Observing the evolution of the election narrative through the market’s beer goggles has been quite something to behold over the past couple of months.
It’s not entirely clear there’s ever been much in the way of “consensus,” but there were two distinct storylines that received some measure of market “buy-in” (figuratively and literally) from August through October.
One narrative was that America might be headed for the worst domestic crisis since the Civil War. Donald Trump’s refusal to commit to a peaceable transition of power stoked those fears, and when he doubled (and tripled) down on that refusal, some market participants were forced to begrudgingly accept the notion that the “science fiction” scenario (in which Trump asserts autocratic powers) was a non-zero probability outcome. Far-fetched? Well, sure. Totally far-fetched. But non-zero, nevertheless.
That narrative gave way in late September/early October to “blue sweep” fever, as Trump’s performance (and it really was a “performance“) during the first debate coupled with his COVID-19 diagnosis, prompted many to assume that “The Apprentice: White House” was likely to be canceled after its fourth season. Recall the spike in volume on PredictIt around Trump’s diagnosis (figure below).
Nomura’s Charlie McElligott talked about this narrative evolution in a Tuesday note.
“First, it was the ‘Extended Election Chaos’ scenario as vols out into Dec and Jan went super sticky ‘bid’ into what was at the time an almost consensual ‘buy-in’ to the worst-case scenario of a disputed outcome with vote recounts, Supreme Court involvement, fraud allegations, civil disorder and general policy confusion which, in turn, scared hedgers straight and saw the bid vol expiries well past the event itself,” he wrote.
In the figure (below) you can clearly see when that narrative shifted. Again, it was during the week that captured the first debate and Trump’s COVID diagnosis.
That ushered in what McElligott describes as “blue wave mania,” which he notes was “based on a rather sudden shift in market view away from ‘standard’ Wall Street views on (negative) Democrat policy implications for the economy and market, and instead, into one where a unified Democratic White House [and] Congress would see unprecedented government spending and fiscal largesse.”
That, in turn, triggered reflation bets, as the curve steepened, long-end US yields pushed up against their 200-day moving averages, and small-caps outperformed, alongside value shares (among other expressions of the same reflation optimism).
The idea was that better growth outcomes tied to a demonstrably larger fiscal impulse (i.e., big, sustained spending under a united Democratic government) would ultimately offset the mechanical drag from higher corporate taxes — and then some.
On Friday, and extending into Monday, disappointment on the fiscal front and disconcerting virus news seemingly shifted the narrative anew.
While you can plausibly attribute some of the jitters to the increased risk of new lockdowns, McElligott said Tuesday that the previous session’s “broad repricing of vols higher… into the election event date itself” is likely also down to “increasing concern of a ‘split leadership outcome.”
Remember, the Senate matters perhaps more than The White House when it comes to stimulus. No matter who holds the keys to the Oval Office, a Republican Senate will likely remain recalcitrant when it comes to countenancing large fiscal initiatives.
As McElligott puts it, a GOP Senate might “act as a thorn in the side of the new administration.”
That also goes for a hypothetical second term for Trump. If the Senate was as amenable to the president’s exhortations to stimulus as he claims, GOPers would have demonstrated that over the past several weeks. After all, if not now, when? That is: If you’re a GOP senator and you believe a big stimulus deal could help your president win a second term, now is the time to get behind big spending, even if it goes against your purported aversion to large deficits.
So, under either Biden or Trump, the fiscal side will be hamstrung if the GOP holds the Senate. If you’re asking yourself why, at this point, Republicans would continue to parrot obviously outdated notions around fiscal rectitude after having just presided over three years of ballooning deficits (even before COVID), you’re not alone. This charade that says deficits matter for developed economies is becoming a harder and harder sell with the public. If the GOP does manage to hold the Senate, but doesn’t soften its tone on spending, they’ll probably be wiped out electorally over the next decade, assuming inequality continues to spiral.
In any event, McElligott underscores that the prospect of “this surprise ‘split government’ scenario” playing out suggests the need to again consider duration, flatteners, and longs in momentum and secular growth (e.g., big-cap tech and bond proxies) as hedges against what might be described as a possible disinflationary election outcome.
After all, if the GOP holds the Senate, that would presumably be USD+ (at least in the near-term) as the market prices out massive spending. At the same time, yields would likely drop as inflation expectations come down. That could mechanically drive reals higher, feeding dollar strength. At the very least, it’s something to consider.
In the meantime, McElligott notes that these “‘election narrative overshoots’ continue to swing wildly” both due to the proximity of the event itself and also “as a function of horrific market illiquidity, with banks/dealers on facilitation lockdown, as per risk management ‘VaR shock’ muscle memory from 4 years ago.”