jebmo’s posthaven

1. Who’s in the lead?

Secretary Clinton continues to appear to have an advantage, but the race has tightened considerably over the last few weeks. Despite this, the public continues to expect a Clinton White House in 2017, with prediction markets assigning around a 65% probability to that outcome (Exhibit 1).

Exhibit 1: The public expects Clinton to win

Source: Iowa Electronic Markets, Goldman Sachs Global Investment Research

Sec. Clinton continues to hold a lead in the average of national polls. As shown in the right panel of Exhibit 2, she leads national polling by around 2.5pp at the moment. This is a relatively thin margin, but it has been consistent; Mr. Trump has led in a few polls, but at no point yet this year has he led the national polls on average.

For the last several weeks, Sec. Clinton has held a slightly wider lead in the states that look likely to provide her with the marginal 270th electoral vote required to win in the Electoral College. She appears to hold a lead of 4 to 6 percentage points in New Hampshire, Pennsylvania, Virginia, and Wisconsin. However, state polls fluctuate just like national polls, and her earlier wide lead in Colorado and Minnesota, for example, has shrunk considerably in the few recent polls that have been published. In fact, if current polling averages are an accurate reflection of the state of the election, her 270th electoral vote might come from Colorado, which she leads by only 2.5% at the moment, based on an average of recent polls. In some cases, these shifts are much sharper than the change seen in the more frequent national polls, often driven by one or two outlier polls. While this suggests that the state-by-state analysis could once again tilt more heavily in Sec. Clinton’s favor, for now the electoral vote count looks fairly close, with Sec. Clinton holding a slim lead (left panel of Exhibit 2).

Exhibit 2: The race for electoral votes has tightened, too

Source: Real Clear Politics, Federal Election Commission, Goldman Sachs Global Investment Research

The right panel of Exhibit 2 shows the average of national polls as well as a series we have constructed showing the polling average in the state that would provide her with the 270th electoral vote based on polling averages at a given moment. To do this, we calculate a daily average of polls in each state, using the change in national polling to adjust the average in states where no new polls have been released. We then organize the states each day from the widest Democratic advantage to the narrowest Democratic advantage, stopping when the total electoral vote count (assuming Sec. Clinton wins states she is leading) reaches 270 or more. The results suggest that, over the last month or so, Sec. Clinton has enjoyed a lead of 6 to 8 percentage points in the marginal state, but this lead has narrowed and, for now, resembles her national polling.

2. What could still affect the outcome?

The most obvious remaining source of uncertainty is the upcoming series of presidential debates. It is impossible to predict how these will affect voter perceptions, but expectations are higher for Sec. Clinton; a slim majority of voters expect that she will have a better debate performance (53%/43%), and among voters who indicate they could shift their support before Election Day, 60% expect Clinton will prevail.[1] While on its face this is positive news for Sec. Clinton, this also raises the risk of underperforming expectations. More generally, the effect of previous debates on voter perceptions is somewhat ambiguous. While there are several examples of debates that shifted the polls considerably, there are just as many that failed to have an impact. Overall, the median effect on public opinion is negligible following the first and last debates (Exhibit 3). That said, debates have had a larger effect on public assessments of the eventual election outcome. Following the first debate, the median probability assigned to the eventual winner of the election rose by about 5pp after two weeks, and by 7pp around two weeks after the second debate.

Exhibit 3: Debates can affect polls…and election expectations

Source: Iowa Electronic Markets, Real Clear Politics, Wlezien and Erickson (2002), Commission on Presidential Debates, Goldman Sachs Global Investment Research

The large third-party vote in this election, along with a significant undecided vote, also raises uncertainty regarding the outcome. Former New Mexico Governor Gary Johnson, who is running as a Libertarian, and Green Party candidate Jill Stein have been winning collectively about 15% of the vote in public opinion polling over the last few months. This represents the largest non-major party share since 1992, when Texas businessman Ross Perot ran as an independent and won 19% of the popular vote. As shown in the left panel of Exhibit 4, the third-party vote typically fades by Election Day as the two-party contest tightens. However, it is not clear at this point that either candidate would gain disproportionately from a shift away from the third-party candidates. One way to consider this is to compare Sec. Clinton’s average lead in two-way polls and four-way polls, which include the two minor-party candidates; her lead has been about 1pp smaller in four-way polls, on average, though the statistical relationship is weak. The upshot is that, while the large third-party vote share creates additional uncertainty about the election outcome, it is not obviously coming at the expense of one candidate in particular.

