wins but remains constrained by Congress; Trump wins and implements his policy proposals).

Lessons from history
Looking at historical experience, a major takeaway is that no clear pattern emerges: US elections typically have a limited impact on asset prices.

A more detailed look at a range of assets since the 1976 election shows that the S&P 500 and the US dollar have experienced both ups and downs around elections
(Exhibit 2). The main moves, like in 2008, were not driven by the election. Similar conclusions can be reached for the VIX or credit spreads. Two considerations are worth keeping in mind however. First, markets seem to react more positively when the same party dominates both the White House and Congress.
Second, markets have performed better when the same party has remained in power. As such, there appears to be a premium for clarity and continuity post elections.

What can be inferred from markets so far
An important way to gauge whether this specific election is likely to impact markets is to look for signs that changes in outcome expectations have already driven prices. In that respect, the Mexican peso provides the clearest evidence, having depreciated strongly since the beginning of the year and followed the gyrations of the election polls. Uncertainty for MXN is confirmed by the unusually high level of implied volatility in the next three months priced in the market. There is weaker evidence of similar patterns for the Canadian dollar, the Australian dollar and other emerging market currencies, such as the Chinese renminbi and the Malaysian ringgit. The dollar has not reacted materially against its main counterparts in G10 (EUR and JPY) since April, however, nor against emerging Asian currencies generally (Exhibit 2).

Regarding interest rates, there appears to be some correlation between election polls and the two-year interest rate differential between the US and Germany since April, as we have documented in previous research, but little evidence of any sensitivity of Fed policy expectations on the election’s outcome. In our view, the key area here is 2018, after the end of J. Yellen’s first mandate as Fed chair.
Finally, there is evidence that equity markets have reacted positively to a Clinton outcome becoming more likely, notably after the first TV debate. There are also a number of sector-level considerations already showing up in the price action (see below).
Overall, the impact of the election so far has been limited and mostly concentrated on some FX crosses. Clearly these developments have to do with concerns in the market about D. Trump’s proposals regarding trade policy and the increase of import tariffs from trade partners such as Mexico and China. There is however little to suggest that markets are starting to price a replacement of Fed Chair Yellen by a more hawkish policymaker, leading to significantly higher fed funds rate. Neither can we find meaningful evidence of any impact of Trump’s policy proposals to launch a strong fiscal stimulus, renegotiate public debt with creditors or initiate a more activist US dollar policy.

Three scenarios for the election
In recent publications we have considered the outlook for the presidential candidates, looking in some detail at their proposals and how these have evolved over time in Trump’s case. We argued that judging the impact of the candidates’ proposals was difficult as it required not only a judgement on who might win, but also the extent to which the winner would be able to pass policy through Congress.
To discuss the economic implications and hence provide a framework upon which to judge the impact on financial markets, we considered three different scenarios.

1. Hillary Clinton wins the presidential race, but assumes that the House of Representatives remains in a Republican majority.
2. Donald Trump wins the presidency. In a bid to make a legislative impact, Trump follows the House Republican economic proposal that he has now adopted, but allows his more unorthodox campaign policies to drift.
3. Donald Trump wins and follows each of the policies that he has campaigned on. These include the imposition of tariffs on Mexico and China, questioning NAFTA, expelling unauthorised immigrants (11m on recent estimates) and building a wall with Mexico.

