Will low volatility get Trumped?

As we enter the final stretch of the exhausting US electoral cycle, the single most important question confronting investors may well be whether the current low volatility environment for equities, bonds, and exchange rates is dependent on politicians or not.

Clearly, with the VIX hovering around 12, and with volatility in exchange rates barely noticeable, financial market participants are making one of two possible bets:

1) Hillary Clinton will be elected, and policies coming out of Washington will be “business as usual”, or

2) Donald Trump gets elected, and the impact on financial markets will be muted.

Both these views are highly complacent. At Gavekal we are not political pundits, but those who are, like Nate Silver, typically argue that Hillary Clinton is still the favourite to carry the day on November 8 (by 58% to 42% at the time of writing).

Still, the shift in momentum over the past few weeks makes it look like another medical “episode”, or a poor debate performance, could see Hillary’s lead disappear in less time than the Clinton Foundation keeps its foreign donors waiting.

Behind the poll numbers lurk two major questions. The first is whether the people who voted so overwhelmingly for Barack Obama—minorities and young people—will bother to turn out this time around. They did in the last two elections. But back then the democratic candidate was cool, exciting, even inspirational: qualities that few would ascribe to Hillary Clinton. In 2008 and 2012, for the first time ever, the turn-out was higher among African Americans than among white Americans, with around 96% pulling the lever for Obama in 2012. Will Hillary Clinton be able to mobilise such a turnout, with such a percentage skew?

The second question is whether there is a “Le Pen effect” at work. In France, the National Front typically attracts 2% to 4% more votes on the day than the opinion polls anticipated. This reflects the fact that no one brought up in polite society wants to come out as sounding nativist, Islamophobic, borderline racist etc. A similar effect was apparent in the Brexit vote, which according to the polls the “Remain” camp was destined to win by a margin of anywhere from 5pp to 8pp. In the event it lost by 48% to 52%. In other words, if the polls appear close on the day, then perhaps investors should brace themselves for a Trump win.

But would a Trump win even matter? Discussing this question with clients over the past few weeks, I have heard the following arguments:

- A Trump win may be a very positive development for markets.

Interestingly, this view was advanced by some of our more left wing clients (or at least by those who usually like the “more government” solutions presented by Anatole). Their logic is that monetary policy has reached its limit, and that what the US (and the rest of the world) needs is more Keynesian-style fiscal stimulus. Unfortunately, if Hillary wins, she will enter office as the least popular president ever elected and her chances of getting any extra spending through a Republican Congress are slim to none (and Slim just left town). On the other hand, President Trump would have none of the usual Republican “intellectual hang-ups” and could press ahead with government spending on everything from education and healthcare (a single-payer system?) to infrastructure and domestic security. While this is a possible scenario (although it would entail Democrats holding their noses and working with Trump, which is not a given), a massive expansion in the federal government is hardly an exciting prospect. As Charles Gave has shown time and again, the higher government spending, the lower P/E ratios.

- A Trump victory would not matter much because the checks and balances built into the US system would severely curtail his ability to act like “a bull in a china shop”.

This may be true on the domestic front (assuming a GOP-controlled Congress proves even half as opposed to federal government expansion under Trump as it was under Obama). Still, there are two points of concern: the first is that Obama has set a precedent in bypassing Congress by issuing executive orders: a precedent that President Trump would surely be only too happy to build on (as would President Clinton). The second is that although the US constitution ties the president’s hands on domestic matters, it gives the White House a much freer hand when it comes to “dealing with pesky foreigners”. And Trump’s proposals for dealing with pesky foreigners are undeniably the most troubling element of his platform.

- Everyone was convinced that Brexit would trigger a disaster, but it didn’t.

So why should we worry about Trump? This view holds that politicians no longer matter for markets; the only thing that counts is what central banks are doing. This argument was most prevalent in Europe, where clearly some investors got burnt selling into the immediate post-Brexit selloff, and have decided not to make the same mistake again a few months later. This attitude may prove too complacent simply because Brexit has not happened yet, and may not for a few years, so it could well take a while for the possible market consequences to be felt. In contrast, the protectionism proposed by Trump could start shaking up global institutions—the IMF, WTO, NAFTA—pretty much from the get-go, as could his isolationism (would NATO survive?). Would central banks really be powerful enough to cushion the volatility triggered by massive changes in trade policy, foreign policy, fiscal policy, domestic policy? Or would the impacts simply be too big for the Federal Reserve/Bank of Japan/European Central Bank to cushion them all simultaneously?

In a recent paper, Charles Gave reviewed the societal changes that, to a large extent, explain the rise of Trump, Le Pen and others. What is amazing about the current US election campaign is that the political map is being redrawn in front of our eyes. Many of the historical beliefs on which the Democratic Party and, to an even greater extent, the Republican Party were built are being blown to smithereens. One might have expected financial markets to look on these developments and the uncertainties they imply with some trepidation. But far from it; markets have been behaving as if the current political cycle is as normal as it has ever been. I fear it isn’t—and that volatility measures will pick up heading into the election. After all, this vote could very well end up transforming the post-World War II global architecture, and it is quite possible that one or more of the WTO, NAFTA, the UN, IMF, World Bank or NATO will not survive a Trump presidency, at least in their present form.