Countdown to Election Day

In this pivotal election year, billions of voters around the globe are heading to the polls. While there already have been several influential elections this year, including France, Mexico, South Africa, and the UK, to name a few, the US election stands out to us as the most significant. The upcoming November election carries the potential for material policy changes with important macroeconomic and investment implications.

Potential Policy Shifts

With the US election, there are many pertinent issues and significant changes proposed by both parties with attendant implications for the economy. Certainly, topics like energy, immigration, labor, geopolitics, and other issues may ultimately influence markets, the economy, and the US dollar, but not necessarily immediately. Financial markets can only focus on a finite number of variables. While other issues may come to the forefront in time, for now, we think the two big areas on which the market is focusing are trade and fiscal policy.

1. Trade Policy

While both parties may potentially increase tariffs, particularly against China, former President Trump has proposed a 60% tariff on imports from China and a 10% tariff on imports from other countries. If implemented, these trade proposals would send US tariffs to their highest levels since the 1930s. The magnitude of these proposals could certainly change, and it is impossible to know how or when any new trade policies would be implemented. However, even if only half of these tariffs are introduced, 70 years of US trade liberalization will be reversed. It is extremely difficult to forecast the impact of such a large policy shift on financial markets, inflation, domestic and global growth, or geopolitics. Hence, it is unlikely that markets are fully pricing in the impact of these proposals. To what extent these tariffs are a negotiation tactic is unclear. It is clear, however, that both Trump and trade officials from his prior administration believe tariffs can reduce the US trade deficit, raise government revenue, and create manufacturing jobs. Additionally, they believe tariffs can be imposed without Congressional approval, including on countries with which the US has free-trade agreements.

Implications: The introduction of broad-based import tariffs would result in a one-time increase in prices but would have a relatively limited impact on medium-term inflation. At the same time, we would expect a large negative shock to global growth that would disproportionally impact US trading partners. Even if higher tariffs have a modest direct impact on US GDP, they will worsen the economic slowdown already underway. Ultimately, we expect large tariff increases to lead to lower bond yields, with higher inflation breakevens more than offset by lower real yields.

Typically, when a large, closed economy increases tariffs, its real exchange rate should increase. That was indeed the case when the US increased tariffs on Chinese imports during the Trump administration. In the event of a Trump victory in November, the US dollar (USD) is likely to rally, especially against currencies most sensitive to global trade growth. The Trump administration may wish to weaken the dollar, which is already strong. However, in the absence of the Federal Reserve's (Fed’s) cooperation, it is unclear how dollar devaluation can be achieved on a sustained basis.

2. Fiscal Policy

Understanding the implications of fiscal policy, including both spending and taxation, remains a work in progress. However, that is not to say that fiscal policy changes will be inconsequential. The next administration must determine the fate of individual income and estate tax cuts that are set to expire at the end of 2025. If extended, these tax cuts, part of the 2017 Tax Cuts and Jobs Act (TCJA), would cost $3.4 trillion over 10 years, according to the Penn Wharton Budget Model¹, or up to $4.6 trillion, based on Congressional Budget Office estimates.²

Adding to his signature legislation, the TCJA, Trump is proposing a variety of tax cuts and credits, including exempting tips and Social Security benefits from taxes, an expanded child tax credit, and reducing the corporate tax rate to 15% from 21% for companies making their products in the US. The 10-year cost of this agenda could be upwards of $10.5 trillion.²

The agenda proposed by the Harris campaign, which is likely to continue many of the priorities set under the Biden administration, also includes extending many of the TCJA’s individual tax breaks for middle- and lower-income households. In addition, expanded child tax credits and larger incentives to first-time homebuyers, aimed at making homeownership more affordable, are features.

Where the candidates differ is how they propose to pay for their proposed agendas. The Harris campaign is proposing to raise taxes on the top 3% of households, or households making more than $400,000 annually. She also is seeking a new minimum income tax of at least 25% on individuals whose net worth is at least $100 million. Meanwhile, Trump is likely to repeal the Biden administration’s clean energy credits from the Inflation Reduction Act (IRA), while intending to generate most of the revenue to pay for the tax cuts through tariffs.

