Volatility beckons as Democrats seek to turn the tables

Many wealth managers had been looking to ‘Trump-proof’ client portfolios before Joe Biden’s withdrawal, but a whole new market dynamic may now emerge.

US President Joe Biden’s decision to withdraw his candidacy for a second term in office, less than four months before the November election, plunges the Democratic nomination into uncertainly.

The announcement by the oldest sitting president in US history came amid mounting pressure from increasingly senior Democratic Party leaders and top donors, sceptical of his ability to govern for another four years, following poor performance in a debate with Republican nominee Donald Trump on June 27.

Former President Trump’s polling lead, both nationally and in swing states, had also widened following a failed assassination attempt on July 13.

But how are these dramatic events likely to affect markets, and impact asset allocation decisions?

“While the timing of the announcement was a surprise, betting odds had already priced it in as a very likely outcome,” says Ross Yarrow, managing director of US equities at international financial services firm Baird.

Just before the announcement, Mr Biden had only a 7 per cent chance of winning the Democratic nomination, versus 64 per cent for vice-president Kamala Harris, now endorsed by President Biden as the Democratic nominee.

“We therefore wouldn’t expect any major market reaction to the news, especially if Harris runs on a similar policy platform to Biden,” comments Mr Yarrow.

How Ms Harris is received by the US public and which way this swings the polls and odds will be key.

While the contest has been “reset”, Mr Biden’s withdrawal is unlikely to change the election’s dynamics, believes Solita Marcelli, chief investment officer for the Americas at UBS Global Wealth Management. The American electorate is now “highly polarised” and most of Mr Biden’s supporters will be reluctant to abandon the party’s nominee. Ms Harris has already secured the support of a majority of Democratic delegates, to become the party's nominee for president, according to a survey by the Associated Press.

“The outcome of the election could be consequential for investors, especially if either party wins control of both the White House and Congress,” says Ms Marcelli.

Higher tariffs

A Trump victory, especially if supported by a Republican majority in Congress, would likely raise market expectations of tax cuts and lighter business regulation, while adding to concerns over higher trade tariffs. Primary beneficiaries of regulatory changes could include financial services firms, while higher tariffs on imports could harm US companies with global supply chains.

Meanwhile, a Democratic administration would likely continue to support initiatives benefiting green energy, efficiency and electric vehicle makers.

The base case for UBS is that the S&P 500 will end the year around 5,900, modestly higher than the current 5,505. This prediction would hold in most political scenarios, apart from an unlikely Democratic sweep to power leading to higher corporate taxes, or a scenario in which former President Trump imposes trade tariffs as high as proposed in his campaign speeches. Either outcome is unlikely at present, according to UBS.

In addition, the global bank believes the positive outlook for top US tech companies is likely to more than offset political uncertainty. In the near term, investors should expect some market volatility as investors digest the news, according to UBS.

“We have seen some rotation toward ‘red’ sectors and away from ‘blue’ ones in recent weeks as recent momentum has favoured the Republican party,” says Ms Marcelli. “That could at least partially reverse in the coming days as markets parse the latest developments.”

But investors should remember that US political outcomes “are far from the largest driver of financial market returns”, or even sector performance, she adds. Economic data and Federal Reserve rate-cut expectations remain at least as important.

Also, much can still change ahead of November's ballot and a range of outcomes remain possible. “We therefore advise investors against dramatic shifts in portfolio strategy based on their expectations or political preferences,” says Ms Marcelli.

Strategies recommended by UBS to manage risks surrounding the election include holding a well-diversified portfolio and considering structured investments with capital preservation or yield generating features.

President Biden’s decision to exit the campaign “makes a Trump sweep somewhat less of a foregone conclusion and as such we should expect some volatility over the next four months”, believes Lindsay James, investment strategist at UK firm Quilter Investors.

For now, however, expectations of rate cuts will remain the driving force for market returns, rather than a noisy election campaign, she says. “Trump is favoured but if Kamala Harris, or another nominee, makes inroads then the recent rotation may lose legs and volatility could take over.”

