Investors are warming to a 'blue wave' that could keep driving a stimulus-hungry market higher

Published Mon, Oct 12 20203:26 PM EDTUpdated Mon, Oct 12 20203:39 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

With just weeks to go until the election, the stock market appears to be switching horses. That's not to say that Wall Street no longer perceives President Donald Trump as better for the economy, the market and taxes. But there's been a clear warming to the idea that former Vice President Joe Biden is getting far enough ahead of Trump in the polls that the threat of a contested election has been reduced, and Biden's policies could, in fact, be stimulative. "The market is pricing in a Democratic wave. It's not scared," said Quincy Krosby, chief market strategist at Prudential Financial. "The market is accepting this in lieu of a contested election...The market, I think is beginning to understand a blue wave doesn't necessarily mean an ultra progressive agenda." Stocks were sharply higher Monday and last week was the best week for the S & P 500 since early July, as Biden gained steadily in polls. According to RealClearPolitics, he is leading by an average 10.6% in major polls, up from just around 7% two weeks ago. "A prevailing market narrative a few months ago was that a Blue Wave election outcome — former Vice President Joe Biden wins the presidency and the Democrats sweep Congress — would be negative for equities because it would result in higher corporate taxes and more regulation," note UBS strategists. "But in the past two weeks this narrative has completely flipped, to the point where investors now view a Blue Wave as being a catalyst for a reflation trade: cyclicals and value stocks higher, a steeper yield curve, and a weaker US dollar." Biden has said he would raise taxes, boosting the corporate tax rate from 21% to 28%, basically reversing the Republican tax cuts from 2017. He said he would raise capital gains taxes and taxes on the rich. But he is also expected to unfurl a large infrastructure spending program, which would be quickly approved if Democrats are to win the Senate. Given the inability of Congress to act on Covid relief ahead of the election, some investors expect an even bigger package from Democrats if there continues to be no progress. Goldman Sachs strategists say a blue wave would have a modestly positive impact on S & P 500 profits next year. "If the Democrats were to implement both fiscal stimulus and tax reform in 2021, we estimate these policies would have largely offsetting effects, leading to S & P 500 EPS being roughly in line with our status quo 2021E estimates but lower thereafter," the Goldman strategists wrote. Trump took credit for Monday's rally in a tweet. John Normand, head of cross-asset strategy at JPMorgan, said a Democratic sweep could "reboot" the U.S. and global expansion that started in May but stalled in August. "Whatever one thinks about the course of regulatory policy, the margin impact of higher corporate taxes and the possibility of stealth deglobalization, what will matter more for the next 12 months will be front-loaded stimulus," according to the JPMorgan note from Normand. Krosby said there's been an unwinding of some hedges in the options market, where investors had been betting on extreme stock market turbulence around the possibility of a contested election. Investors were concerned by Trump's criticism of mail-in ballots and his claim that he could only lose if the election were rigged. Raymond James analysts said industrial stocks could do better with a Democratic sweep, which should improve the earnings outlook, but it would be partially offset by higher tax rates and more regulation. If Trump wins and Congress remains divided, that would likely result in an even more contentious relationship with China, which could hurt some industrial companies but there would be no tax changes and there could be some stimulus spending. Biden is seen as less antagonistic towards China. Morgan Stanley analysts explored what higher taxes under a Biden administration would mean for financial companies. A 7 point increase in the corporate tax rate could cut consumer finance and bank earnings by a median 7.4%. But higher infrastructure spending would be a positive, as would higher interest rates for banks under Biden. The Morgan Stanley analysts expect the benchmark 10-year Treasury to yield 0.95% at year end, but they say there's a bear case under which it could reach 1.50%, on expectations of more U.S. debt and better growth. Yields move opposite price. "However, there is a wide range of EPS impacts from -6% to +3% with names that are more asset sensitive, credit sensitive and have commercial loan skews better positioned," said the analysts. They said Wells Fargo, Capital One, and Bank of America are best positioned. State Street , American Express and Goldman are not are least well positioned, they added. The idea of a Biden win has already shown up in clean energy stocks, with solar stocks and clean energy names rising. Biden proposes spending $2 trillion over four years. He would seek a carbon neutral power sector by 2035, and decarbonization of the transportation sector through spending on electric vehicles. JPMorgan strategists warned of two other scenarios that would be less positive. "Beware of two wildcards, however: that either Biden or Trump faces a divided Congress in 2021 no more willing to spend than the current one (due to a conservative minority of Republican Senators); or that a Blue Wave (more House seats) skews a centrist Biden agenda towards progressive policies," said the note.

U.S. Democratic presidential candidate Joe Biden speaks during a campaign event at United Association (UA) Plumbers Local 27 in Erie, PA, October 10, 2020.

Kevin Lamarque | Reuters

With just weeks to go until the election, the stock market appears to be switching horses.

That's not to say that Wall Street no longer perceives President Donald Trump as better for the economy, the market and taxes. But there's been a clear warming to the idea that former Vice President Joe Biden is getting far enough ahead of Trump in the polls that the threat of a contested election has been reduced, and Biden's policies could, in fact, be stimulative.

"The market is pricing in a Democratic wave. It's not scared," said Quincy Krosby, chief market strategist at Prudential Financial. "The market is accepting this in lieu of a contested election...The market, I think is beginning to understand a blue wave doesn't necessarily mean an ultra progressive agenda."