Having delivered on what I felt was an editorial obligation to mark the US election with one of the signature, visceral, “slice of life” pieces regular readers have become so fond of over the years, I wanted to briefly recap the tactical setup and reiterate a few points about possible post-election market reactions.
Global equities were aggressively “risk-on” headed into the US cash session Tuesday, and rates responded accordingly, with yields higher and curves steeper. The dollar was sharply lower.
All of that was (rather plainly) indicative of expectations for a Democratic sweep. Higher yields tipped anticipation of ramped up borrowing/coupon supply to “pay for” bigger stimulus (ironically on the heels of Treasury cutting its borrowing estimate in half for the final three months of the year to account for the possibility that no new fiscal stimulus legislation will pass), the slumping dollar reflected the same expectations of wider deficits (as well as Fed accommodation and the read-through for capital flows from a more onerous tax regime), and rising equities at least in part suggested markets were preparing for a “cleaner” outcome thanks to the apparent durability of Joe Biden’s poll lead.
Chatter from bank clients suggested the consensus was still that a Democratic sweep would be an acceptable (and perhaps even desirable) outcome in the near- to medium-term, as it would green-light huge stimulus and pave the way for (forgive my candor) a saner approach to damn near everything, from foreign policy to the pandemic, even as fears abound that Biden might take the country back into virus lockdown.
But there’s a caveat. Some still suggested a clear-cut win for Trump was the surest path to immediate equity upside, as a landslide for the president (no matter how unlikely that seemed headed in) would remove the prospect of a contested outcome and take tax hikes and re-regulation (“re” with an “r”) off the table. As for stimulus, the assumption would be that an emboldened Trump could simply demand that a GOP-controlled Senate “hand over” the money he wants to spend. In the (extremely unlikely) event Trump won The White House but Democrats flipped the Senate, well then everyone who “matters” would be on board with stimulus — it wouldn’t be about the price tag anymore, but rather just about the allocation choices.
What about gridlock? Isn’t that usually a longer-term positive for markets? Yes. History does show that (depending on the asset, of course). But here too, there are some caveats.
“DC gridlock is normally a market positive, but in the case of a Biden White House paired with a Republican Senate, this gridlock would actually be the SHORT-TERM ‘risk-off’ catalyst, as it locks in a more contentious stimulus battle and ultimately a much smaller relief package,” Nomura’s Charlie McElligott said Tuesday, adding that over the longer-term, “the gridlock would help offset fears about the magnitude of tax hikes and re-regulation” from a prospective Democratic White House and Congress.
Of course, when it comes to a Democratic sweep, the upside from a decisive outcome is being weighed against an assumed longer-term drag from higher taxes and more regulation. However, when it comes to actual analysis around the economic implications of a unified Democratic government, I think it’s (totally) fair to say that most analysts see the combined effect of a bigger, more persistent, demand-side impulse and more predictable policies, offsetting the drag from higher taxes.
Now, when it comes to the actual mechanics and flow dynamics in play, you’re reminded of a theme that’s been discussed in these pages at length over the past several weeks. Namely that in the event of a “favorable” election outcome (and here “favorable” is party/candidate neutral — “favorable” just means “fast” and “unequivocal”) an over-hedged market that’s still positioned for protracted uncertainty could be forced to unwind “crash” protection into a rally, thus turbocharging the upside. Said differently, if you’re hedged for some kind of “science fiction” scenario and the process ends up being unexpectedly smooth, that protection is going to decay into expiry and quite possible decay hard. So, you’ve gotta shed it, and that could be an upside catalyst.
“I’m going to repeat my punchline from the past few weeks: In a world long so much ‘crash’ for an event that will find it very difficult to ‘realize’ versus the moves which are being priced in the vol market– IF a ‘less bad’ election outcome scenario were to play out, it’s then likely that we will see that ‘crash’ hedge decay hard into the key expiries and get unwound back into the ether, which will mechanically sling-shot the market higher,” Nomura’s McElligott said, in the same Tuesday note mentioned above.
Add to that expected positive news on the vaccine front and the prospect of any relief rally compressing realized volatility (with knock-on effects for a latent, mechanical bid from the vol-control universe), and the stage would be set for a melt-up.
There are all manner of “ifs” and “coulds” and “mays” embedded in the above.
So, just to be clear: For all anyone knew on Tuesday morning, America “could” look up a week from now and find the streets on fire “if” something goes horribly awry, and that “may” damage sentiment both at home and abroad, opening the door to a surreal outcome that nobody wants to fathom and that, frankly, nobody is “hedged” for. Because you can’t hedge for a hard turn towards autocracy.