Asset allocation: US election outlook

The eagerly awaited outcome of the US election is slowly becoming clearer although the ultimate result could take some time, particularly the determination of the Senate. The composition of Congress will be just as significant as the President from a policy perspective, particularly as talks over fiscal stimulus remain in gridlock.

In the near term, there are two most likely outcomes incorporating a Biden win, although several key states remain too close to call. Both scenarios could have varying effects on the economy and financial markets, and have seen US Treasury yields seesaw as the race remains tight.

The possibility of a democratic clean sweep outcome still remains, albeit looking less likely as the path to a Democratic Senate majority appears to hinge on two Senate runoffs in Georgia in early January 2021. Should a Democratic sweep occur, we would expect a stimulus package worth at least $2tn, which could significantly boost the economy next year. According to Federal Reserve staff models, such a package could lift real GDP growth by about 5 percentage points and lower the unemployment rate by nearly 2 percentage points. Tax increases would very likely come, but these would not be of a concern for 2021. US 10-year Treasury yields are predicted to move back up towards 1% in response.

Should the Republicans win control of the Senate, we could be left with a divided government – as we are now. Expectations are for more legislative gridlock, conservative fiscal stimulus under $500bn and executive orders on regulation which could be negative for near term growth. The restrained fiscal stimulus is unlikely to be enough to offset the sharp recession in the US as it continues to battle persistent COVID-19 infections. US 10-year Treasury yields would be expected to fall towards 0.5% in this scenario.

Fiscal stimulus is one of the key differentiating factors between the scenarios and it is important to note that all stimulus is not the same and will impact the private sector in varied ways. If the current COVID-19 uncertainties remain, the private sector may remain conservative with spending and tighten the belt to prepare for further uncertainty. If this occurs, the supply of Treasury notes is unlikely to materially reprice the market as private savings are sufficient to fund public borrowing.

For US interest rates in the longer term, economic conditions are going to be more important than the imminent election result. Official policy rates have been constrained by the uncertainty around, COVID-19 in the medium term and the Federal Reserve has affirmed several times that it is “not even thinking about thinking about a rate hike”. It is very possible that official policy rates in the US are not raised throughout the whole presidency, whilst continuing with assets purchases to achieve Average Inflation Targeting¹ goals.

The outlook on inflation is still biased to the downside. In an environment of persistent labour market slack, inflation is expected to remain subdued, although trending upward very gradually.

Through the majority of the year we have been – and still are – defensively positioned within the Real Return strategy, with currently less than 40% exposure to equities overall and have recently moved to be overweight to duration at 3.6 years. We have implemented options to protect the portfolio against tail events, for example we hold S&P 500 put options that do not expire until late December 2020, to account for the risk of a contested US election. Market volatility remains elevated due to the uncertainties around COVID-19 and the economic consequences. Risk management is an integral part of our investment process and we will keep on monitoring and managing the risks in our portfolio. We believe the portfolio is well positioned based on where the world stands at the moment, but we remain willing to continue to adjust the portfolio to navigate risks and seek opportunities that can present themselves in this environment as required. Once the US Presidential, Senate and House election outcomes have been confirmed, we plan to re-assess our long term return expectations and reset our neutral asset allocations accordingly.

1 To target an average inflation rate over time, as opposed to a fixed inflation target rate. The US Federal Open Market Committee announced it will seek to achieve 2% inflation over time as of 15 September 2020.