Author: Tim Dowling, Head of Global High Yield at NN Investment Partners

If you’ve been worried about the effect that the potential election of Donald Trump could have on risky assets, you are probably focused on the wrong risk.

Many investors have been watching the US presidential election campaign with great anticipation, particularly because the potential election of Donald Trump as president could lead to a turn to protectionist, anti-immigration policies in the US. As many election strategists have pointed out, the path to Trump’s election is narrow, requiring him to win most swing states to negate the Democratic lean in the majority of large population states. The last couple of weeks may have hurt his candidacy and investors now may need to turn their attention to the possibility of a Democratic tidal wave.

Although still unlikely, the chance that the Democrats could win the presidency and both houses of Congress has increased; if this happens, the fiscal discipline flowing from the current gridlock would be broken, with potentially significant market consequences. I believe the recent increase in volatility reflects this risk.

Democrats look back fondly on the election of 2008, when Barack Obama won the presidency and both houses of Congress. Ambitious legislation soon followed, including the expansion of healthcare rights in the Affordable Care Act and of increased Wall Street regulation through Dodd-Frank. In 2010, the Republicans won back the House of Representatives, ending the Democrats’ ability to freely enact legislation. Since that election, the US has been experiencing divided government, or gridlock, in which significant legislation requires compromise to pass.

Pundits dislike gridlock, as negotiation to produce legislation never fully pleases anyone. The markets love it, though. Less new legislation means less government spending, and the limited supply of US treasury bonds keeps prices for them high. With treasury bond prices high, the value of risky assets with good yields, such as high yield bonds and dividend paying stocks, also should stay high.

With Trump’s numbers falling, there is a chance that the Democratic party wins the presidency and both Houses of Congress. The Democratic platform calls for higher social spending to support programs such as debt-free college, which would be funded by increased taxes on the wealthy, derived partly by extending the holding period required for the full benefit of long-term capital gains treatment from one to six years. By some estimates, the Clinton proposals could reduce after-tax income for the top 1% by 7%, reducing the incentive for the well-off to work and invest. Other Clinton proposals, such as paid family and medical leave, could reduce employers’ flexibility.

Although Clinton’s proposals may end up being fully funded by the proposed tax increases, investors will likely focus on the risk that outlays could exceed inflows and that in turn the US debt grows. The US is heavily indebted, as is. During the gridlock that we have been experiencing, the US deficit as a percentage of Gross Domestic Product fell from 8.7% in 2010 to 3.2% in fiscal 2016, according to the Congressional Budget Office. Even without the effect of new legislation, the deficit is projected to expand to 4.6% of GDP by 20261 as Social Security and healthcare spending grow with the aging of the population. If the increased taxation of the wealthy fails to cover the increased social spending, the debt problem may become acute even more quickly.

With many more Republican than Democratic senators standing for re-election in this cycle, the Senate has long been considered likely to swing Democratic in this election. In contrast, the House of Representatives has been deemed more likely to remain Republican, as Republican state legislatures have designed congressional districts advantageously many urban districts overwhelmingly Democratic. In the 2008 election of President Obama, congressional democrats were able to overcome this structural disadvantage. It’s difficult for congressional democrats to overcome this disadvantage, but they managed to do so in 2008 during the election of President Obama; the lack of enthusiasm for Trump could mean that many Republican choose not to vote, hurting Republican candidates for the Senate and House.

Early in the evening on Tuesday, November 10th Trump’s loss may become evident, if he fails to win critical Eastern swing states such as Florida, Virginia and Pennsylvania. Even if the Presidential outcome is determined early, it will be worth staying up for the main event. I think the outcome will prove to be gridlock.