What are the two most likely scenarios for the U.S. election, and how should one trade? This is Morgan Stanley's answer

The "suspense" of the U.S. election is about to be revealed, and investors are focusing on the election results and their impact on the stock market to better deploy capital.

Recently, Mike Wilson, Chief U.S. Equity Strategist at Morgan Stanley, released a report analyzing the possible outcomes of the U.S. election and their implications.

Wilson stated that although polls show a tight race, the prediction markets still lean towards a victory for Trump and a Republican sweep of Congress. In this scenario, if U.S. Treasury yields fluctuate within a limited range, cyclical stocks will perform well; however, if Treasury yields rise "significantly," tariff-sensitive consumer stocks will decline. As election day approaches, the likelihood of Harris winning and a divided Congress is also increasing. In this case, tariff-affected consumer stocks and renewable energy stocks will perform well.

Wilson also pointed out that the likelihood of the other two scenarios—Trump winning with a divided Congress and the Democrats sweeping Congress—is relatively low.

Republican Sweep of Congress and Stable U.S. Treasury Yields: Cyclical Stocks Will Perform Well

In the case of a Republican sweep of Congress, Wilson believes that if U.S. Treasury yields remain within a certain range in the days following the election results (for example, if the 10-year Treasury yield fluctuates no more than 20 basis points), and the rise in yields is driven by improved nominal growth expectations, then cyclical stocks (financials, industrials, and sectors sensitive to commodities) may perform well and drive the index higher.

Conversely, if U.S. Treasury yields rise "significantly," driven by an increase in term premium due to market concerns about the sustainability of fiscal prospects, risk aversion in the stock market may increase.

For instance, last August, when the term premium rose by about 50 basis points from its low in June 2023, the stock market began to take notice of this risk. By October of last year, the term premium had increased by a total of about 140 basis points. During this period, the stock market's decline corresponded with the increase in the term premium beyond the initial rise of about 50 basis points.

Since the low in mid-September this year, the term premium has also seen a similar increase. Analysts believe that in this election scenario, tariff-sensitive consumer stocks will be impacted.

Harris Winning + Divided Congress: Tariff-Affected Consumer Stocks and Renewable Energy Stocks Will Perform Well

In the case of Harris taking office and a divided Congress, Wilson and many other traders expect that tariff-affected consumer goods stocks and renewable energy stocks will perform well.

At the same time, in this scenario, a decline in interest rates may also benefit housing-sensitive consumer stocks and high-beta stocks, while financial stocks, industrial stocks, and sectors sensitive to commodities may perform poorly.

However, Wilson also stated that this initial trend is expected to be relatively mild. Aside from financial stocks, the bullish trades on a Republican victory did not see much fluctuation in October. Compared to Trump's administration, financial stocks may perform poorly in the short term due to potential stricter regulations

Wilson stated:

"In a divided Congress, the market's dominance may depend on the economic cycle, the Federal Reserve's responses, and industry-specific fundamental factors after the election."

Trump's Victory + Divided Congress: Cyclical Stocks Benefit in the Short Term, Consumer Stocks Affected by Tariffs Continue to Struggle

In the case of Trump's victory and a divided Congress, Wilson expects that the market's initial reaction may moderately favor cyclical stocks, but this could change shortly after the election results are announced. Analysis indicates that, in a divided Congress, the macro environment and stock fundamentals will become more important determinants of industry price trends by the end of the year.

Additionally, the risk of tariffs remains until clearer policies are introduced. Wilson anticipates that consumer stocks affected by tariffs will continue to perform poorly.

Democratic Sweep: Cyclical Stocks Underperform

In the case of a Democratic sweep, cyclical stocks are likely to underperform due to potential increases in corporate taxes, and investors may initially trade cautiously. However, considering that certain market sectors ( such as consumer stocks affected by tariffs and renewable energy stocks) may achieve significant outperformance before the end of the year as these sectors seem somewhat undervalued in light of the Democratic victory.

Furthermore, Morgan Stanley also discussed the impact of corporate tax rates on the S&P 500 index, analyzing that if corporate tax rates increase to 23%, 25%, or 28%, it would result in approximately 1.5%, 3.5%, or 5.5% "earnings headwinds," respectively. Among these, the U.S. domestic market (consumers, communication services, industrials, financials, and energy) is most susceptible to the potential increase in corporate tax rates