Initially, scenarios 2 and 3 were constructed on an assumption that Congress would be split. However, we now assume that a Trump victory would reflect a sufficient voter swing to the Republicans to maintain the current majority in both Houses. This is consistent with a Trump presidency having a more visible impact on activity.
The Clinton scenario envisages only a modest impact on the outlook and to the economic policy framework. Clinton’s infrastructure proposals would lift GDP growth modestly but not prevent the economic deceleration we expect from 2018. We assume a programme of about 1.25-1.5% of GDP, with a fiscal multiplier of 0.8, lifting growth from 2018. As a result, a Clinton election is likely to follow the historical experience and have little impact on financial markets in itself.
By contrast we see a more material impact of a Trump win. In the constrained scenario where a Trump presidency sticks to Republican orthodoxy, the corporate-focused stimulus package would raise GDP growth over the next three years and likely accelerate the pace of Fed policy tightening. We use an assumption of a $400bn stimulus with a fiscal multiplier around 0.6. Such a boost then in turn lifts growth by more than 1pp, reduces unemployment and raises wages, fuelling private consumption. We follow a standard Taylor rule to model the monetary policy reaction in this environment, in line with a more rule-based Fed (see Appendix)
In our “full Donald” scenario, Trump enacts not just corporate-focused fiscal stimulus, but also imposes tariffs and begins to expel unauthorised immigrants. The outlook for the economy under such an extreme set of policies is more uncertain. However, we believe that the stimulus to demand and simultaneous damage to supply conditions in the US could have a marked impact. We assume a 20% reduction in 25% of US exports, a negative shock mitigated by declining imports. We project inflation picking up materially in this scenario, lifted by an initial demand boost and supply contraction narrowing the output gap, but further impacted by the imposition of trade tariffs on US imported goods. We envisage the Fed tightening policy in response to this material shift in the inflation outlook.
A Trump election would also alter the policy framework in the US in several respects. There may be changes to Fed policy, not necessarily through a change in the mandate, but at least through a change in heads. Harsh comments towards Chair Yellen suggest that she will likely not be reappointed at the end of her mandate in case of a Trump presidency. A recent column from Trump’s economic advisor Judy Shelton helps understand the direction of change at the Fed if he is elected6: in brief, not necessarily more hawkish but certainly more rule-based. In the current context though, such a change is likely to imply a more hawkish Fed from 2018.
Changes to financial regulation feature high in investors’ concerns. A Clinton victory is bound to see the complete implementation of Dodd-Frank, with perhaps a firmer stance if the Sanders/Warren doctrine gains further traction. At an extreme, the reform wish list could span financial transaction tax and break up of large banks. A GOP Senate would act as a brake to such risks, but in that case, regulatory appointments could still keep up the pressure on banks via stricter specifications for stress tests and/or the trading book review. On the other hand, Trump has made reference to almost undoing Dodd-Frank, so arguably he represents an easing of the regulatory environment. That said, the GOP proposal to allow banks to opt out of current capital and liquidity standards in exchange of a 10%+ leverage ratio may not prove a better option ultimately. Net-net, a Clinton outcome should be creditor-friendly if it suggests safer banks, although the benefit diminishes as banks already operate at high levels of capital. Bank profitability, on the other hand, would remain a key concern. Break up risk, however, could change the benign backdrop for spreads.