Exhibit 4: The third party vote pulls from both candidates and may shrink before election day

Source: Real Clear Politics, Polling Report, Various polls, Federal Election Commission, Goldman Sachs Global Investment Research

Despite the potential for surprises over the coming weeks, we note that it is very unusual for the winner in public opinion polls at this point in the race to lose the popular vote in November (Exhibit 5). We measure this from the date of the last convention, since the convention can significantly but temporarily affect public opinion polling. In every election since 1952, the candidate leading in public opinion polls seven weeks following the convention (usually but not always around mid-September) has won the popular vote. One near-exception was 1980, when President Carter and then-former California Governor Ronald Reagan traded leads back and forth several times over this period.

Exhibit 5: The leader in September usually wins in November

Source: Real Clear Politics, Wlezien and Erickson (2002), Goldman Sachs Global Investment Research

3. What about Congress?

We expect a closely divided Congress in nearly any scenario, though the base case appears to be a slim Democratic majority in the Senate and a slim Republican majority in the House. The Senate majority appears likely to be determined by the outcome in a few competitive seats, nearly all of which are in presidential swing states. Republican incumbents in Illinois and Wisconsin—both are Democratic-leaning states, as shown in Exhibit 6—trail their challengers by a considerable margin, and most analysts and prediction markets expect Democratic candidates to win these seats. In addition, the Republican-held open seat in Indiana—the incumbent is retiring—has consistently polled in favor of the Democratic candidate, former Sen. Evan Bayh, since he announced he was entering the race. Losing these three contests would take Republicans from 54 seats currently down to 51 seats. Beyond these, Republican incumbents also face serious challenges in Pennsylvania and New Hampshire, both of which appear to be leaning Democratic in the presidential election. Potentially offsetting this is a Democratic-held open seat in Nevada, where the race is essentially tied. Since the Vice President breaks ties in the Senate, a 50-50 split would result in procedural control by the party that wins the White House. In light of the higher implied probability that Sec. Clinton will win the presidency and the Democratic leaning states that look likely to determine the majority, a Democratic majority looks more likely than a Republican majority in the Senate next year, though we think it would be surprising for either party to hold more than 51 or 52 seats.

Exhibit 6: Several Republican seats in Democratic states

Source: Federal Election Commission, Real Clear Politics, Goldman Sachs Global Investment Research

In the House, the outlook is a bit clearer. We would make three observations. First, the “generic ballot” poll, which asks which party a voter prefers hold the majority in Congress, has reverted back to roughly neutral after having been in Democratic-friendly territory over the last couple of months (left panel of Exhibit 7). Second, the presidential vote and the House popular vote have been closely correlated (middle panel of Exhibit 7. Since Republicans have a structural advantage related to the allocation of voters across districts that is worth roughly 4% of the popular vote (right panel of Exhibit 7), this suggests that, unless Sec. Clinton wins by a wider margin than polls currently suggest, the probability of Democrats winning the House majority is fairly low, and lower than it appeared previously.

Exhibit 7: Generic congressional polling has returned closer to neutral

Source: Real Clear Politics, Federal Election Commission, Clerk of the US House, Goldman Sachs Global Investment Research

This suggests that the most likely election outcome is a continuation of divided government, with a Democratic White House and divided Congress. There is also a clear possibility of single-party control under Republicans if Mr. Trump wins. While we do not rule out the possibility that Democrats could win a narrow majority in the House, this looks less likely than the other two scenarios. Likewise, while it is possible that Mr. Trump could win the White House while Democrats win the Senate majority, this also looks unlikely since most competitive Senate seats are in swing states likely to determine the presidential outcome, and where Republican candidates have generally been outperforming Mr. Trump in the polls.