Implications: Ultimately, the success of either candidate’s plan hinges on control of Congress. There are several congressional races that are too close to call, but a divided government appears probable. Even with a congressional sweep, majorities for either party will be slim. With or without full control of Congress, Democrats likely will have difficulties pushing some agenda items through, most notably a minimum income tax on the ultra-wealthy. Similarly, Trump also faces challenges to realizing his agenda without massive spending reductions, potentially to social programs like Medicaid, Medicare, and Social Security. He has pledged to make the TCJA provisions permanent and repeal the IRA, but may lack the necessary votes to realize these campaign objectives since the TCJA originally was paid for in part by capping state and local tax (SALT) deductions, an unpopular move, while the IRA has produced significant job gains in several red states.

Campaign rhetoric aside, we see the following key takeaways with regard to future fiscal policy:

• Most households are not likely to see a huge tax decrease as in 2018, but they also are unlikely to see a large increase given both candidates’ pledges.
• Success of either party’s agenda will be up to Congress, and it is unlikely that either side’s extreme proposals will pass “as is” given the narrow majorities.
• It will be difficult for the Democrats to regain the Senate due to the challenging math and tight path to majority involved.

Lastly, both campaigns have provided little guidance on any real commitment to rein in the skyrocketing US budget deficit. But while the overall US fiscal deficit remains a significant concern, it is the change in this deficit—the ‘fiscal impulse’—that matters most for economic growth. Hence, we will be tracking how tax cuts and fiscal spending may play out to gauge the ramifications for growth.

What Are Markets Pricing In?

As stated previously, it is difficult for investors and markets to incorporate too many major macroeconomic drivers at the same time. Primarily, asset market performance has been driven by Fed policy implications up to this point.

Currently, market expectations for the Fed’s next rate move in November are nearly evenly split between a cut of 25 basis points (bps) or 50bps. Because of this uncertainty, markets may remain more focused on the Fed than on the upcoming election. Meanwhile, the Fed will be focused on the next two payroll numbers. It is still unclear whether recent softness in the labor market reflects a natural slowdown and weaker immigration, or signals something more negative going on in the economy. Hence, the Fed remains very attuned to the employment data. Inflation numbers may matter somewhat, but it will be the labor numbers that determine whether the Fed does 25bps or 50bps next.

From a market perspective, the election will probably only become dominant a week or two beforehand unless there is some event or a big October surprise that forces investors to reconsider the election odds. While the election polls are extremely close, we believe investors appear to be leaning toward a Harris victory with a divided Congress. Generally seen as least disruptive and a continuation of the status quo, this outcome would have modest impact on financial markets since major policy shifts would be unlikely due to the constrained administration, in our view. At the same time, the removal of election uncertainty may provide a short-term boost to economic growth.

Currently, a Trump win would be a surprise to the markets, and the biggest surprise with the greatest impact would be a Trump victory with a clean sweep of Congress. We think the most likely impact of a Trump presidency would be a stronger dollar, at least in the short term. Long-term bond yields may also increase as a result of a Republican clean sweep.

Portfolio Positioning

Our fixed income portfolio composition has been more focused on what the economy and inflation have been doing and the Fed’s reaction function than on the upcoming election. Over the past three months, US bond yields have declined sharply in response to lower inflation and softer labor market data. Markets are pricing in an aggressive Fed easing cycle at a time when economic conditions remain fair. It is not clear that the economy is decelerating rapidly, and signs appear to point more toward a soft landing. Given less compelling bond valuations, we have brought our duration exposure toward neutral from a large overweight. As the election nears, reducing portfolio risk and adopting a more conservative approach to position sizing may be prudent because of the possibility of large market shocks in November.

¹Chris Matthews, “Why Republicans ‘don’t have the votes’ to pass Trump’s tax plan,” MarketWatch, September, 7, 2024, https://www.marketwatch.com/story/why-republicans-dont-have-the-votes-to-pass-trumps-tax-plan-8c4c31b7

²Erik Wasson and Enda Curran, “Trump Tax Cuts Would Cost More Than Almost All Federal Agencies,” Bloomberg, September 4, 2024, https://www.bloomberg.com/news/articles/2024-09-04/trump-tax-cuts-would-cost-more-than-almost-all-federal-agencies