US Election Countdown: The many ways the election could yet shock markets

Polling numbers are according to fivethirtyeight.com, a polling aggregator.

The oddsmakers this week say:

Betting odds numbers are according to polymarket.com, a real-money betting site for event outcomes.

This week: The many ways the election could yet shock markets.

The inexorable tightening in the US election polls has continued as Harris’ lead versus Trump has narrowed to the narrowest margin since early August. Many believe from the faulty polling in the 2016 and 2020 elections that the polls always underestimate Trump’s chance of winning. But the pollsters have changed their ways, possibly improving their accuracy, but just as possibly making themselves wrong in new ways.

That’s why this week we focus on what happens if the polls are badly off once again – but in both directions.  We also look at the major risks that could drive post-election market uncertainty if the election results are as close as the polls suggest they might be. 

Chart of the week: US Small cap stocks will be more sensitive than the large cap stocks to election surprises 

The chart above shows the two ETFs that track the US S&P 500 index (red), the most followed index of large US stocks and another that tracks the S&P 600 Small Cap index (blue), nearly all of which are companies with a market capitalization between just under USD 1 billion and up to about USD 8 billion. We chart these ETFs to point out that US small caps strongly outperformed in the period after Trump’s first election win in 2016 (note the arrow) on anticipation of the Trump tax cuts. That’s because small cap stocks are generally more domestically focused than the large US companies that have a global reach and dominate the S&P 500 index. So small cap stocks would likely get a bigger boost on a Republican sweep on hopes for the promised corporate tax rate cut to 15% from 21%. By the same token, a shock Democratic sweep this time around would likely have the opposite impact on small caps because Harris has promised to hike the rate to 28%. A gridlock scenario in which the party of either candidate does not have control of both houses of Congress is neutral on this issue because no change to the corporate tax rate would be likely.

Note: specifically, the two ETFs charted above are the euro-based iShares Core S&P 500 UCITS ETF and the iShares S&P Small Cap 600 UCITS ETF. Both are listed in Germany, the UK and Switzerland. 

First: what if the polls systematically wrong in either direction?

Both the 2016 and 2020 election cycles showed us that the support for Trump was badly underestimated. In 2016, it was the huge surprises in specific states in the mid-West that proved decisive in handing Trump the victory. In 2020, the polls massively over-estimated Biden’s edge nationally – suggesting he had a more than 8% advantage, which ended up only being a 4.5% edge on Election Day. Given these missteps, the pollsters have been out with significant overhauls to their polling methodologies to get closer to “the truth”. In the end, we won’t know if they have succeeded until the results are calculated starting next Tuesday evening. 

But let’s consider what happens if the polls are very wrong in either direction:

What if we get a landslide Republican sweep (Trump 2.0) scenario? This is what the market has supposedly already been leaning hard in favour of in recent weeks, judging partially from market moves, but also the betting odds. But it is by no means fully priced in, and a Republican sweep involves the highest stakes because it brings the most forceful policy initiatives, from tax cuts and deregulation to even larger budget deficits and big new tariffs. Many suggest that it is an unambiguous positive for US stocks on the pro-business angle. Others suggest that US public finances are in such a horrible state that Trump and the Republicans would never be able to pass the promised tax cuts, and that US treasury bond yields (interest rates) would spiral out of control if they even try. 
And then there are the Trump tariffs and the US dollar and its role in global trade. This is where a Trump 2.0 scenario could have the most impact on global markets. Robin Brooks, a former chief currency strategist with Goldman Sachs, posted last week that China’s “main weapon” if Trump delivers big tariffs would be a large devaluation of its currency. This would further aggravate the US-China trade war risks. And other exporting countries – think Japan and Germany in particular – would find themselves less competitive. As well, a super-strong US dollar is destabilizing for anyone holding debt denominated in dollars, especially painful for emerging market countries. Clearly, a Republican sweep could bring many new shocks. 

What if we get a shock Democratic sweep scenario? First, let’s make it clear, given the momentum in the consensus that Trump is likely to win, that this would be a real shocker. But if the polls have simply badly missed how many of harder-to-reach younger voters are turning up and voting pro-Harris and anti-Trump, it is a theoretical possibility. If it emerges that Harris will win and the Democrats miraculously retain control of the Senate and retake the House, the market would likely suffer an ugly quick correction as it would have to price in the likely eventual rise in corporate taxes. Since US markets dominate world markets, this would inevitably spill over to global markets as well. US treasury yields would struggle to figure out how much new fiscal spending a Harris administration would bring and whether the deficit would worsen further, so inflation concerns and yields might stay higher, driving further headwinds for US and global equities.

Second: what if the outcome is as painfully close as the polls suggest it might be?

Until the recent surge in odds that Trump looks set for a strong performance in the election, the consensus was, and perhaps still should be, that the outcome could be extremely close. I lean a bit more toward a very close election based in part on how the polls got the 2022 mid-term elections wrong. Just ahead of those elections (for about a third of Senators and all of the House members, who must run every two years), a leading poll aggregator, fivethirtyeight.com, projected that the Republicans were slightly favoured to win the Senate and that they were likely to get about 230 of the 435 seats in the House. What actually happened was that the Democrats not only didn't lose, but actually strengthened their majority in the Senate and the Republicans only won 222 of the House seats, providing them a fragile and tiny 222-213 majority. The results were driven by voter turnout as more women and especially younger women showed up to vote after the US Supreme Court overturned the right to an abortion at the federal level, leaving every state the right to make its own rules on the issue. 

In this election, there are any number of ways that a very close election result could play out. First, simply getting the result itself could take additional days and weeks if key states demand recounts of extremely close vote totals. 

More profoundly, if one side refuses to accept defeat and launches a legal effort with significant backing to question the result of the election, the uncertainty could drag on for longer. On the Republican side, a defeat could see a challenge of whether the Democrats are guilty of voter fraud and allowing illegal immigrants to vote in specific precincts. If the Democrats lose by a very narrow margin in states the have changed rules for presenting voter ID, on the other hand, they might challenge the election result on the grounds of “voter suppression”. 

Possibly the most nail-biting of all scenarios would be a 269-269 tie in the Electoral College. There are actually four possible ways that this could happen using different combinations of the results in the swing states and a single electoral vote in Nebraska. (Maine and Nebraska are the only two states that allow splits in their electoral votes). The rules are complicated, but an Electoral College tie would in essence bring a state-by-state vote that would favour Trump because he has the edge in more states than Harris- But it would also mean that Wyoming and its population of 600,000 would have as much power in determining who becomes president as California and its population of 39 million. Let’s say the election is determined this way after Trump loses the overall national popular vote by 3% or more. How would that go down with Democrats? 

In short, we should respect the uncertainties and how the longer the uncertainty drags out, the worse it is for global markets, although most investors should keep calm and carry on and leave the short-term guesswork to the traders.

That’s it for this week. See you next week with some points on what to watch for on election night itself!

About the author: John is Saxo’s Chief Macro Strategist, with over twenty-five years’ experience in the financial markets, chiefly as Saxo’s former Head of FX Strategy. He is also an American, having grown up in Houston, TX and has a long-standing passion for following the course of US elections and their place in history since being allowed to stay up late as a young kid to watch the 1980 election results roll in and Ronald Reagan winning the presidency over Jimmy Carter.