ElectionWatch 2018: Sector Impact Chief Investment Office Americas, Wealth Management 29 October 2018 2:47 pm GMT Justin Waring, Investment Strategist Americas, justin.waring@ubs.com; Michael Ryan, CFA, Chief Investment Officer Americas, mike.ryan@ubs.com We continue to expect a historically average result in the midterm elections, with a 60% chance that the Democrats win a small majority in the House of Representative and Republicans retain control of the Senate. If Democrats capture the House, we expect an increase in gridlock, with a higher risk that must-pass legislation is passed through last-minute "midnight deals" that could be market-disruptive in the short-term. By contrast, the "Republican control" scenarios look more market-friendly. In this report, we look at the potential implications on US equity sectors. We expect limited impact overall, largely due to the limits on passing legislation in a divided government, but there are two "swing sectors" financials and industrials where there is more at stake in this year's election. Visit ubs.com/electionwatch to simulate results and see their implications On the whole, political factors continue to favor Democrats this year, while economic factors favor Republicans. Using a multivariable regression model to combine these elements (summary of current readings in the right panel), we estimate that the outlook for Republicans has improved a little since our original analysis. On the whole, this model continues to suggest a smaller-than-average loss of around 13 Republican House seats, which would leave the GOP with a very thin House majority. However, this assessment comes with a large "margin of error" and can't capture other factors Republicans' lower-than-usual incumbency advantage due to a high number of retirements, Democrats' fundraising advantage, and the tone set by special elections that will likely boost the probability of a strong midterm result for the Democrats. All about the base As we head into the final stretch, turnout is the key variable that we simply can't predict with accuracy. Despite high apparent enthusiasm among voters ahead of this election, history tells us that we will see a big drop-off in turnout from 2016. Midterm turnout averages 39%, versus 56% in presidential elections. But this dropoff isn't uniform, so the key question is which party will be able to turnout more of their base. One reason why Democrats' midterm losses have been larger than the Republicans' losses in recent elections is due to a larger drop-off in their voters' participation during midterm years. In the 2010 and 2014 midterms, Democrats were able to turn out about half of the voters that they saw in the prior presidential election, versus two thirds of Republicans. Additional reading What are the midterm elections really about? Which key races should we keep an eye on? Can we rely on polling? For these answers and more, please see this Special Washington Update report from our UBS US Office of Public Policy. Status update Checking in on the key political and economic criteria featured in our first ElectionWatch report: The 'generic ballot' According to this national poll metric, 49% plan to vote for a Democrat, versus 41% planning to vote for a Republican. This 8% gap is slightly worse for the GOP than the 7% August reading. Presidential approval At 44%, there has been an improvement from August's 41% reading, but this is still an historically poor metric for the GOP. Perhaps more importantly, President Trump's 87% approval rating among Republicans is among the highest of sitting presidents. Misery Index The "Misery Index," which is the sum of unemployment and inflation rates, first gained popularity in politics when Jimmy Carter used it to defeat Gerald Ford in the 1976 presidential election. At the time, its high reading summarized the woes of the mid-1970s US economy. At 6.0% (3.7% unemployment + 2.3% CPI inflation), the reading has fallen even further from 6.6% at the time of our last report, and now sits below 90% of all previous readings. Consumer confidence After a previous reading of 133.4, which was already the highest we've ever seen ahead of a midterm election, economic confidence has moved even higher into uncharted territory, with a September reading of 138.4. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.
