Although some recounts and legal action may still be outstanding, markets have rallied over the past week on the back of more clarity and less policy uncertainty.
Investors have also been focused on the Senate, where Democrats and Republicans have each secured 48 seats. The final tally will not be known until the two Georgia runoff elections in January, but the math suggests either a Republican or razor-thin Democratic majority. In either event, the Democratic “blue wave” that investors had feared would unify government and lead to significant policy shifts has evaporated.
Under a divided government, we would expect a moderate fiscal package (approximately $1 trillion) and limited legislative potential otherwise. Significant changes in tax policy would probably not happen. Multi-trillion-dollar fiscal spending would also be off the table. A divided government reduces regulatory risks in our view, and leaves incremental differences in regulation dependent on White House control. Even a slim Democratic majority would likely limit the scope of potential policy to the realm of executive order or moderate reconciliation.
The economic implications of this outcome do not significantly change our forecasts.
GDP: Growth is largely dependent on reopening, a vaccine, and continued policy support. Goldman Sachs Global Investment Research (GIR) expects GDP growth of 5.3% in 2021, with a reacceleration in Q2 after the winter slowdown.
Inflation: Inflationary pressures will likely be weaker under a divided government, with core PCE forecasted to be 1.7% for FY 2021.
Federal Reserve: Limited reflation, a still-improving labor market (5.6% estimated headline unemployment rate by YE 2021), and less substantial fiscal spending may allow the Federal Reserve to maintain its accommodative positioning. GIR projects the first potential rate hike of the cycle to come in 2025.
For markets, we believe a divided government allows investors to move on to focus on fundamentals.
Equities: Moderate fiscal stimulus remains a priority, and without plans for higher tax rates, equities may move higher. Growth stocks may continue their long-term trend of outperformance, supported by low nominal rates and investors putting a higher premium on quality earnings and strong balance sheets in the absence of substantial fiscal spending.
Rates: US Treasury yields may move higher in line with risk sentiment and broader economic recovery, but we would expect the rise in rates to be checked by a smaller fiscal spending package and still-dovish Federal Reserve.
FX: The US dollar is likely to continue to weaken due to its high valuation, its countercyclical status in a recovering global economy, and deeply negative real interest rates in the US. But a divided government that results in less fiscal stimulus and a more constructive US approach to trade may imply less US dollar downside.
In 2021 political risks may remain top of mind, but we think the key drivers of the macro and market environment will be COVID-19, a potential vaccine, re-opening, and recovery.