By Lewis Krauskopf and Maiya Keidan
NEW YORK (Reuters) - Four years after Donald Trump's surprise presidential victory roiled markets, investors are prepared for short-term trading turmoil and major long-term policy shifts, on the eve of Tuesday's U.S. election.
Investors could confront dramatically different paths for the country on taxes, government spending, trade and regulation depending on who wins the White House, the Republican Trump or Democratic former Vice President Joe Biden.
Biden is ahead in national opinion polls, but races are tight in battleground states that could tip the election to Trump. And perhaps the outcome most likely to shake markets - at least in the near term - is no immediate outcome at all.
"At this point, markets fear a contested election," said Kristina Hooper, chief global market strategist at Invesco. "Anything other than a contested election, a decisive victory in particular, would be good news for stocks."
For weeks, market moves have indicated investors are betting on a "Blue Wave" by which Biden becomes president and Democrats capture the U.S. Senate and retain a majority in the House of Representatives to gain full control of Congress.
That includes a steeper yield curve and weaker dollar on expectation of a fiscal stimulus package and gains for industries expected to benefit under Biden such as green energy and solar stocks.
"If the Senate goes 'blue', I think rates move up and that will help the financial services sector tremendously," said Peter Bortel, general partner at Bortel Investment Management. "My investments are long-term and I think we benefit from that scenario."
Over a two-month period that ended on Wednesday, a "Biden basket" of stocks created by JPMorgan (NYSE:JPM) gained 4.5% versus a 16% drop for a "Trump basket."
But in the run-up to the vote, analysts have pointed to concern about over-confidence in a Biden win, and are mindful of the violent asset-price swings in 2016 when investors were expecting a Hillary Clinton victory.
Stocks saw big moves last week as investors pointed to uncertainty about the election outcome, as well as concerns about the lack of a stimulus deal and mounting coronavirus cases.
Hedge funds have been shaving off some risks, according to Oct. 21 research by Lyxor Asset Management, with U.S. long/short equity strategies "cautiously positioning" on a Democratic win.
Shawn Kravetz, chief investment officer of Esplanade Capital, said his hedge fund has bet on solar stocks but also has "some thoughtful and creative hedges in place" so he is not taking "undue risk."
"It’s not the time to be a cowboy," Kravetz said.
BIGGEST FEAR
The biggest fear for markets is for Wednesday to arrive with the election still in doubt and the vote too close or contested.
Lacking a clear result, investors would likely flock to safe-haven assets, such as gold and U.S. Treasuries as well as perhaps the Japanese yen and U.S. dollar, Invesco's Hooper said.
An unclear result - or indeed a result with split party control, for example Biden winning and the Senate staying Republican - would also throw more doubt on prospects for a fiscal relief package.
A Democratic sweep is seen as the surest path to massive stimulus to help revive an economy decimated by the pandemic that has killed nearly 230,000 Americans. A stimulus deal could lift shares, fuel a long-awaited rotation to economically sensitive value stocks and accentuate trends of a weaker dollar and steeper yield curve.
"With a Blue Wave, you are going to see a much larger fiscal stimulus package," said Anthony Saglimbene, global market strategist at Ameriprise Financial (NYSE:AMP).
Beyond any near-term market boost, however, a Democratic sweep poses concerns for stock investors. Those include the prospect of a potential corporate tax rate hike to 28% from 21% which could crimp company profits as well as herald a tougher regulatory environment.
A Biden win could also be negative for the dollar, if his administration brings a calmer tone to negotiations with China and other trade partners which boosts growth prospects for other countries.
On the flip side, a "status quo" result with Trump winning and Democrats running the House, would have investors weighing the likelihood of a more modest fiscal package against relief that tax increases were unlikely.
A bigger surprise for investors could come in a "Red Wave" by which Republicans win the presidency and all of Congress, viewed as a low-probability event but which would likely lead to an unwinding of the so-called Biden trades and a move back to sectors seen benefiting from Trump.
JPMorgan last week called an "orderly" Trump victory the most favorable outcome for equities.
To be sure, since the 2016 election of Trump, who ushered in corporate tax cuts that supported equities and imposed trade tariffs that led to volatility, the U.S. stock market has gained about 53% and hit new highs.
At the end of the day, investors just want some certainty.
"Markets will have to figure out what will change in the next Congress and in the next administration," said Paul Christopher, head of global market strategy at the Wells Fargo (NYSE:WFC) Investment Institute.