Scenario recap With all of this in mind, we're leaving our scenario probabilities unchanged. A divided Congress (Democratic House, Republican Senate) is the strong favorite, with 20% likelihood given to the scenarios where each party holds a slim majority in both chambers. As a reminder, we assess the "Democrat control" scenarios are neutral to negative for risk assets. This isn't a judgement on their policy platform, but an assessment of the potential political dysfunction that could arise from combative relationship between Congress and President Trump, which increases the risk that Congress will fail to advance "must-pass" legislation. Could a Democratic victory boost sentiment? Winning elections (as measured by the change in House seats) tends to boost voters' optimism for economic outcomes. The impact is more muted during midterm election years, and it is also asymmetric boosting the winners' outlook more than it dampens sentiment among the losing party. At the moment, there is a large skew between Republican and Democratic voters' confidence in the economy. Based on the October release of the University of Michigan Consumer Sentiment report, the index of Democrats' consumer expectations sits at 65.3, while Republicans' expectations are at 85.3. So if Democrats pick up seats in the House, which we deem highly likely, we could see a further boost to already-elevated economic confidence. Fig. 1: Elections can have a notable impact on economic confidence Change in U. of Mich. Consumer expectations, preto post-election +7 Winners +23 Mid-term -2 Presidential Losers -18 Source: UBS, Bloomberg, as of 26 October 2018 Fig. 2: Scenario recap Red tide (2% probability) Status quo (18% probability) Historical norm (60% probability) Blue wave (20% probability) Republicans expand the size of their majority Republicans keep their majority in both chambers of Congress Democrats gain a House majority, but Republicans control the Senate Democrats take control of the House and the Senate Market impact (risk assets) Policy possibilities Entitlement reform Regulatory relief acceleration Border wall funding Obamacare repeal Regulatory relief continues Border wall funding Entitlement reform Obamacare repeal Gridlock Regulatory relief continues Government shutdown Impeachment (but removal unlikely) Supreme Court freeze Extreme gridlock Regulatory relief slows Government shutdown Supreme Court freeze Debt ceiling showdown Congress constrains trade authority Impeachment (but removal unlikely) Source: UBS Chief Investment Office Americas, Wealth Management 29 October 2018 2
US equity sector analysis There is a limit on what legislation can be passed by the next Congress. Even with majorities in the House and the Senate, as well as control of the White House, Republicans failed to pass a repeal of the Affordable Care Act and only barely managed to push through tax reform by using the procedural tactic of "reconciliation" to overcome a filibuster. We give a 98% probability that Republicans will have an even more difficult task in the next two years. And even if Democrats are able to secure a majority in both chambers, which is possible but unlikely, their majorities will be razor-thin and they won't be able to pass anything without President Trump's signature. On several key economic issues of the day for example trade, immigration, internet regulation the two parties will either need to find a bipartisan approach, cede responsibility to the executive branch's limited authority, or accept the status quo until after the 2020 presidential election. This is one reason why we expect a limited impact to markets, and this holds true when we look at US equity sectors. As we outline in the table below, there are several important issues facing each sector, but we expect very limited action on these items under the 116 th Congress. Fig. 3: The midterms are unlikely to have a meaningful effect on our US sector strategy Estimated election impact, US large-cap sectors Sector Name Midterm impact Key Issue(s) Red tide (2%) Status quo (18%) Scenarios Historical norm (60%) Blue wave (20%) Consumer Staples Deregulation could benefit the food, beverage, and tobacco subsector, but the Trump administration has actually increased tobacco regulation. Consumer Discretionary, which would make some personal tax cuts permanent, could help to boost consumer spending. Communication Services Internet regulation will be a heated topic, and could be a headwind, but seems to be largely bipartisan so little impact from the midterms Under all scenarios, we expect to see continued pressure on internet companies. Energy Barring a change in Republican support for the Iran sanctions which have driven oil prices higher Congress is unlikely to impact the sector. infrastructure bill Headline risk from House committees Anti-fracking and environmental initiatives (state level), headline risk from committees Financials Medium While Democrats would struggle to enact unfriendly legislation, control of committees can pose headline risk. Headline risk from House committees Slower deregulation, headline risk from committees Health care Controlling rising drug costs is a largely bipartisan issue, with little change based on the midterm outcome. Under all scenarios, we expect to see continued pressure on pharmacy benefit managers (PBMs), with a risk of a stronger push that could impact pharmaceuticals. Industrials Medium Deregulation, potential budget gridlock or defense cuts infrastructure bill, Defense cuts Defense cuts, slower deregulation Info Tech Another round of tax cuts could help boost corporate confidence, capital investment, and IT spending Materials Any change in pro-business agenda. China trade war and potential spending on infrastructure. infrastructure bill, Real Estate Although Democrats will push for a repeal of parts of the Tax Cuts and Jobs Act pecifically the SALT deduction cap this is unlikely to pass. Rent control initiatives (state level) Utilities An infrastructure spending package could provide a boost, while slower regulatory relief would remove a tailwind. infrastructure bill Slower deregulation All sectors Less gridlock Extreme gridlock, possible debt ceiling showdown Source: UBS Chief Investment Office Americas, Wealth Management 29 October 2018 3