4. What could policymaking look like in 2017?

Under the base case of divided government described above, Congress and the White House are likely to struggle to enact significant legislation. The main obstacle would be a divided Congress. When the two chambers are controlled by opposite parties, legislation that passes one body often fails to even come up for a vote in the other body. Moreover, given what is likely to be a slimmer House Republican majority in 2017, Republicans will have fewer votes in excess that can be used to offset frequent defections from within the party. Such defections were a critical part of the last-minute nature of legislating during 2011-2014, the last period of divided Congress, as party leaders hesitated to reach across the aisle for votes from the other party unless or until absolutely necessary. In such a scenario, we would expect a return to more deadline-oriented legislation—a new spending agreement will need to be reached by September 30, 2017, and the debt limit is likely to need to be raised by October—and that legislation aimed at structural reforms would generally face greater obstacles.

By contrast, under single-party control, there would be two important differences. First, one party—probably the Republicans but a small chance of Democrats—would set the legislative agenda and focus public attention on certain issues. Second, certain decisions could be made with a simple majority. This means that the majority party could approve most nominations (except for the Supreme Court) and most fiscal legislation without support from the minority party, as described in more detail below.

5. What would this mean for fiscal policy?

Overall, we expect a slightly more expansionary fiscal policy stance over the next couple of years, but in the base case election outcome the difference is likely to be modest. As we have detailed elsewhere, the main focus at the outset of a potential Clinton Administration is likely to be an economic package that combines new infrastructure spending with international corporate tax reform, including a plan to tax previously untaxed foreign profits of US multinationals to generate revenue. Sec. Clinton proposes to increase infrastructure spending by $250bn over five years, or $50 billion per year.

If enacted, it would likely result in a significant flow of repatriated earnings from foreign subsidiaries to US parent companies, though the details would likely differ from the last low-tax profit repatriation enacted in 2004. Specifically, the tax would apply to all untaxed foreign profits, even if they are no longer held in cash available to be repatriated. The provision would only be enacted, in our view, if it were used as a transition mechanism to a reformed system for taxing US multinationals’ foreign profits. Therefore, in order for Congress to approve a profit repatriation plan, it would also probably need to reach agreement on some type of corporate tax reform, which would not be an easy task.

Nevertheless, if the proposal did pass, the amounts would be large. As of Q2, total profits permanently reinvested overseas totaled $2.9 trillion across all US businesses. Some of this amount likely consists of untaxed profits that have been reinvested for other purposes, so the foreign cash balance is likely to be smaller. As a ballpark figure, cash balances among S&P 500 companies excluding financials are currently $1.5 trillion, and we would expect the vast majority of this to be held overseas for tax reasons, suggesting that a bit more than $1 trillion in cash could be available for repatriation, though firms’ foreign funding needs are likely to determine how much would ultimately be repatriated.

We expect that, if Mr. Trump wins, fiscal policy would be looser than under the base case, for two reasons. First, we expect that a Republican Congress would be more likely to enact tax reform that results in net tax reduction, at least in the short term, than under divided government. This is partly related to the “reconciliation” process, which allows the party in power to pass tax, spending, or debt-limit related legislation with a simple majority in the House and Senate. Second, although he has not highlighted the issue the way that Sec. Clinton has, we expect that Mr. Trump would support and potentially push for significant infrastructure spending once in office. In fact, we would argue that, since congressional Republicans have generally been less supportive of additional infrastructure spending than Democrats have been, a Republican president might be more likely to succeed in persuading hesitant Republican lawmakers in a politically polarized Congress to support a spending boost.

