Assuming no black swans come splashing down in the macro lake, equities may be somewhat insulated from dramatic swings in the weeks leading up to what most expect will be an epoch-making US election.
That’s according to Nomura’s Charlie McElligott who, in a Tuesday note, writes that realized vol. may remain “stuck in no man’s land” as dealers are “incentivized from both P&L and risk management perspectives to be ‘long vol, long gamma'”.
This setup could serve to “keep things in check” he notes, again with the caveat that the macro environment is highly uncertain and the geopolitical landscape remains exceptionally fraught, meaning the door is always open to some manner of “shock down”, left-field catalyst (or tweet).
He cites “‘doomsday’ permutations” tied to the view that “a final [election] determination [is] dragged out into year-end or worse”.
You might recall that Goldman last week challenged the view that the results won’t be known for weeks (or months), suggesting instead that even if a winner isn’t called on election night, the market will know the outcome with enough certainty to trade it.
For McElligott, that more benign outcome (or something like it, where markets do get some certainty on election day) is underpriced. Instead of what he calls the “extended chaos” scenario, Charlie posits an “earlier final determination” or even “a large, clear-cut Biden electoral win”.
While there’s a solid argument to be made that equities would need to de-rate to account for the mechanical impact of Biden’s tax plan on corporate earnings (especially in the event the Senate flips), it’s important to note that whatever happens in cash equity land, something has to come of all the canned-goods-hoarding. That is: If there’s a winner, and it’s not close, then those hedges are going to decay — and fast.
“This then risks in my mind a dynamic where all this ‘doomsday prepping’ suddenly is decaying powerfully against the event-risk hedgers, forcing a potential puke of said ‘crash’ back into the Street”, McElligott writes. That could overwhelm the simplistic selling associated with the above-mentioned pricing-in of the optically “unfriendly” aspects of the Biden platform (higher corporate taxes, more regulations, etc.)
Again, this would be a tug of war dynamic between what I’m characterizing here as “simple” selling and what Charlie is talking about from those who have hedged the “extended chaos” scenario. Here’s McElligott:
A potential puke of “crash” back into the Street, could mechanically (and counterintuitively) catapult markets higher, EVEN IF the market narrative on risk sentiment into Biden’s “negative for growth” higher tax-, higher regulation- framework is believed to be headwind for corporates / equities. To be fair, the counter “sell flow” to be aware of then into this potentially “mechanical bid” would be investors turning “hard sellers” in the case of a clear Biden win, as most anticipate a large Capital Gains tax increase coming in Year 1 of Biden regime.
So, that’s your push-pull. Trying to choose a side in that tug of war is probably a fool’s errand. I’m not sure you’re going to be able to pick a directional “winner” if all you’re trading is the index.
McElligott underscores as much, noting that “it might be more about a dispersion trade”, as expected “Biden winners” take off, especially if positive news on the vaccine front is already in place, just waiting on an excuse to be priced-in alongside an assumed Democratic fiscal impulse.
Expectations for that, Charlie notes, are visible. “‘Crash-UP’ [is] rather surprisingly more pronounced than ‘crash-DOWN’ across ‘risk proxy’ ETFs”, he writes, noting that three-month call skew %iles are “way up in long-term, multi-decade ranks”.
All of the above is important to keep in mind. As I’ve tried to emphasize here over the past several weeks, one needs to separate the political science/political theory discussion from the market debate, at least as far as near-term trades (and especially equities) are concerned.
I do think it’s worthwhile to consider what an actual authoritarian shift in America would mean for the dollar and USD obligations (i.e., USTs) over the longer-run. A “science fiction” scenario — where the Senate stays with the GOP and Trump effectively declares the presidential ballot void, at first through a stacked SCOTUS and then, if “necessary”, via William Barr and a new defense chief, for example — is not an impossibility. It might still be properly described as “infinitesimal”, but serious people (i.e., not partisan hacks) are openly discussing it. And that’s to say nothing of the myriad ways in which Trump could attempt to effectively overturn the results using election arcana and other less overt means of staying in power.
But that might as well be immaterial for equities. In fact — and I’d be interested to get Charlie’s take on this, actually — I’d venture that if the science fiction scenario were to actually play out, some markets would have to be shuttered for a time, and the Fed would have to issue some manner of literal (as opposed to tacit) guarantees. Who knows what that would mean for options.
The point, then, is simply this: If we’re talking about outcomes that are actually tradable, we have to steer clear of the science fiction outcome.
And it’s worth considering the possibility that, if Biden does win a clear-cut victory, Trump’s authoritarian bluff will be called. He can challenge a close vote, but the only way to “challenge” a landslide would be to simply declare the Constitution void. If you think there’s a chance the polls are correct to suggest a Biden win is likely, and you doubt Trump’s willingness to “go there” (so to speak), then things might look a lot brighter than consensus imagines in the days and weeks after the election. Both for the country and for equities.