Deteriorating price momentum, rising political risk
As of Friday’s close the S&P 500 had recorded nine consecutive down days, falling back to its 200-day moving average. One can point the finger for this pull-back at any of several factors: broadly disappointing earnings (ex-financials), rising foreign exchange volatility, higher long term interest rates and, of course, rising political risk. Unfortunately, none of these forces looks set to abate any time soon, perhaps not even political risk.
Leaving aside earnings, or the move higher in bond yields, over the coming days most investors’ outlooks are likely to be dictated by the rise, or fall, in political risk. Now, as a rule, we at Gavekal tread warily on political matters, for not only is our broader readership split fairly evenly between left and right, so is our own partnership. Consequently, we try to avoid getting involved in fruitless political debates. Still, with the stakes in the upcoming US election so high, it is obvious that over the coming week the American voter will have a disproportionate impact on financial markets. As I see it, there are four potential scenarios, all with very different investment consequences.
The first is the consensus scenario; the one opinion polls indicate is the most likely. Specifically, House, the Senate is more or less evenly divided, and the GOP keeps control of the House. This is the scenario that investors have generally seen as the most benign— although one may question whether this scenario would really be all roses for financial markets. With the scandals surrounding the Clinton Foundation and the unorthodox email policies followed by Clinton and her staff, the GOP will likely look at anything short of a Clinton landslide as an open door to subpoenas, impeachment proceedings, etc. The upshot should be more paralysis on Capitol Hill, and a Federal Reserve that would likely continue to be the only “actively functioning” arm of government. In turn, this would likely mean a range-trading US dollar (because the Fed would probably hike less than currently expected), mediocre US growth, and continued outperformance from emerging markets (as the political risk in EMs continues to be low relative to DMs). In short, more of what we have experienced in 2016…
Hillary Clinton wins the White
second scenario is the
scenario: GOP voters stay home and Democrats turn out in droves (though importantly, early voting seems to indicate the opposite, with a worryingly low turnout for Clinton among Millennials and African- Americans), with the Democrats winning the White House, the Senate and the House. In such a scenario, bond yields would likely rise on the promise of large future budget deficits, the US dollar would most likely weaken on the same expectation, while stable US growth stocks (especially pharmaceuticals) would get crushed on the back of rising bond yields and the threat of higher taxes and increased regulation. In this scenario, any US equity market relief rally should most likely be faded. The third scenario is the possibility that
emerges as a clear winner, either because too many states are too close to call in a repeat of 2000 (both candidates are already deploying armies of lawyers), or because third party candidates win New Mexico (Gary Johnson) and/or Utah (Evan McMullin). That would leave both Clinton and Trump short of the required 270 Electoral College votes and send the final decision to the House of Representatives. One could argue that such an outcome would prove that the system works, and that the Founding Fathers in their genius had devised an idiot-proof electoral mechanism, as a vote by the House would open the door to someone other than one of the two most loathed people in America becoming president!
Still, it is unlikely that the markets’ initial reaction to such an outcome would be positive. Instead, stocks and bond yields
neither Clinton nor Donald Trump
would fall together, while the US dollar would most likely rise (on the “risk-off” bid), along with the yen and possibly sterling (the pound remains deeply undervalued and, arguably, most of the bad news for sterling is already out there). Finally, the fourth scenario is that
— a possibility that seems to us much more likely than the odds currently being given by most political experts. This view is based on our own recent experiences: in almost every vote in recent years, nativist/nationalist parties or causes have tended either to do better, or to do much better, than political polls predicted. The latest example of that was the Brexit vote, but before that one can look at the results of the National Front in France, or UKIP in Britain, or the Freedom Party in Holland, or the True Finns etc… Simply put, the overwhelming political correctness of our days means that, in most countries, there exists a “shy voter” syndrome whereby a significant portion of nationalist voters are reluctant to reveal their preference to pollsters.
Of course, one may argue that no such shyness exists in America, where people are more prone to flag-waving while shouting their country’s name than anywhere else on earth.
On this last scenario, we have had intense debate internally and externally over the likely immediate financial impact of a Trump
However recent market movements would seem to indicate that we should, at best, expect the same type of environment that prevailed in the UK immediately after the Brexit vote: a collapse in the US dollar (over the past month the DXY has had a 1:1 negative correlation with Trump’s poll numbers), combined with a big pullback in stocks (as Trump’s numbers have edged back up, equity markets have headed south), along with lower bond yields (would the Fed really raise rates in December if Trump wins?) and a higher gold price. The question would then be whether such a pullback in the US dollar and in global equities represented a buying opportunity for both and a selling opportunity in bonds, or whether it was the start of a much nastier investment environment.
Putting it all together, it seems unlikely that the markets will act pre-emptively on any of the above scenarios; and neither should our clients. Instead, it probably makes sense to wait out the immediate aftermath of the vote in the few asset classes that should still perform respectably almost regardless of the outcome. As we see it, these are UK gilts denominated in sterling, Japanese government bonds denominated in yen, and gold. At this stage these seem to offer the best risk-return profile going into this highly important, but most uncertain, election.