While these are all serious issues, with state and local governments already implementing cutbacks and enhanced unemployment benefits set to expire at the end of July, a political standoff that extended into the fall could result in a slower and more painful recovery.
Election Chaos
A further political risk is the potential for chaos surrounding the November elections. Part of this, of course, springs from a very deep political divide in America in 2020. However, in addition, polling problems so far this year in a number of states have highlighted the additional difficulties caused by the pandemic, as millions of Americans will likely try to vote by absentee ballot. Unless one side or the other wins by a very decisive margin, this could easily degenerate into accusations of fraudulent or rigged elections. Even if this is resolved, any unrest or uncertainty caused by election chaos could further undermine an economic rebound.
Higher Taxes And Interest Rates In A Recovery
Finally, there is the matter of a fiscal and monetary reckoning after the election and once the pandemic finally subsides. Assuming that Congress passes a further $2 trillion in federal pandemic relief over the 12 months, we estimate that the federal debt will swell to 114% of GDP by the end of the next fiscal year in September 2021. This would far exceed even the debt-to-GDP ratio after the end of World War II. At the same time, if the Federal Reserve continues to buy Treasuries at the current pace of roughly $80 billion per month, its total holdings of federal debt would exceed $5 trillion, in a balance sheet that had grown to over $8 trillion.
How these issues are tackled may well depend on the outcome of the November election. In a Democratic sweep, the new Administration might feel pressure to reduce the federal deficit while simultaneously increasing spending on health care and infrastructure. This would likely mean higher taxes on wealthier individuals and corporations, both of which would negatively impact real, after-tax returns.
In addition, under the new Administration, the Federal Reserve could well take the opportunity to reassert its independence, and, once the economy is on a strong recovery path, it could taper its purchases of Treasuries and begin to raise short-term rates, with potentially negative consequences for stocks.
Long-Term Fiscal And Financial Meltdown
However, an alternative, longer-term risk to investors could result from a continuation of current very easy fiscal and monetary policy. If, following a Republican sweep, the Administration and Congress refuse to countenance tax increases while simultaneously pursuing higher infrastructure spending, federal debt would likely grow more quickly. If the President replaced the Fed Chairman and other Fed governors with people he regarded as more loyal, monetary policy could remain more expansionary for longer.
However, such a path could eventually result in a fiscal and monetary meltdown. As modern monetary theorists are fond of pointing out, a sovereign government with a captive central bank can never be forced to default on its own bonds for the simple reason that it has a ready buyer with unlimited powers to print money.
However, while investors can be sure of being fully paid back in dollars, they could lose confidence in the dollar itself, and higher inflation, along with dollar devaluation could be the result. Such an inflation could only be ended by very painful fiscal and monetary actions to restore trust in the value of the currency. A lesson learned in the U.S in the 1970s and 1980s and in many emerging market countries since then is that, once you have forfeited trust in your currency, you have to run a much tighter monetary and fiscal ship to regain it.
It is, of course, possible that the U.S. will avoid all of these dangers. However, investors should bear them in mind when considering strategy today. Many may be relieved that the stock market is holding up so well in this otherwise dismal year. However, investors should be clear-eyed about these risks, suggesting a somewhat more diversified and defensive stance until events can hopefully dispense with at least some of these more negative outcomes.
David Kelly is chief global strategist at JPMorgan Funds.