Swing sectors There are two "swing sectors" where there is a bit more at stake in this year's election: financials and industrials. Diving into more detail on the specifics below, our sector strategists estimate that there is a 5 to 10% difference between the "best case" and "worst case" election outcomes for each sector. Financials Bradley Ball, CFA For Financials, there will be little change if the Republicans remain in leadership of both houses. The positive regulatory and fiscal policies/trends we ve seen since November 2016 will continue. And even under a Blue wave scenario, this would not significantly alter the positive regulatory progress, and new restrictive legislation is unlikely to survive President Trump's veto. Meanwhile the Trump-appointed heads of key regulatory agencies (already seated at the Fed, the FDIC, and the OCC) should be able to continue making reforms regardless of who is in power in Congress. That said, if Democrats gain control of one or both chambers of Congress, this could have a negative impact through two avenues. First, a less-friendly congress could work to slow the pace of deregulation, and would eliminate hopes of legislation aimed at rolling back parts of the Dodd-Frank Act. Second, a Blue Wave scenario would likely see Maxine Waters and Sherrod Brown chairing the House Financial Services and Senate Banking committees, respectively. Their control of the committees hearing calendar and their unhelpful ideological rhetoric would, at a minimum, cause headline risk for Financials. It's also notable that Financials will become a key target for the Democrats if they win the Presidency in 2020 so even if the chance of legislation is low in the meantime, markets will begin to fret about "what dreams may come" if Democrats win a follow-up victory in the next election. Industrials Adam Scheiner, CFA For Industrials, the Red tide or Status quo outcomes would be positive, if only because we could see less gridlock in Washington. An extension of the personal tax cuts would also be a positive, as would a potential infrastructure bill. The former will be a particularly tough sell if the Democrats pick up seats (e.g. except in a Red tide scenario), while the latter looks possible as a compromise between the two parties. Even so, if an infrastructure bill is financed at the expense of lower defense spending, this would limit infrastructure's benefit for the overall sector. Trade is obviously a negative for industrials, but so far we've seen very little sign that the midterms will have an impact here. Republican voters largely support President Trump's trade negotiations at the moment, and we would need to see a change of heart before there is any bipartisan push to curtail the executive branch's authority regarding tariffs. Even under a Blue wave scenario, Democrats won't have enough votes to override a presidential veto, or even to overcome a Republican filibuster. If Democrats gain control of the House, we see some latent risks to the sector. In particular, gridlock can be particularly painful for Industrials given the fact that any failure to pass a defense budget and other stop-gap spending measures would trigger so-called "sequestration cuts" that could have a significant impact on defense spending. With current defense spending running well above the caps defined by the Budget Control Act, failing to reach a budget agreement could result in an up to 13% cut in defense spending in a worst case scenario. However, we see the odds of this result as very low as growth in defense spending has received bipartisan support historically and believe both parties would not want to see such a disruption to this vital industry. Most likely the overall growth in defense spending could be on the chopping block even if that means only that the spending increase will be less than expected if the Democrats want to free up room in the budget for their own initiatives. With nondiscretionary non-defense spending already cut to the bone under the current budget (making up only 16% of federal spending), defense spending would be a key target in any bipartisan budget deal. Conclusion We currently recommend an overweight to financials, while we recommend a moderate underweight to industrials. Due to these potential effects, we would become incrementally more positive on both sectors if Republicans outperform expectations next Tuesday. But there are bigger factors at play, and political considerations are unlikely to override the fundamentals, even in the case of a Blue wave surprise. With the 2020 election campaign effectively underway already, speculation will shift quickly as soon as the results are in. We'll be discussing this, and other considerations, in our policy panel at next week's CIO Global Forum events in Atlanta and San Francisco. For more, please visit ubs.com/cio-forum. Chief Investment Office Americas, Wealth Management 29 October 2018 4
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