The US elections may have passed. But other issues remain: the pandemic, the arrival of vaccines and all the economic uncertainty attributable to return of economic activity to pre-Covid levels.
4 November 2020
While the election results are not certain at the time of this writing, with Joe Biden appearing to be in a position to win the Presidency and the Senate being held by Republicans, we can begin to consider the impact of these outcomes on investing going forward.
Prior to the election, the biggest driver of election volatility was not who might win the election, but rather that there would be a decided winner at all. The fear of contested election or drawn-out vote counts kept volatility elevated not just for options expiring near election day, but also for December and January options. While that risk has not been entirely removed and may appear to remain high given the close races across swing states that have not been called, implied volatilities have begun to decline to reflect increasing optimism around a definitive outcome. Should further clarity develop and a clear winner emerge, we would expect that implied volatilies would continue to fall.
However, the passage of the election may not lead to a collapse of options prices as the market continues to grapple with the pandemic, the arrival of vaccines and the uncertainty around the return of economic activity to pre-Covid levels. It is likely that until the market resolves those concerns, volatility across the term structure will remain high.
Heading into the election, there was great consideration given to a blue wave outcome with Democrats capturing the Presidency and both Houses of Congress. There were discussions of potential stimulus packages as emergency relief for Covid-19 and then longer infrastructure and other spending. Numbers as high as USD5 trillion overall were frequently mentioned as possible under the blue wave outcome. Ten-year Treasury bond yields had risen to 88 basis points ahead of the election as fears of inflation as a result of increase fiscal spending started to grip the market.
With Congress apparently divided going forward, prospects for large-scale stimulus seem diminished and, as one would expect, bond yields have reversed much of the increase and fallen back to 78 basis points. Relatedly, Value stocks which had been reacting positively to prospects for increased spending and, to some extent, higher rates, seem to have diminished with Value significantly underperforming growth in the early hours of post-election trading. Again, while results are not yet known, the narrative around Value seems to be worse and investors have once again flocked to Growth and Momentum as those have worked well all year.
Another victim of the split outcome of the election, irrespective of Donald Trump or Joe Biden winning in the end, is the Federal Reserve’s ambition to transfer some of the crisis management of the economy and markets to the government in the form of fiscal spending. Both Fed Chair Jerome Powell and European Central Bank President Christine Lagarde have discussed at length the need for governmental policy response to increasingly replace the role of the central banks. In part, this has been a result of little left in the toolkit for either the ECB or the Fed. However, given the Republican Senate’s previous animosity toward large-scale emergency Covid relief, it would seem difficult to expect even that level of policy response, much less a larger-scale one in an economic downturn.
As such, the electorate may very well have put the onus for stability right back on Powell and the Fed. While the central banks will argue their tools are limited, in the US, there may still be room to do more. This might mean negative rates, asset purchases extending to other risk assets and even yield curve control. Regardless, investors will have to evaluate whether fiscal responses will be timely and commensurate to crises as they occur and how the Fed might respond should government responses fall short. This may have broad implications for the utility of bonds in portfolios going forward.
Looking beyond election day, should volatility normalise further, it would be reasonable to expect further allocations to risk assets. Systematic strategies that use volatility as an input to their models will be more free to add risk. Similarly, the passage of the election event does remove a potentially risky binary for portfolio managers across assets classes and investing styles. Those who reduced gross or net risk ahead of the election may seek to reinitiate positions; however, given the pandemic remains a persistent concern for the global economy and the election is not entirely resolved, that re-risking process may be slow. In short, a big event has passed and thus markets can turn their focus back to other issues. By and large, today, that has meant continuing to own Growth and tech stocks, while relying on stability of bonds.