The U.S. midterms could well be a source of volatility for markets, although that contention will doubtlessly bump up against various attempts to demonstrate that, historically speaking, investors shouldn’t fret too much about November.
For instance, in a note dated August 25, Goldman writes that “the median change in the S&P from the close the day before Election Day to the close the day after Election Day has been +0.7% in midterm elections back to 1954.” The results are similar if you look only at elections that have resulted in Congress flipping from one party to the other or in years when the President’s party has performed poorly.
Importantly, Goldman notes that the reason stocks don’t move sharply in one direction or the other is down to prediction markets doing a good job of anticipating the results. “In the 2006 and 2010 elections that turned over the House majority, prediction markets already assigned more than an 80% probability to the outcome on the day before the election”, the bank observes. Here are the current odds, which show Democrats likely flipping the House but not the Senate:
If the House does flip, the White House will need to prepare for a veritable deluge of investigations. With Don McGahn on his way out the door, and with the Mueller probe looming, those closest to the President are concerned he isn’t prepared for a possible disappointment in November.
“President Trump’s advisers and allies are increasingly worried that he has neither the staff nor the strategy to protect himself from a possible Democratic takeover of the House, which would empower the opposition party to shower the administration with subpoenas or even pursue impeachment charges”, the Washington Post wrote this week, adding that “within Trump’s orbit, there is consensus that his current legal team is not equipped to effectively navigate an onslaught of congressional demands.”
As far as markets are concerned, BofAML thinks the midterms could lead to an uptick in FX volatility.
“Regarding the upcoming US midterm election, the US federal election risk tends to be underpriced in FX historically, with sizable rise in volatility around the election date”, the bank writes, in a note dated August 30. Here’s a bit more:
While political uncertainty tends to rise ahead of elections and then declines, FX volatility does not. Rather, realized volatility empirically has either declined or stagnated ahead of Presidential elections, only to rise predictably afterward (Chart 3). Among all federal elections, realized vol rose ahead and after the election (Chart 4). In the case of midterm elections, implied vol rises after August slump, falls a bit closer to the election and then rises again.
How to play it? Well, for BofAML, the answer is three-month USD/JPY vol., which they say could be a good hedge not only “against a midterm election shakeup” but also for a potential deterioration of trade with China and fallout from North Korea denuclearization talks.”
Currently, three-month implied vol. on USD/JPY is sitting well below its one-year average.
On Thursday, Bloomberg reported that the Trump administration is looking to move ahead with tariffs on an additional $200 billion in Chinese goods as early as next week and the President has variously accused Beijing on undermining his strategy on North Korea.
“Post-election, our biggest concern is whether a complacent market can handle a rise in volatility”, BofAML continues, before concluding that “in the case of US midterm elections leading to further deterioration of trade-war risk, owning JPY can offer an attractive hedge with its sensitivity to China risk as well as flight to quality”.
Here’s what a Trump ally told the Washington Post for the article linked above:
Winter is coming. Assuming Democrats win the House, which we all believe is a very strong likelihood, the White House will be under siege. But it’s like tumbleweeds rolling down the halls over there. Nobody’s prepared for war.