It’s called the “October surprise”. In the lead-up to the US presidential elections, candidates strategically hold back big, campaign-altering news until the month before Americans go to the polls in the hope of pushing themselves over the electoral line.

Over the summer, political pundits warned that the Trump campaign would make positive announcements regarding a Covid-19 vaccine, to buoy volatile markets and lift public sentiment about the administration’s handling of the coronavirus pandemic, which has killed more than 200,000 Americans.

Instead, the big surprise came last week when the president announced in the early hours of October 2 that he and his wife had tested positive for Covid-19.

Markets immediately dipped on the news. Though they later rallied, Donald Trump’s diagnosis raised volatility levels and unsettled investors.

The disturbance focuses attention on an even bigger event for markets — the election itself. What are the likely scenarios and how can investors around the world, including those in the UK, mitigate the risks?

British investors are exposed because they are active in international markets, with their foreign holdings concentrated in the US. At Interactive Investor, one of the UK’s largest DIY investment platforms, customers have some 20 per cent of their equities invested overseas, of which, on average, 77 per cent is US shares.

Even more than who wins the election, what matters to investors is the degree of victory, experts say. A contested election result complicates market forecasts.

Video: Why investors fear the US election

Adding to the uncertainty is the simultaneous race for the Senate, where Republicans currently have control, battling with the Democrats who now dominate Congress. A Democrat majority in both houses, combined with a Biden win, could pave the way for increased regulation on business and higher taxes. All of that has been traditionally bad news for shares, just as Mr Trump’s early tax cuts boosted US equities.

However, divided party control could spell gridlock and uncertainty over stimulus packages, which tend to boost markets.

On top of this, for foreign investors, come currency considerations. The dollar has been generally strong in the past five years, including the Trump presidency. But can this last, especially if the election were to be contested? Can British investors in particular, with the volatile pound as their home currency, possibly get right the timing of any foreign exchange-linked bets?

Does Mr Trump’s illness change anything?

Following the announcement of Mr Trump’s positive test, US stock futures fell in early trading and the Vix volatility index rose 2 points to 28. A shock, but a muted one compared with other jumps in the previous month.

However, investors do appear increasingly concerned by tensions between Mr Trump and the Democrats over a new fiscal stimulus package. Signs of progress on passing a package early in the week prompted fund managers to begin pricing in a “much-needed boost to economic prospects”, according to Richard Hunter, head of markets at Interactive Investor. But equity markets fell after Mr Trump abruptly announced he would walk away from negotiations with Democrats.

“There are also concerns over Mr Trump’s capability to deal with the currently troubling political and economic challenges over the next few weeks,” says Mr Hunter.

After a short stay in hospital, the president returned to the White House, but it remains unclear whether the diagnosis — and his response to it — will lead to a surge in public sympathy for him or hurt the Republican campaign.

“With some key state polls tight and this positive test coming so close to the election, this development will just add to the uncertainty rippling through the markets,” says Susannah Streeter, investment analyst at Hargreaves Lansdown, the UK’s largest investment platform. “There are already signs of a flight to safety with both the dollar and the yen rising sharply, and gold on the rise too. US treasuries have also jumped, as investors seek a place to hide.”

The fall in the US stock market could also suggest investors think a Biden win is more likely than ever. “[Mr Biden’s] intention to raise taxes will not be good for corporate profits and therefore a negative for the stock market,” says Russ Mould, investment director at platform AJ Bell. 

Line chart of S&P 500 indices, rebased showing Tech stocks have been leading the US market

What happens if Mr Trump wins?

A Trump victory combined with a divided Congress — the status quo maintained — would lead to little change in the markets, analysts say. “The focus of markets would shift to the size and timing of additional fiscal stimulus policies, and how any delays in stimulus negotiations could impact markets,” says Adrian Lowcock, head of personal investing at investment platform Willis Owen. 

Investors may regard a second Trump presidency as “pro-business”. Having cut corporate taxes from 35 per cent to 21 per cent, more fiscal action could be in the pipeline, though Mr Trump’s economic latitude to introduce further Covid-related stimulus measures is constrained.

But economic optimism is scarce on the ground. While growth shares such as the five largest tech stocks in the US — Facebook, Apple, Amazon, Netflix and Google, collectively known as the Faangs — have continued to outperform the markets, most other stocks are flagging, suggesting investors do not see a broad recovery in the short term.

“A Trump victory with a split Congress probably is good for stocks. The Faangs will continue to outperform as the focus shifts to tensions with China and the EU once again,” says Graham Bishop, chief investment officer of Heartwood Investment Management.

But a Trump win almost certainly means more trade friction and escalated commercial conflict with China, analysts say.

All this will put pressure on the dollar, a key consideration for non-US buyers of American stocks. “Political risk is high, the dollar is weakening, interest rates are at rock bottom, so gold is attractive. Corporate debt is at an all-time high, government debt is high,” says Luca Paolini, chief strategist at Pictet Asset Management. “Everything is against the dollar.”

