Depending on your viewpoint, this year’s presidential election is disconcerting, entertaining, puzzling or all of the above. According to one pundit, it’s also potentially the most impactful election in decades, and the expected close race could be decided not by Donald Trump’s big mouth or Hillary Clinton’s possible indictment (although both are possible wildcards), but by interest rate hikes and their impact on U.S. equities.

Speaking at Pershing’s INSITE 2016 Conference in Florida, the chief equity strategist at Federated Investors, Philip Orlando, dusted off his crystal ball and gave his far-ranging take on the economy, the markets and politics. And while he didn’t put himself on the line with absolute predictions about who’ll win the election and what the markets will do, he used history as a guide to help investors—and voters—divine which way the winds might blow.

The context: Orlando believes Janet Yellen is probably a lame-duck one-term Federal Reserve chief because whoever wins the presidential election probably won’t renominate her when her term expires at the end of 2017. As a result, he offers that Yellen sees the writing on the wall and is managing her legacy by checking off items on her to-do list.

The first item was tapering the quantitative easing program, which she completed in December 2014. The second was beginning the process of raising the Federal Funds rate, the overnight lending rate that depository institutions charge each other for balances held at the Federal Reserve, which is a key monetary policy tool. The third is scheduled for next year with plans to start unwinding the Fed’s $4.5 trillion balance sheet.

Orlando added a fourth item—avoid a double-dip recession. The thing the Fed is most scared of, he said, is to make a policy error much as the Fed did in 1937.

“That [a double-dip recession] is not our forecast, but we are looking at a deceleration in terms of economic growth and the labor market,” Orlando said. “The economic metrics the Fed are looking at aren’t going in the right direction.”

And that’s key heading into the upcoming election. “I believe the election might be the most significant election in our lifetime because we’ll be dealing with five key elements of government,” Orlando said, referring to the race for the White House, his take that the U.S. Senate and House are both in play, the likelihood of a new Fed chairman and its impact on monetary policy, and the potential to reshape the Supreme Court given that three justices are at least 77 years old, coupled with the immediate need to replace the late Antonin Scalia.

Looking at the electoral map, Orlando said it’s clear how 40 of the 50 states will vote, and that points to Democrats having a decided edge with 217 of the 270 electoral votes needed to win. It’s all about the swing states (and independent voters), he offered, mentioning Florida, Ohio, Pennsylvania and North Carolina as key battlegrounds.

“I believe whoever wins the White House will win the Senate because the Republicans have a narrow five-seat majority,” Orlando said. “Thirty-four seats are up for grabs. The demographics favor the Democrats in 2016.”

One of the tea leaves Orlando highlighted was that this is President Obama’s eighth year in office, and that he is the fifth president with an eighth year in office during the past 70 years or so, and that the stock market was down about 11 percent on average during the eighth year of those past administrations, and that the year-to-date return on S&P 500 in 2016 is more than 3 percent.

“So if history holds, that suggests the second half of this year could be rocky depending on how ugly the political situation gets,” Orlando said.

And that presents an interesting political dynamic.

“The stock market has an uncanny ability to predict the next president,” he said. “Since 1928, the S&P 500 has correctly predicted the next president 86 percent of the time.”

To see why, look at the stock market’s performance three months prior to the election.

Orlando explained that when the stock market is positive during the months of August, September and October the incumbent party wins. On the flip side, the challenging party tends to win when those months are negative.

This ties back to the Federal Reserve. “I think one of the conundrums that Dr. Yellen isn’t talking about is her concern that the Fed tightening policy may have a deleterious impact on investor psyche and financial market performance,” Orlando said. “I think the Fed is deathly concerned that if they tighten policy it might be perceived as a mistake, the market trades off, and if done at the wrong time it could impact the election.”

He wasn’t suggesting that Yellen will play politics with potential interest rate hikes (though other people surely will suggest that), but he does think there’s a good chance the Fed will hike rates sometime this year—most likely in December.

Getting back to the impact of politics on the markets, Orlando noted there have been 11 post-war recessions in the U.S., and seven of those occurred in the first year of a new president’s term. And that’s due to fiscal policy error when a new president and Congress come in and feel they have a mandate to change the agenda. Those politically induced recessions typically roll into the middle of the second year of the new presidential administration.

“The second half of this year could be choppy because it’s the eighth year of President Obama’s term. 2017 and perhaps part of 2018 could be choppy because our new leaders might drive us into a recession,” Orlando said.

“I’m giving you a roadmap for the next five years,” he continued. “I’m suggesting that we [Federated Investors] are cautious because of the politics and we’re playing defense. If our worst-case scenario is correct where the second half of this year is tough and we roll into recession next year, there’s money to be made on the other side of recession, and the buy-in typically comes in the middle of year two [of the next presidential administration, or mid-2018].

Source:  Jeff Schlegel

http://www.fa-mag.com/news/yellen–s-p-500-could-determine-next-president-27339.html