As Americans prepare to go to the polls after one of the most bizarre election campaigns, here are the main things that investors should keep in mind.
Although the presidential race tightened in the last 10 days, many prognosticators and betting sites still predict that Hillary Clinton will win. If her victory is combined with down-ballot results that prolong gridlock in Congress – the most frequently predicted outcome for the legislative-branch elections — markets would likely react in a relatively calm and orderly fashion. Equities would remain range-bound overall, as would bonds and currencies.
There are two market “tails” that accompany this baseline; and they would lead not just to major moves in indices, but to notable compositional changes, too.
An equity market selloff is likely should Donald Trump win the presidential vote and also reaffirm his intention to move quickly on policy positions that disrupt long-standing trade relationships (such as tariffs on China and Mexico and the revocation of the North American Free Trade Agreement). The selloff would be larger if he also were to also create uncertainty about the future shape of the financial system, such as by calling for an immediate repeal of the Dodd-Frank legislation without offering a credible alternative.
Under this first tail scenario, the turmoil in equity markets would cause risk spreads to widen on both investment grade and high-yield corporate bonds. The reaction of government bond markets would likely be more nuanced. Nominal Treasuries would find themselves pulled between expectations for lower growth and those for higher inflation — that is, unless Trump repeats his attacks on the Federal Reserve, in which case higher yields would ensue. The outlook for inflation-sensitive securities, particularly TIPS, would be less ambiguous given that markets would likely revise up their projections for the possibility of a fiscally induced increase in inflation.
The other tail event, a Clinton win combined with a Democratic sweep of Congress, would likely bring about an equity market selloff that would entail more pronounced moves for certain sectors (such as pharmaceuticals and traditional energy). Bond markets would also come under pressure because of the higher probability of fiscal stimulus.
The currency markets are where the these two tail scenarios would have have quite different effects. In the case of a Trump win resulting in anti-trade measures, upward moves in the dollar could materialize. Although a trade war would initially hurt both the U.S. and its major trading partners, the U.S. would have less to lose in relative terms given that it is a less open economy. By contrast, a Democratic sweep would lead to a weaker dollar.