What Should Investors Do in The Event of a Contested Election?

In these days of the 24-hour news cycle, breathless hyperbole around elections is only to be expected. However, this time, phrases such as “the most important election in our lifetime” could quite possibly have some validity. Certainly, the two candidates represent very different views, not just in policy terms but in terms of what type of leader the U.S. should have but, there is one other thing about this election that is different, and that could well have a bearing on investment decisions.

For the first time, a sitting president has pointedly refused to say that he would accept the results of the election should he lose. He and many in his party have spent months in the runup to it attacking democracy, claiming in advance that the whole process is unfair and that the only way he can lose is if the election is “rigged.”

Of course, given that he is trailing in the polls with a week to go, the most likely reason for him losing is that he gets less votes, but that isn’t really the point. If a big enough minority of Americans believe that he was cheated, it can still cast doubt on the result.

On the other side of the coin, a consistent and growing lead in the polls for Biden, both nationally and in the majority of swing states, means that Democrats too believe that the only way they can lose is if the election is taken from them. Should Trump win, Biden supporters will be convinced that it is because the election was stolen through voter suppression and intimidation, undue intervention by the Supreme Court, Russian misinformation campaigns, or by some other nefarious means.

It seems, then, that anything other than a landslide win for Biden will result in a contested election, and conventional wisdom is that it would be bad for markets. But is that true?

It is based on the old adage that markets abhor uncertainty, but that is just so 2016. The last four years have been nothing but uncertainty, with on-again, off-again trade wars, presidential policy guided by talking heads on TV and issued by tweet, and a turnover of staff at the White House like never before. We have had missile launches in North Korea, the impeachment of the President, scandal upon scandal, and even a global pandemic that shut the developed world down for a while and which is peaking again. And yet, here we are, with the S&P 500 just off all-time highs:

Obviously, at least in an environment of deregulation and corporate tax cuts, and when the Fed is creating and handing out trillions of dollars of investable cash every year, uncertainty is not that big a deal.

Now, if there were to be some uncertainty about the Fed’s continued support, or if there were reason to believe that a re-elected Trump would increase corporate taxes and reimpose regulations, or if there was doubt that a Biden win would be swiftly followed by a big stimulus package, then of course sustained market weakness would be inevitable. As it stands, though, with the Fed as a backstop, the only doubt that a contested election would bring to stock traders is what kind of help they would be getting.

I am sure there will be selling as a knee-jerk reaction should it look like the election will be close and therefore contested, but it is unlikely to last long as neither of the two most likely results, a Biden win or a contested election, should logically cause a big drop in the market.

After such a large, sustained lead in the polls, a Biden win must be priced into stocks by now to some extent, and if you believe that the market is where it is because of Trump not in spite of him, then a contested election looks like the best of the two possible outcomes. At least that way, there is still a chance of more tax cuts and even less regulation.

The real danger to markets after the election, however, may not come from stocks.

Lest we forget, the U.S. government has a debt of over $27 trillion and growing at an alarming rate. That is what inevitably happens when you cut taxes and increase spending at the same time and so far, nobody other than a few old fuddy-duddies like me sees it as a problem. Democrats have never been known for their fiscal responsibility and Republicans have made it clear that debt and deficits, while the ultimate evil under a Democratic administration, are no problem at all when Republicans are in power.

With interest rates at historic lows and the stock market at historic highs, it seems that even a debt that size really doesn’t matter. That, however, can change very quickly.

The stock market may not mind all the uncertainty, but if the bond market decides it does, the stock market’s tolerance is irrelevant. The global bond market is bigger than the global equity market by several orders of magnitude, and if the big money traders and investors there, the so-called bond vigilantes, see a contested election as a real danger to the long-term stability of America and its institutions, they will lose faith in that government’s ability to meet its obligations.

If that happens, debt of $27 trillion plus becomes more than a problem, it becomes a potential disaster. A rout on Treasuries and other debt would cause big jumps in interest rates, forcing more borrowing, which in turn pushes rates higher, resulting in more borrowing to cover interest payments, etc., etc. The only bulwark against that would be the Fed, but with the current balance sheet having nearly doubled over the last year to over $7 trillion, their ability to withstand a concerted attack on U.S. debt would be extremely limited.

I should reiterate that this is a worst-case economic scenario and that it is far more likely that a few weeks on from the election, we will be bouncing along as normal. The market tends to drop when Democrats are elected, even though both the economy and the market have historically done much better under Democrats. That means that, barring a very unlikely clear Trump win, there will be a selloff after the election, but it will be short-lived. There is, however, a possibility of much more serious disruption.

So, what is a poor investor to do on election night and the following morning?

For long-term investors the answer, as usual, is as little as possible. Assuming that America survives this crisis as it has every other, things will be fine and, over long periods, the market goes up. That is just historical fact. In the weeks that follow election night though, if the result is in doubt, keep an eye on the longer dated Treasuries, like the 10-Year Note and 30-Year Bond. If yields rise significantly, that will be a warning that should be heeded. It could be an early sign of the kind of market disruption that cannot be ignored, and would be a serious sell signal, even for long-term investors.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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