How a Stressful Election Could Stress Your Portfolios
Most market observers agree that the many uncertainties swirling around the US Presidential election are likely to generate volatility in the US equity market that could last well beyond November 3rd. Furthermore, that volatility could spread to foreign equity markets, the corporate bond market, FX market and elsewhere. History shows there is often (but not always) an increase in stock market volatility in the weeks leading up to a Presidential election, but that volatility has quickly subsided in a few days.
Volatility is likely to be high between now and the election and beyond
While volatility typically increases prior to a presidential election, this time the VIX futures market is signaling that volatility is expected to be elevated both before and after the actual election. Clearly, this election involves an elevated level of uncertainty.
That uncertainty is likely to persist unless there is a true landslide victory for one side or the other. There will be an unprecedented number of mail-in ballots to count, and that will take time. President Trump has already stated that he may not accept the results of the balloting and may turn to the Supreme Court, which could delay any resolution for some time.
As this chart shows, VIX futures recently showed expectations for an increase in market volatility the weeks before and after the election, with a dip in volatility for the VIX futures contract that expires the day after the election.
Compounding the election drama is the ongoing race to develop one or more COVID-19 vaccines. While approval and distribution of safe and effective vaccines would be a tremendous shot in the arm (pun intended) for the global economy, unfounded rumors about the “imminent approval” of one or more vaccine candidates is likely to complicate the volatility picture.
Given this backdrop, we believe it is important to stress-test portfolios under various possible volatility outcomes and time horizons. We see a number of possible scenarios worth considering, including the following:
- A “risk off” trade causes equities to decline in the days leading up to the election, with Treasuries and gold rallying. This would likely be bearish for the USD.
- Biden wins outright, and equity markets rally on the expectation of a fairly large stimulus package after he takes office in January. Retail investors may sell in anticipation of higher capital gains taxes in 2021. Pension funds, which are non-taxable, would have no tax-driven motive for selling. Longer-term, infrastructure spending is likely to increase, which may put upward pressure on longer-term Treasury yields.
- Trump wins outright. Given that this would increase the likelihood that any stimulus package would be small, this could have a somewhat negative impact on the US equity market and a small increase in the VIX.
- Biden appears to have won but Trump challenges the results. This is probably the biggest threat to market stability. We would expect a large increase in the VIX, higher gold prices and a lower dollar. However, there is some possibility that investors could sit on the sidelines until the dust settles, so a “bet” on a higher VIX is just that – a bet, not a sure thing.
- The Senate “flips” so that both houses of Congress will be controlled by the Democrats in January 2021. In this case, the lame duck Senate could quash any pandemic stimulus bill the House might propose, which would be a setback to the US equity market.
As with any scenario testing, the art is in determining plausible changes in the key variables (volatilities) and the probability (ranging from “highly likely” to “worst case”) that the scenario will occur. Since no one has a crystal ball, we recommend assessing whether the “worst case” would be catastrophic and if so, taking steps to reduce that risk.
Managing the risks inherent in their positions, including holding sufficient margin, is absolutely essential for prime brokers. The key question is whether or not they are measuring risks and managing margin effectively and proactively.
This summary is based on research conducted between February and March 2021 with 20 banks looking at current trends and priorities for Prime Brokers in the Margin, Collateral and Data areas.
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