Implications for financial markets
Rates, curve and the dollar:
Long-term US bond yields should be strongly impacted by our scenarios as they drive both the path for the fed funds rate and the cyclical component of the term premium. In the baseline scenario, a very dovish Fed delays expectations of normalisation, while the soft cyclical backdrop keeps the term premium in negative territory for the next few years. Under the Trump scenarios, a much more hawkish monetary policy raises interest rates through the yield curve. Also, the term premium rises more quickly, especially in the constrained scenario, on the back of a stronger economy.
As a consequence, the yield curve bear-flattens significantly (where accelerating short-term rates start to converge with long-term rates) in the constrained scenario compared to our baseline case where the short end remains firmly underpinned by monetary policy. In the full-Donald scenario of recession, the yield curve inverts as monetary policy tightens aggressively before easing back.
Regarding the US dollar, we would target 1.05 by year end against the euro in case of a Trump victory, compared to 1.08 in the baseline scenario of a Clinton win. Further out in the constrained scenario, the large divergence in monetary policy should keep the dollar at this strong level. In the full Donald scenario, a significant appreciation of the dollar initially may be followed by a decline as the economy deteriorates and expectations build of rate cuts. Long term, we ultimately stick to our fair-value estimates driven by purchasing-power parity, currently at 1.09.
Equities:
Equity markets have recently shown tentative reactions to the polls, with weaker performance and higher volatility when a Trump win has looked more likely. This is in line with our view that a Trump election will be met with a short-term risk-off episode, reflecting a possibly unfavourable electoral composition and greater policy uncertainty. Equities have also historically reacted negatively to changes in presidential party and to a split Congress – both of which would be possible under a Trump victory.
Although considering a Trump presidency is likely to deliver the most stimulus, beyond any initial reaction, this does not pose a threat to earnings in the initial years of the term. The expected pick-up in activity and inflation coupled with significant corporate tax rate cuts and the focused fiscal easing proposed by House Republicans is likely to provide a boost. Our longer-term outlook would be negative under a Trump scenario. We expect short term stimulus to result in a medium-term bust.
According to our estimates, the sectors that would benefit from a Trump presidency represent the majority of the MSCI US Index, while those benefitting from Clinton are marginal. Illustratively this suggests a Trump presidency would be relatively positive for the markets beyond any initial reaction. We highlighted the impact of different outcomes on sector performance in a previous publication. While the outcome remains in the balance, the ultimate impact on economic and financial conditions depends not only on who is elected but how closely they enact, or are allowed to enact, their economic proposals.
Credit:
Our views on US credit would remain broadly unchanged under a Clinton presidency. Continuity in government policy and Fed outlook would leave us comfortable with duration risk (IG credit) while still constructive on spread risk (HY credit). In relative terms, HY should post higher returns than IG, given its superior carry. We also see a modest fiscal expansion under Clinton as a moderate positive for credit, by helping companies to lessen their leverage through improved earnings.
Under a Trump presidency, the prospect of a much steeper rise in policy and market rates would make us more wary of duration risk and hence US IG credit. Furthermore, the risk of a boom-bust fiscal policy could make non-domestic investors, a key positive technical in the past couple of years, a lot more averse to US credit, exacerbating flight risk out of US IG. On the other hand, Trump’s ambitious plans for infrastructure spending and corporate tax reform should prove a positive for corporate earnings. That said, the balance between the reductions in corporate tax rates and the potential phase-out of debt servicing tax deductibility will determine the degree of the benefit to corporate earnings. Net-net, we think that the tailwinds for earnings may be unable to offset the elevated duration risk. Similarly, a Trump presidency could prove a key support for HY credit (earnings) over IG credit (duration risk), as long as the rates backdrop does not disrupt the market refinancing channel.
Drilling down to sectors(Appendix, Exhibit B), financials, pharma and energy appear more likely to see a material impact from a change in government policy. A potential repeal of Dodd-Frank by Trump could drive US bank spreads wider, if it changes banks’ behaviour towards higher leverage. Trump’s opposition to Obamacare, plus his intention to lower corporate and repatriation taxes, may alter corporate attitudes to mergers and acquisitions (at a cost to leverage) in order to boost earnings or for tax efficiency reasons (inversions). Clinton’s intentions to encourage renewable energy would put pressure on the earnings of traditional energy companies, albeit over the longer term. US utility companies tend to issue at the longer end of the maturity spectrum, so again, any aversion towards utilities debt could have a clear duration effect in terms of US credit performance.

Spillovers of Trump policies: Europe and EM
From a macroeconomic perspective, higher US fiscal stimulus would have a positive but limited impact for the euro area, as the US represents less than 3% of gross exports in value added terms. The dollar appreciation would also be marginally beneficial both to growth (through trade competitiveness) and to inflation. Altogether, we believe the implications for European Central Bank (ECB) policy are limited. In the constrained scenario, a rising US dollar should benefit the euro-area growth and inflation outlook, and strengthen the case for tapering in the latter part of 2017. The financial channel, in case the US cyclical outlook is boosted by fiscal policy, should also benefit the region.
But the main impact of the US elections would be felt in the “full Donald” scenario if the US initiates a trade war or simply hardens the tone against “currency manipulators”. Germany, and by now the entire euro area, post substantial current account surpluses of respectively 8.6% and 3.4% of GDP this year, which are expected to remain above the 3% threshold flagged by the US Treasury’s FX Report7 as a “material current account surplus”. The negative impact on the euro area would be much more substantial and a coordinated retaliation unlikely, leading the ECB into more dovishness.
On China, Trump has threatened to impose punitive tariffs. To the extent that these actions will be against the WTO rules, and possibly deemed hostile by the Chinese government, we think that China will most likely exercise (possibly in-kind) retaliation against the US products sold in China. Our analysis8 suggests that such a counter action could inflict significant pain on US exports, whose third largest market is China. On the RMB exchange rate, we do not expect the US elections to alter China’s “managed-float” FX policy. In particular, if a Trump victory causes large swings in the US dollar, the Chinese authorities may intervene in the short term to limit market volatility. However, the long-term trend of FX reforms – i.e. moving towards a more market-oriented exchange rate – will unlikely be abandoned.
For emerging markets more generally, the worst scenario of trade protectionism in the US would trigger a drop in global trade volumes. Broader retaliations are possible, as the historical example of the adoption of the Smoot-Hawley Act in the 1930s in the US shows. An important question in that context would be that of NAFTA9 and the trade relationship with Mexico in particular.

Research & Investment Strategy – AXA Investment Managers