That said, even under single-party control, there are limitations to how much the party in power could accomplish regarding fiscal policy. Beyond the challenging longer-term outlook for federal finances, the “reconciliation” process does not provide unlimited power. Specifically, as a result of changes enacted in 2007, the process might not be available to pass legislation that increases the deficit over the following ten years. Lawmakers often find ways around these sorts of rules—the possibility of greater use of “dynamic scoring”, which credits the economic effects of legislation against the estimated budgetary costs, might be one way—but these rules would probably constrain Republican plans, by limiting the scope of tax legislation or by requiring offsetting spending cuts to be passed as well. The upshot is that while the probability of a fiscal boost under Mr. Trump appears to us to be higher than under Sec. Clinton, there would be limits in both cases.

6. Would the election affect monetary policy?

It might, in two potential ways. First, as we recently noted, monetary policy would likely tighten in response to a fiscal boost. While this could have benefits related to reducing the risk of returning to the zero lower bound, it suggests that the near-term growth effects of fiscal policy changes would be smaller than would be the case had they been made several years ago when slack in the labor market was much greater and rates were pegged at zero.

Second, Federal Reserve Chair Janet Yellen’s term expires February 2018, and the next President is likely to name the next Chair in mid-2017. If Sec. Clinton wins, the most likely option in our view would be for her to nominate Chair Yellen for another term. By contrast, if Mr. Trump wins, his public comments regarding the Fed suggest he would look elsewhere for a new Fed chair, but his choice is hard to predict, as a number of well-known Republican economists have publicly supported Sec. Clinton’s campaign, potentially—but not necessarily—narrowing the list of potential nominees. In addition, Republican Fed critics in Congress—particularly in the House—have been arguing for a more rules-based approach to policy, and Mr. Trump could come under pressure to nominate someone associated with that approach. That said, if Mr. Trump wins the White House, his views on the Fed could also shift away from his current more hawkish tone, particularly if he intended to enact a looser fiscal policy as discussed above.

7. Would trade policy really change as much as current rhetoric implies?

We doubt it, though some changes are likely. Both candidates have opposed the Trans-Pacific Partnership (TPP) in its current form, and both have suggested renegotiating NAFTA. Mr. Trump has gone farther, also proposing significant tariffs on imports from China and Mexico, and even raising the possibility of withdrawing from the WTO. Overall, we expect that TPP will be sidelined for the foreseeable future under either scenario, though we do expect that eventually—probably not for another few years—the next President will try to resurrect the agreement.

The more immediate issue is whether Mr. Trump would follow through on his statements regarding foreign trade. While his suggestion to renegotiate the North American Free Trade Agreement (NAFTA) has drawn considerable attention, and even appears to be resulting in volatility in the Mexican Peso (Exhibit 8), our expectation is that NAFTA, and US-Mexico trade relations more generally, would be a less important issue under a Trump Administration than relations with trading partners in Asia, particularly China. We draw this conclusion for two reasons. First, over the last several years, the political debate over trade has focused mostly on China, not Mexico. Second, withdrawal from NAFTA is essentially a binary decision. It is likely that Mr. Trump could withdraw from the agreement without congressional approval, but he would not be able to renegotiate terms unilaterally. By contrast, the president has several options to address US-China trade issues, some of which could be WTO-compliant, like the increased use of anti-dumping and countervailing duties to target specific imported products, and some of which probably would not be, like the obscure authority the President has under the Trade Act of 1974 to impose temporary 15% tariffs on certain imports to address a balance-of-payments deficit. Overall, while we expect that Mr. Trump would take a more cautious approach to trade if elected than his current rhetoric might imply, this issue is likely to be a key source of uncertainty.

8. How would regulation be affected?

We would expect that in most areas, Sec. Clinton and Mr. Trump would follow more traditional party lines regarding regulatory questions. With a divided Congress, Sec. Clinton would have a difficult time passing significant regulatory-focused legislation, in our view. In theory, this makes major legislative changes regarding issues like drug pricing less likely, for example. That said, to the extent that developments force action on certain issues—returning to the healthcare example, there is a possibility that Congress will need to intervene in the Affordable Care Act health insurance exchanges next year, in light of weak enrollment, rising premiums, and the withdrawal of several large insurance companies—some of these issues could nevertheless become a focus.

