Special Situations Memo: US Election Snapshot
“There are decades when nothing happens, and there are days when nothing happens”
-Market consensus implied from current price action (ie. October’s frothy calm in markets appears like investors are largely looking past the upcoming US elections.)
When will the party end?
Introduction:
Capital markets are psychologically driven by the collective thoughts, actions and requirements of its participants. They have an uncanny ability to always move towards the point of greatest pain or surprise for investors. This memo will explore the three prevailing US November 3rd Election outcome scenarios and then discuss market expectations and hedge fund positioning across Macro/Diversifying and Equity Long/Short strategies.
US presidential election headlines are quite confusing and misleading and polling does not help either.
Potential scenarios for November 3rd are:
1: Blue Wave Scenario
2: Mixed results Scenario
3: Contested elections
Summary:
The market is clearly geared for a Biden victory and the potential for an increase in market volatility seems under appreciated by market participants, but a market crisis event spurred by the US election is a low probability. Equity Long/Short managers continue to focus on bottom-up stock picking, which has been highly successful YTD, while Global Macro strategies remain tactical heading into the election, but with a trading roadmap depending on outcomes.
Election Scenarios
Scenario 1: New Regime with bold mandate Election results known: Stability/Non Event; Biden clear victory, Democrats sweep Congress.
Political analysts consider Trump has run a weak campaign where he has alienated undecided voters and spent all time and resources on his base.
What was/is Trump’s campaign strategy?
COVID is turning out to be a major detractor for Trump and he is doing nothing to change people’s minds that his management of the pandemic has been suboptimal. The COVID frustration with Trump is especially pronounced among seniors who are fed up with COVID restrictions.
Grandma and Grandpa want to see their grandkids
Biden Win: Biden has a credible group of politicians in his camp that will push through wide sweeping changes to taxes, regulations and energy policy. Some analysts think a Biden win could be a watershed moment in US history as impactful as the 1932 election that brought FDR into office. Ultimately, businesses would suffer as the national focus would be on closing the income inequality gap, but overall society could benefit from clear and rational policy.
Scenario 2: Uncertainty Election Results Known; Split Congress and Biden or Trump win; Stalled government policy.
The Congressional races are open and a split Congress will result in further gridlock and partisanship rancor in Washington.
Trump Win: There is a chance of a “Berlusconi” affect in US elections where Trump voters do not tell polls ahead of the election, but vote for him. Many comparisons are made to the 2016 elections, however, this year there are far less undecided voters, plus Joe Biden is considered a far more likable candidate than Hillary Clinton.
People generally have decided who they want in office by now
Scenario 3: Non-Result Year 2000 situation on steroids; Civil Unrest, culminating in Scenario 1 or Scenario 2 after days/weeks/months?
Some forecasters have assigned an 80% probability that votes will not be completely counted on election night. Biden will need a blowout win to surpass this hurdle. Either way, 50% of America will be unhappy with November 3rd results, whenever they are finalized.
That was not much fun……………….
Market Expectations
2020 has truly been the year for surprises in markets, so we expect more of the same leading into year-end. In early June, Manhattan’s Fifth Avenue was looted and the country was ablaze while equities trekked higher. This example reminds of us how central bank liquidity continues to fuel animal spirits regardless of economic, political or societal outcomes, especially over the short-term.
WTF is going on?
Over the medium-term, deeper issues in American political and societal structures could potentially make the country a less appealing place to do business resulting in the negation of the American exceptionalism premium on US equity and fixed income assets.
The unthinkable? US underperforms ROW for the next decade?
We therefore expect more market volatility, but have no forecast for short-term reaction to November’s political events, expecting the unexpected.
Given the massive government support of global capital markets, the election does not appear to be the catalyst for a selloff in equities below the March lows (a 30% to 40% March-esque drop), but a swift equity drawdown of 10% to 20% is not unlikely. A recent study by the Wall Street Journal found that over the past 50 years the S&P 500 and Dow Jones Industrial Averages have both failed to move more than 3.2% in either direction between election day and inauguration day when a new party takes the presidency. The consensus is for US dollar selling and higher US interest rates on a Biden victory.
A favorite target to benefit from this trend is Asian equities, currencies and fixed income instruments.
Hedge Fund Positioning
Prime brokerage reports from investment banks like Goldman Sachs clearly indicate that overall hedge fund industry gross and net levels, especially in Equity Long/Short, are elevated.
Goldman’s HF clients are generally well-risked here
However, Equity Long/Short funds in the portfolio are neither aggressively de-risking or holding above-average net and gross risk exposures. The highly supportive market conditions YTD for stock pickers is creating a “recency bias” bolstering Equity Long/Short PM’s confidence in their bottom-up portfolio construction capabilities to weather any upcoming election volatility. The outperformance of Equity Long/Short managers in down months like September further cemented belief in their books.
When fundamental Equity Long/Short HFs can make money on their long and short books, they tend to ignore the macro
Global Macro managers are far more tactical, as expected. Most are preferring to avoid aggressively risking into postelection outcomes, maintaining dry powder and remaining committed to following every data point and market price tick until year-end. The Asian equity and currency outperformance theme has existed in portfolios throughout 2020 so risk is being maintained. Long reflation themes common in manager portfolios, like long commodities, are viewed as secular themes that will be in place regardless of US political outcomes.
A secular renaissance in commodities is not necessarily tied to US political outcomes