Trump trades

“With Biden stepping down, the primary question looming over investors is whether to continue betting on the ‘Trump Trade’, says CEO Nigel Green at financial services firm deVere.

The term refers to profiting from market behaviours and trends that emerged during Trump’s presidency, driven by his administration’s looser fiscal policies, deregulation, higher tariffs and infrastructure spending.

“The impact of these policies on markets included a rising dollar, higher bond yields, specific sectors like banking, healthcare, energy, and industrials seeing gains due to deregulation and anticipated infrastructure projects, plus bitcoin seeing increased interest,” notes Mr Green. “If Harris can gain significant traction and pose a credible threat to Trump’s lead in the polls, market volatility is expected to persist.”

The idea that the presidential race could now resume a more traditional debate centred on policies rather than fitness for office is not however convincing, says Aaron Rock, head of nominal rates at asset management firm abrdn.

“Trump is now likely to have the tables turned and face his own accusations of being too old for the presidency,” he says. In any case, a somewhat less self-assured Trump may well increase his campaign’s intensity, with contentious headlines and attacks on character inevitable.”

When adding to this a recent softening in inflation and labour market data implying interest rate cuts before November, the one thing that appears certain is that market volatility will remain high.

Weighing up potential scenarios, Steve Brice, global CIO, Standard Chartered Bank, believes a Democrat victory would likely mean the House and Senate are split. Arguably, from an economic perspective, this could be the “best outcome” as dramatic policy changes would be challenging to implement, resulting in “the least fiscally irresponsible outcome”. This may reduce concerns about potential bond market fire-sales resulting from an unconstrained Republican agenda.

However, the political environment would be challenging, admits Mr Brice. In this scenario, it is possible for Republicans to formally endorse the “stolen election” mantra, provoking significant clashes between ardent supporters of both parties. This could be unnerving for investors who still look to the US for leadership.

“Ultimately, I am a believer that economics ‘trumps’ politics when it comes to financial market performance,” says Mr Brice. “Therefore, while volatility would likely be higher, especially in the immediate aftermath of the election, this is probably the best outcome for financial markets, both for bonds and equities.”

Standard Chartered maintains its overweight position for US equities. “We see central banks cutting rates around the world, including in the US itself,” says Mr Brice. “These lower discount factors should boost more growth-focused areas of the market disproportionately and the US has a higher exposure to these sectors than other major markets.”

Fundamental powers

The political environment is likely to dominate headlines and potentially affect market price action in the coming three to four months, but fundamentals will ultimately win out. “Policies will be important in determining the outlook for earnings and interest rates,” says Mr Brice. “But we would focus more on the short-term macro and policy outlook rather than worrying excessively, at this stage at least, about what might happen in 2025 after the election.”

The presidential winner may have to work with congressional leadership from the opposing party, predicts Paul Christopher, head of global investment strategy at Wells Fargo Investment Institute.

“In such a scenario, we doubt that a Democrat in the White House would have enough congressional support to raise taxes significantly, or a Republican to cut taxes. However, there may be compromises that widen the deficit further,” he says.

In addition, it is possible that the already wide deficit and growing interest cost of the debt could constrain Congress and force spending cuts or selected higher taxes, even for a party that sweeps to power.

“Clearly, many decisions most relevant for markets are likely to depend on compromises to be hammered out next year, including a likely debate over raising the public debt ceiling in 2025,” says Mr Christopher. “The bottom line for the US is that pre-election guessing about which scenario could occur requires making many more assumptions than just who is leading in the presidential polls today.”

While election and economic uncertainties bunch up to produce “possibly rough seas” in the coming months, Well Fargo’s investment guidance continues to focus on quality, prefering US markets and US firms with strong balance sheets, good revenue prospects, and attractive valuations. At a high level, these include US large cap equities, over mid and small cap equities, investment-grade fixed income over high-yield fixed income; a broad-based commodity exposure; and alternative investments that historically have low correlations with equity and fixed income markets.