How might the U.S. elections influence markets?
Risk assets rallied on Wednesday morning, with Donald J. Trump seemingly on track to return to the White House and the potential for the Republican Party to gain control of both the House and the Senate.
Post-election market rally
The S&P 500 Index hit a fresh record high, up 2.0%, small caps gained north of 4.5%, while Bitcoin is up nearly 6.0% on Wednesday morning.1 It’s fair to say that market expectations for potential pro-cyclical policies under the incoming Trump administration are likely to have contributed to the positive sentiment.
Notably, shares of regional banks also surged, as financials are seen as one of the big winners from possible deregulation. Meanwhile, bond yields are surging (the 10-year U.S. Treasury yield is up ~15 basis points (bps), to 4.47%, as of this writing), likely reflecting investors’ deficit concerns (and, to a lesser extent, the potential for tighter immigration policy that might push up wages). The U.S. dollar gained more than 1.5% against a basket of major currencies, moving in tandem with higher rates.1
10-year U.S. Treasury yields (%)
The 10-year Treasury yield is now up over 80bps since mid-September, a move that’s been tightly correlated with the improvement in Donald Trump’s odds of winning the election. In light of the dramatic move in yields within such a short period of time, we wanted to look back at the bond market during the 2016 election.
As it turns out, the 10-year U.S. bond yield jumped post-election in 2016, likely because the outcome was a bigger surprise to markets back then. This time around, we’ve seen significant moves pre-election—possibly because the bond markets have been expecting a Trump win.
It’s worth noting at this point that back in 2016, the 10-year yields went into a consolidation phase for a year after the initial surge and then ramped on pro-cyclical policies, most notably the 2017 Tax Cuts and Jobs Act (TCJA). By 2019, however, they came back down near where they started as disinflationary forces took hold due to the lagged impact of monetary tightening policies that were announced throughout 2017 and 2018. While no historical example is perfect, this is a road map worth considering—particularly since TCJA provisions are due to expire at the end of 2025 and the issue of tax reforms will come into focus again.
U.S. mid caps deserve investor attention
On the equity side, we expect U.S. mid-cap stocks to benefit from any upcoming pro-cyclical policies while managing valuation risk. Although small caps are surging on the back of the outcome of the election, we prefer moving up in cap to mid-cap equities as they feature higher-quality, more profitable businesses, and having an overweight in the industrials sector, a potential winner under looser fiscal policy. In addition, mid caps can have a role to play in helping to protect portfolios from the valuation risk that we’re seeing in U.S. equities.
Stocks have gotten historically expensive, with the S&P 500 Index trading at 26x trailing earnings today, up from 17x two years ago (this is the third-highest valuation on the index in modern history, only behind 1999/2000 and 2021).1 Within the U.S. equity market, mid caps are trading at the steepest discount to their large-cap counterparts since the late 1990s, helping lower valuation risk.
Fixed income: balancing credit and duration risk
On the fixed-income side, we’re balancing credit and duration risk, advocating for core-plus positioning with overweights in mortgage-backed securities and investment-grade corporate bonds in the middle of the credit spectrum.
Lower-quality credit has become increasingly expensive as of late as high-yield spreads remain tight at 278bps, well below their 20-year average of roughly 500bps,1 meaning there’s a chance that high yield is priced to perfection.
On the other side, long duration could see issues if there’s greater deficit spending, as it increases supply and strengthens the economy (reducing the need for the U.S. Federal Reserve to cut rates). This leaves us in the middle of the credit and duration spectrums, balancing risks with intermediate core-plus-type fixed-income mandates.
As always, we expect more clarity to emerge over the coming days and weeks. For now, though, markets might be able to heave a sigh of relief as the fog of uncertainty associated with the presidential election lifts.
1 Bloomberg, as of 11/6/24.
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