Reward for political risk
admin | October 9, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
After most presidential elections of the last 50 years, risk markets have generally rallied in the months afterwards. The S&P 500 has rallied in the 90 days after the election by an average of 1.87%, and credit spreads have tightened. Excluding the election of 2000, which coincided with the bursting of the Internet bubble, and 2008, which happened as financial crisis set in, equity markets have rallied by an average of 4.55%, more than twice the usual 90-day showing of the last half century. Credit spreads have reflected the relative performance of equity. If past is prologue, the next leg of this year’s spread tightening should start after the coming election ends.
Risk usually rallies after elections
Equity markets have delivered positive 90-day returns after 10 of the last 12 presidential elections (Exhibit 1). Ninety days roughly covers the period to inauguration but before significant legislative change. Some of the return reflects the usual performance of US equity markets. The usual 90-day return on the S&P 500 since 1972 has come in at 1.84%. By that benchmark, typical post-election returns, though positive, are little more than average. Seven of the last 12 elections have given way to performances above that benchmark, five have given way to performance below that benchmark. Excluding the elections of 2000 and 2008, post-election returns over 90 days rise to 4.55% and exceed the usual market return by 2.71%.
Exhibit 1: Equity markets have typically rallied after US presidential elections
Consistent history on credit spreads is more limited but shows the same pattern. Credit spreads widened after the elections of 2000 and 2008 and tightened after the elections of 2003, 2012 and 2016 (Exhibit 2).
Exhibit 2: Credit spreads after elections parallel equity market performance
History suggests that absent an ongoing or imminent market failure, broad risk markets respond less to the political or policy stakes in an election and more to the resolution of election uncertainty itself. Positive and negative equity returns, or tighter and wider credit spreads, have come after both Democratic and Republic presidential wins. The economy and corporate earnings outweigh politics.
It would probably be a mistake to conclude that elections have no effect at all. Political differences in tax and spending policy, for instance, almost undoubtedly shape winners and losers within equity and credit markets. Oil and gas may win under some administrations and lose under others. Agriculture or manufacturing or technology may win under some administrations and lose under others. For investors, the impact is more on security selection than on broad asset allocation.
Application to the current cycle
The market has clearly priced in volatility after November 3, so the issue is whether it will meet expectations or deliver a November surprise. A close election with litigation that runs right up to December 14, the date the Electoral College casts its votes, would exceed the expectations now priced into online markets and likely hurt risk assets. A landslide where litigation would have limited practical effect on the outcome would likely resolve volatility faster than expected. In either case, resolution should start the next leg of tightening. History does show that spreads nevertheless could widen if markets crashed for other reasons, and the current pandemic creates some other reasons. But past markets did not have the current Fed behind them. The prospects for risk assets in the next few months look good.
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The view in rates
First the Fed and now the election continue to tilt the yield curve toward bearish steeping. The Fed’s flexible average inflation targeting started the process at Jackson Hole by outlining a historically dovish approach to inflation. The election has followed by putting stimulus on the table. With either a divided or unified government, Washington is likely in either case to pass another round of pandemic stimulus after the votes are counted. With a Democratic sweep, the prospect of Biden’s proposed $4 trillion of additional federal spending over the next 10 years would add to that. Some of the pressure toward higher, longer rates comes from supply, some from potential inflation. The market has steadily bid up 10-year breakeven inflation, which now stands at 174 bp, slightly below the 180 bp peak right after Jackson Hole.
The view in spreads
The next leg of tighter spreads should come after the conclusion of the coming elections. That conclusion may land well after November 3. Spread compression took a holiday in August as spreads broadly moved sideways to wider and interest rate and equity volatility picked up, and that seems a reasonable expectation through November 3 and its aftermath. After final election results, however, an important element of uncertainty should resolve, and risk assets should rally. In the aftermath of elections, risk assets remain caught between Fed buying on one hand and heavy net supply of Treasury debt on the other. There is still fundamental risk in the most leveraged corporate balance sheets with corporate leverage going up through 2020, and only there might spreads continue lagging the rest of the market.
The view in credit
Fundamental credit remains as uncertain as the economy, and the lack of new fiscal stimulus increases risk for households and small businesses. The downside in leveraged credit has outweighed the upside since March, and the imbalance without fiscal stimulus looks likely to get worse. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. High yield and leveraged loans have nevertheless done well. But the hard part is about to start as winter approaches and some of the outdoor activity that sustained bits of the economy starts to go away.