Under Mr. Trump, we would expect the differences to be mostly limited to non-legislative issues, such as incremental differences in regulatory actions related to healthcare, domestic energy production, or financial institutions. From a legislative standpoint, bipartisan support would still be necessary to pass the Senate, where Republicans are likely to have no more than 52 or 53 seats in their best-case scenario, but would need 60 Senate votes to pass most (non-fiscal) legislation.

9. How might the election affect financial markets?

The effect on markets should be a combination of the change in policy uncertainty resulting from the election outcome, and the expected effects of the policy changes anticipated under the new president and Congress. It seems likely to us that uncertainty would rise following a Trump victory, since his positions on certain issues have fluctuated and are in some cases genuinely uncertain, and because the potential range of outcomes under single-party control is wider than under divided government. In particular, we would expect his position on trade-related issues to be a focus for financial markets if he were elected, given the president’s greater unilateral authority in that area. Heightened uncertainty could be a short-term negative for risk assets like equities. Sec. Clinton and a divided Congress would represent something close to a status quo outcome, with limited uncertainty and a narrower range of outcomes if control of Congress is split between the parties.

From a policy perspective, the effects look mixed. Fiscal policy is likely to be looser under Mr. Trump and a Republican Congress than under Sec. Clinton and a divided Congress. In isolation, this should support equities, but expectations of tighter monetary policy, in response to looser fiscal policy or perhaps in anticipation of a change in Fed leadership, could offset this.

10. Is the election already affecting financial markets?

There is only weak evidence that the election is having a significant effect on broader markets at this stage. To explore this, we regress daily changes in the S&P 500 on changes in the probability of a Clinton victory implied in prediction markets, as well as the implied probability of a divided government, single-party control under Republicans and single-party control under Democrats. To control for the effect of growth, policy, and inflation surprises, we include proxies for these influences that have been estimated by applying principal components analysis to 18 market variables since January 2000.

The results are mixed. We do not find a meaningful relationship between the implied probability of Sec. Clinton winning the election and equity prices measured from the end of the primary campaign. While there is a statistically significant negative relationship between changes in equity prices and changes in the probability of a Clinton victory over the last several weeks, this effect disappears when we include the odds of single-party control under Democrats (Exhibit 8). The upshot is that in recent weeks equities appear to react negatively to the prospect of Democratic single-party control but show no clear reaction to the other potential scenarios. In all cases the coefficients are small, suggesting a modest overall effect.

Exhibit 8: The election might be affecting equities

Source: Bloomberg, Iowa Electronic Markets, Goldman Sachs Global Investment Research

The effects of the election appear clearer in a few specific segments of the market, however. One notable example is the Mexican Peso, where the term structure of implied volatility suggests market participants are expecting increased movement around the time of the US presidential election (Exhibit 9). To the extent this is related to rhetoric concerning NAFTA, it seems likely that, in the event Mr. Trump wins, markets would nevertheless eventually focus their attention elsewhere if we are correct that renegotiating trade agreements, particularly NAFTA, might be less of a focus under a potential Trump Administration than it has been in the campaign.

Exhibit 9: …And the Mexican Peso

Source: Bloomberg, Iowa Electronic Markets

Our portfolio strategists have noted that certain subsectors of the equity market appear to be correlated with election odds: healthcare providers—which stand to lose if the Affordable Care Act is repealed—and apparel stocks—which could face increased costs if tariffs are placed on imports—rise with increased expectation of a Clinton victory, while software firms—which are among the sectors with significant unrepatriated cash—benefit from increased expectations of a Trump win. While there is no clear statistical relationship with pharmaceuticals, we would expect this to be another area where the market is likely to view a Republican administration to be more industry-friendly. Over the next several weeks, our expectation is that the effects of shifting election expectations are more likely to become apparent through these sectoral channels than in markets more broadly.