As Americans prepare to go to the polls after one of the most bizarre election campaigns, here are the main things that investors should keep in mind.
Although the presidential race tightened in the last 10 days, many prognosticators and betting sites still predict that Hillary Clinton will win. If her victory is combined with down-ballot results that prolong gridlock in Congress—the most frequently predicted outcome for the legislative-branch elections—markets would likely react in a relatively calm and orderly fashion. Equities would remain range-bound overall, as would bonds and currencies.
There are two market “tails” that accompany this baseline; and they would lead not just to major moves in indices, but to notable compositional changes, too.
An equity market sell-off is likely should Donald Trump win the presidential vote and also reaffirm his intention to move quickly on policy positions that disrupt long-standing trade relationships (such as tariffs on China and Mexico and the revocation of the North American Free Trade Agreement). The sell-off would be larger if he also were to also create uncertainty about the future shape of the financial system, such as by calling for an immediate repeal of the Dodd-Frank legislation without offering a credible alternative.
Also Read: What makes Donald Trump tick?
Under this first tail scenario, the turmoil in equity markets would cause risk spreads to widen on both investment grade and high-yield corporate bonds. The reaction of government bond markets would likely be more nuanced. Nominal Treasuries would find themselves pulled between expectations for lower growth and those for higher inflation—that is, unless Trump repeats his attacks on the Federal Reserve, in which case higher yields would ensue. The outlook for inflation-sensitive securities, particularly TIPS, would be less ambiguous given that markets would likely revise up their projections for the possibility of a fiscally induced increase in inflation.
The other tail event, a Clinton win combined with a Democratic sweep of Congress, would likely bring about an equity market sell-off that would entail more pronounced moves for certain sectors (such as pharmaceuticals and traditional energy). Bond markets would also come under pressure because of the higher probability of fiscal stimulus.
The currency markets are where the these two tail scenarios would have quite different effects. In the case of a Trump win resulting in anti-trade measures, upward moves in the dollar could materialize. Although a trade war would initially hurt both the US and its major trading partners, the US would have less to lose in relative terms given that it is a less open economy. By contrast, a Democratic sweep would lead to a weaker dollar.
What about the longer-term prospects?
Under the baseline of a Clinton presidency and congressional gridlock, the consensus predictions are for a prolongation of the two characteristics that have underpinned relative market stability and supported financial asset prices: low but stable growth and repressed financial volatility. I would suggest that this consensus view is likely to be challenged in the years ahead on both counts.
First, the prolonged period of low growth is fueling elements of its own disruption. Indeed, the rise of the anti-establishment movements in the US and Europe is just one element of a broader set of evolving disruptors to the “new normal” that have broad political, economic, financial and institutional drivers.
Second, the continued effectiveness of central banks in repressing financial market volatility also needs to be questioned and even doubted. Some institutions have demonstrated a declining ability to perform this function. (A prime example is the Bank of Japan, which has experienced a huge erosion of its influence on the value of the yen.) Others, such as the Federal Reserve, have shown a lack of willingness to carry on as before. And in most cases, including the European Central Bank and the People’s Bank of China, this reticence also is caused by the growing threats of collateral damage and unintended consequences.
As for the likely duration of market moves under the two tail scenarios, it would be unwise to take too much comfort from the snapback experienced in the aftermath of the Brexit in the UK.
US markets have much greater global prominence because of the dollar’s status as a reserve currency and the extent to which other countries essentially have outsourced some of their financial intermediation function to American markets. As a result, the repercussions of a spike in volatility would likely be deeper and more durable. Add to that legitimate concerns about the possibility of strained market liquidity, and the possibility of unsettling moves should not be dismissed lightly.
Put all this together and it should come as no surprise that market measures of upcoming volatility have risen in the last week while equity markets have moved lower. The previously held comfort that the elections would have rather benign short-term market outcomes is being questioned on two counts: the recent tightening of the race for the White House, and the extent to which the artificial market stability of the recent past is threatened by a growing host of longer-term economic, financial, institutional and political disruptors. Bloomberg