Polls for the U.S. presidential elections indicated a tie, but recent events have shifted momentum towards the Republican candidate, former President Donald Trump (2017-2021). Various hesitations by the current President and Democratic Party candidate, Joe Biden, along with an incident last Saturday where Trump was injured by a gunshot to the ear, have positioned the former president and magnate as the favorite in the race for the Oval Office.
The fixed income markets are reacting to this shift, as the implied volatility of Treasury bonds (measured by the ICE BofAML MOVE index) spiked following the presidential debate on June 27, according to a Morgan Stanley report.
Conversely, major stock indices have continued to rise to new all-time highs, suggesting that equity markets might be ignoring recent political developments.
Morgan Stanley’s Global Investment Committee warns, “Investors cannot afford to be complacent about potential political changes, especially at a time when U.S. debt sustainability is in question, the economy is slowing down, and the Federal Reserve is still looking for evidence that inflation is under control.”
According to analysis by Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, the current proposals of a Republican triumph, both in the executive and in Congress, could have significant implications in three areas:
Tax Cuts
If Republicans sweep the November elections, the Tax Cuts and Jobs Act of 2017—which reduced tax rates for businesses and individuals and is set to expire at the end of 2025—could be extended and potentially enhanced. The extension of the Act could add around $1.6 trillion to federal deficits over the next decade, according to calculations by Morgan Stanley’s expert team cited by Shalett.
Additional deficits are a critical issue with current interest rates, as the cost of servicing Treasury debt has nearly doubled in the last two years. As federal debt and deficits increase, inflation-adjusted interest rates rise, likely putting pressure on U.S. corporate profits and stock valuations.
Tariffs
Current proposals from the Republican Party include sweeping trade barriers, potentially against historical allies and partners such as Mexico, Canada, and the European Union.
Historically, tariffs have caused a one-time price increase and supply chain disruptions that distort short-term growth. As a result, tariffs could disrupt recent progress toward containing inflation, potentially exacerbating consumer pain and increasing the prospect of “stagflation,” meaning persistent inflation amid stagnant growth, the report adds.
Immigration
Morgan Stanley’s chief U.S. economist, Ellen Zentner, and other researchers have noted that the increase of more than 3 million immigrants to the United States in 2022 and 2023 has had a dual economic benefit: higher population growth and a positive labor supply. This has helped drive higher GDP growth, stabilize housing prices, and reduce wage costs, contributing to lower inflation.
The adoption of radical measures at the border, as suggested in some proposals, could slow the growth of the U.S. working-age population, which could drag down the economy and reignite wage-based inflation.
Investment Implications
Considering all these factors, portfolio adjustments may be necessary, warns Morgan Stanley.
Investors should consider adding what could be leaders in a Republican sweep scenario, such as energy, telecommunications, and utilities.
Additionally, they should consider positioning portfolios defensively, focusing on investments that offer growth at a reasonable price, in areas such as healthcare, industrials, aerospace and defense, certain energy generation and grid infrastructure, the financial sector, and residential real estate investment trusts.
Additional exposure to Japan, gold, hedge funds, and investment-grade credit may also be beneficial, concludes the report.