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For UK investors, though, sterling provides them with a natural hedge. In times of financial stress — such as a possible future dollar shock — the pound tends to soften because of UK markets’ dependence on inflows of foreign capital. So the sterling value of US shares would not be hit as hard by a dollar sell-off as their value in a harder currency.

However, predictions involving sterling are complicated by another seismic political event: the outcome of the Brexit negotiations. A successful deal could strengthen the UK currency and devalue international investments; pessimists, by contrast, might look to increase their international exposure.

Would a Biden win really be bad for business?

Perhaps, if the Democrats also secure the Senate, say analysts. This is an under-appreciated element, says Ian Jensen-Humphreys, portfolio manager at Quilter Investors. If the Democrats win back the Senate from the Republicans, as some polls predict, “this raises the likelihood that Biden could push through his campaign promises such as increasing the corporate tax rate.”

Others agree. “There is a tail risk with a massive Democrat win in the House and the Senate that they could introduce fairly radical legislation — which would likely include harsher antitrust measures and tax rises,” says Harish Natarajan, head of economic risk at Ake Group. However, renewable energy would be expected to take off, in light of Mr Biden’s campaign commitments to the sector. 

Mr Biden is also expected to be tough on fossil fuel-based energy, including shale, and increase regulation. But that is not bad news for all energy shares. Oil regulation in the US could drive up the price, making international suppliers a more attractive investment. 

Poles apart: Donald Trump and Joe Biden during their bad-tempered televised debate © Jim Lo Scalzo/EPA-EFE/Shutterstock

A Democratic victory “would be supportive for risk assets but would also entail a larger deficit outlook and an increased risk of inflation, which implies lower real rates”, says Olivier Konzeoue, a trader at Saxo Markets. “Overall, [this is] an environment that would in our opinion make gold more attractive.”

Any switch in administration tends to be followed by a period of underperformance in the markets, says David Bailin, chief investment officer at Citi Wealth Management, a part of Citigroup. Yet, historically, markets have done better under Democrats, he adds. 

“Democrats have tended to take over in times of problems needing to get resolved,” he says. “In general, markets tend to do better than people expect, especially under Democrats, for the past 52 years.”

Mr Bailin says investors should be invested for the expected recoveries in 2021 and 2022, regardless of the US election, and would be wise not to sell in the current market but to consider strategic reallocations. He favours a shift away from being overweight in tech, media and telecoms — into more cyclical industries. “Buy stocks with good earnings and dividends,” such as European shares, he says. “Go global, away from the US to Europe, Asia and Latin America.”

Advisers note that wary investors are sitting on higher cash balances than normal. The added anxiety of an uncertain election can delay investors’ re-entry to the markets, and risks them missing out on recovery. Mr Bailin says many investors missed out on a decade of gains after not fully reinvesting following the financial crash.

Line chart of S&P 500, Oct 2000 to Jan 2001 showing The stock market fell in 2000 when the election result was uncertain

What if the election result is contested?

A contested result would shake markets. Mr Natarajan cites the month-long delay to the 2000 election result, when the S&P 500 index fell more than 4 per cent. “It’s plausible that 2020 will be more fractious.”

Stocks also dropped on the night of the 2016 election. “At the time, the narrative around these moves was that the stock market feared a Trump presidency,” says Kristina Hooper, chief global market strategist at Invesco. But she suspects the real reason was fears of a contested election. They should be prepared for a similar effect this time. “In this environment, I would expect gold and Treasuries to perform well.” 

Does it matter in the long run?

Probably not. New analysis from fund manager Vanguard finds that the impact of elections on returns in financial markets is statistically negligible over the past 150 years — with no pattern in market swings before or immediately after an election. The research found annualised volatility in the S&P 500 index was 2 percentage points lower in the 100 days preceding and following a presidential vote.

“Elections are impactful because they set the trajectory of policy,” says Andrew Patterson, a senior economist at Vanguard. “Instead of focusing on election outcomes themselves, [investors should] focus on economic fundamentals.”

The election could have an outsized effect on industries that are vulnerable to big policy shifts. But other factors may become more important, such as news about the pandemic, curbs on economic activity and potential vaccines, as well as the effects of fiscal stimulus, including possible inflation.

Many advisers say that despite the uncertainty, retail investors should do as little as possible to avoid overtrading and incurring fees and taxes.

An academic study from 2017 found that feelings of confidence in the market were profoundly impacted by political affiliations, and this shifted people’s perceptions of risk. When your candidate wins, you’re more bullish and more likely to take risks. Though the difference can be small, investors do better when their own party is in power.

Line chart showing how Trump and Biden are doing in the US national polls

“The underlying mechanism is optimism,” says one of the study’s co-authors, Yosef Bonaparte, associate professor at the University of Colorado Denver Business School. “If Biden is elected, a lot of Republican investors won’t be optimistic.”

The strength of investor bias has increased since the study was first published in 2012. However, as economies are increasingly global, “investors should not base their optimism based on a single political leader”, he says.

The consensus among advisers is that no short-term anxiety about an election should topple a well-structured investment plan. No one can predict the market, says Georgia Lee Hussey, chief executive of US wealth manager Modernist Financial, but “what I do know will happen is that over time, no matter what administration, markets go up”.

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