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How Will the Outcome of the Presidential Election Impact Markets?

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How Will the Outcome of the Presidential Election Impact Markets?

What’s on your mind?

Clients have a lot on their minds these days about how their portfolios will be impacted by various forces–and who can blame them during these volatile times?

Here are three that have recently been brought to my attention:

1. How will the outcome of the presidential election impact markets?
 

While I cannot say that it doesn’t matter who occupies the White House, it’s important to put the presidency into perspective. Naturally the members of the Fed’s Open Market Committee (FOMC), in directing our monetary policy, can have a bigger impact on markets and the economy than the President. While the President appoints the 12 Fed governors, all but the chairman and vice-chairman serve 14-year terms, and their terms are staggered. (The chairman and vice-chairman serve four-year terms.) They are all confirmed by the Senate. Also, five presidents of regional Federal Reserve Banks also sit on the FOMC. So the next president (or any president) does not call the shots on monetary policy.

Second, under our three-branch system of government with its checks and balances, the president’s powers are in fact rather limited–although you wouldn’t know it when you listen to all the promises being made by the candidates. For example, a president could propose massive infrastructure spending spree that could create a lot of construction industry jobs. But it could only become a reality if Congress agreed to fund it.

And even if the majority of members of Congress are of the same political party as the president, that doesn’t guarantee the President will get his or her big wishes granted. When the country is as divided as the U.S. seems to be today, it is unlikely that the next president will win by a large enough margin to claim and convince Congress that he or she has a mandate from U.S. citizens to making big changes.

It seems more likely that other forces, including the price of oil and global economic trends, will have a far bigger impact on investment markets than the outcome of the U.S. presidential election, after accounting for some inevitable volatility around Nov. 8th.

2. How much U.S. treasury debt does China hold? If the next President adopts protectionist tariffs toward China, how can China retaliate on the basis of the treasuries they hold?
 

Let me start with an overview of our debt situation. Total federal debt about $14.5 trillion. The largest portion of U.S. debt, 68% (or about $10 trillion), is owned by individual investors, corporations, state and local governments and, yes, even foreign governments such as China.

Foreign governments hold about 46% of all U.S. debt held by the public, more than $4.5 trillion. According to the Treasury, the largest foreign holder of U.S. debt is, indeed, China, which owns more than $1.24 trillion in bills, notes, and bonds. That amounts to about 30% of the over $4 trillion in Treasury bills, notes, and bonds held by foreign countries. 

But in total, China owns only about 9% of publicly held U.S. debt. Of all the holders of U.S. debt China is the third-largest, behind only the Social Security Trust Fund’s holdings of nearly $3 trillion and the Federal Reserve’s nearly $2 trillion.

It’s also worth noting that the current $1.24 trillion in U.S. debt held by China is actually slightly less than the record $1.317 trillion it held in 2013. Economists suggest the decrease was due to China’s decision to reduce its U.S. holdings in order to increase the value of its own currency.

Even so, 9% of U.S. is significant. But would China use that leverage to retaliate against us, perhaps by selling a lot of it, to retaliate against a protectionist U.S. trade policy? It seems unlikely. First, dumping U.S. debt securities would devalue China’s remaining holdings of U.S. debt. And second, the U.S. already has a $350 billion annual trade deficit with China, which means China has more to lose than the U.S. does.

Regardless, despite rhetoric flying around in the presidential campaign, it seems unlikely that the next president will promote doing anything precipitous in regard to tariffs because the outcome would be too unpredictable. That doesn’t mean smaller steps won’t be taken to gauge their impact before pushing harder.

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3. Are risky mortgages being bundled into securities sold to investors?
 

This is not a big concern at present. First, keep in mind that mortgage-backed securities (MBSs) are investments similar to stocks, bonds or mutual funds. Their value is secured, or backed, by the value of an underlying bundle of mortgages. When you buy an MBS, however, you aren’t buying the actual mortgage. Instead, you are buying a promise to be paid the return that the bundle of mortgages receives. That means an MBS is a derivative because it derives its value from the underlying asset.

Still, that doesn’t mean you can’t have problems, as investors did during the financial crisis. The good news, though, is that these markets are much more closely monitored and regulated, and the new stress-testing of financial institutions by the federal government, appear likely to prevent the kind of catastrophe we experienced in 2008-2009.

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