As Democratic presidential nominee Joe Biden's lead in the polls widens, Wall Street is warming to the prospect of a Democratic sweep in November.
Goldman Sachs and UBS recently advised clients to prepare for a shift to cyclical and value stocks from growth favorites, as a Biden victory increases the odds of additional fiscal stimulus.
The yield curve could steepen as investors prepare for rising inflation and stronger economic growth, UBS added.
Investors should buy a knee-jerk dip in stocks and sell long-dated Treasurys in the event of a Democratic sweep, Morgan Stanley recommended. Once investors gain new insight into future tax policy, fresh stimulus will restart stocks' upward trajectory, the bank's strategists added.
Wall Street is warming up to the idea of a Democrat-led government and the tax policies, spending initiatives, and regulation it may bring.
It wasn't long ago that major banks deemed a second Trump term the best option for the stock market. President Donald Trump's 2017 tax cut drove stronger profits, and deregulation helped companies boost efficiencies.
Yet polls suggest the president is lagging significantly behind Democratic presidential nominee Joe Biden with little time left to eke out a lead. At the same time, Wall Street giants rethought their past forecasts and found reasons to believe a Democratic sweep on Election Day can drive stocks higher.
The market sentiment toward a so-called blue wave "completely flipped" over the last two weeks, UBS said Monday. The government's failure to pass a stimulus measure makes it increasingly likely Democrats will prioritize pushing a larger bill in January. Doing so would punt tax reform into 2022, allowing investors to reap the benefits of fresh stimulus and continued economic growth through the next year.
Biden's widening lead in the polls is already helping stocks, UBS added. Recent weeks' gains tamper down election uncertainties, and an overwhelming victory would likely reduce the odds of Trump fighting the results.
"Investors may have initially feared a Blue Wave, but a delayed or contested election outcome is even more unsettling," the bank said.
Recovery and reflation
With polls increasingly pointing to a Democratic sweep in November, Wall Street is now preparing clients for the best way to position for such an outcome. UBS expects the potential blue wave to drive a reflation trade. Increased fiscal relief will provide a shot-in-the-arm for the US economic recovery and, in turn, lead investors to take on more risk in hopes of greater gains.
Value and cyclical stocks would gap higher after languishing through the virus slump, according to the bank. Sectors still struggling to reach pre-pandemic levels of activity would thrive through the nationwide rebound, and investors would shift capital from the growth favorites that saw outsized crowding over the summer.
Continued recovery would also normalize the Treasurys market after months of historically low yields, UBS said. The yield curve would steepen as investors prepare for rising inflation and stronger growth.
The Biden administration's plan for major fiscal expansion would lift profits for growth-sensitive cyclicals and offset headwinds posed by higher taxes, the bank added.
In all, the stimulus boost would add to an "already above-consensus outlook for the US economy," strategists led by David Kostin wrote. A Democrat-led government would drive a "modestly positive net impact" on corporate profits, the team said. S&P 500 earnings per share could reach $222 by 2024, according to the bank, a 4% increase from a baseline forecast that assumes no change in policy.
Goldman expects the S&P 500 to climb to 3,800 by mid-2021, implying a 7.5% gain from Monday's closing level.
'Dip to buy'
While firms increasingly expect a Democratic sweep to lift cyclicals and drag on growth stocks, Morgan Stanley expects outsized volatility before post-election trends solidify. The broader stock market will initially fall in the event of a blue wave, the bank said, as investors square off against tax policy uncertainties. Emerging-market equities will gap higher, as the stocks avoid such uncertainties and benefit from a greater likelihood of US dollar weakness.
Yet US stocks represent one of the bank's "detour" trades for a Democratic sweep. A blue wave would drive a short-term deviation from Morgan Stanley's base case, "creating an opportunity to buy a dip or fade a rally," the strategists said in a Friday note.
The S&P 500 represents such a "dip to buy" trade, and investors with cash on the sidelines should be ready to hop in at temporarily lower levels, they added.
"We expect fiscal expansion to provide some offset [to higher taxes], but until the market knows the type of fiscal expansion after a Democratic sweep, expect that equity risk premium could remain elevated into January," the team wrote.
Morgan Stanley's strategists suggest shorting long-dated Treasurys and buying West Texas Intermediate crude futures as "straightaway" trades are unlikely to change depending on the election's outcome.
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