How Will the US Election Affect the Market?

With the US Presidential election entering its final few weeks, and the BC election currently underway, we're fielding a lot of questions about how consequential elections could be for our client's portfolios. To answer that question, we have to dig into why elections affect equity markets, why this Presidential election is likely to have a significant effect, and the plausible outcomes of some of the most likely election day scenarios.

This Election is Particularly Important One

We can see that this election has the potential to move the needle by looking at the market for volatility futures. The VIX index, which we've talked about before, is a statistic calculated by the Chicago Board of Exchange to measure the market's expectation of volatility. Market participants use VIX futures to hedge risk, so the more risk the market sees on the horizon, the more expensive the VIX gets.

By charting VIX futures over the following months, we see that November will be something of an inflection point:

Source: VIX Central

This term structure is somewhat abnormal, as volatility tends to slope the other direction. The further out you go, the more uncertainty you're bringing into the equation, which would normally cause volatility futures to get more expensive for later months and cheaper for nearer months. 

Here, though, the futures market displays something called "backwardation," which indicates that the market expects volatility to decline as time goes on. You can see that this trend only starts in November, which suggests that the shift in projected volatility is attributable to either the election or something else happening in November.

Some Plausible Election Outcomes, and Their Effects

Below, we walk through the wide universe of possible election-day outcomes, sorted by the probability assigned to them by 538.

1. Biden Wins Comfortably, Democrats Win the House and Senate

In this scenario, Biden wins the Presidency by a margin that's too wide for Trump to dispute, and the Democrats win both the House and the Senate. The affect on the equity markets would be split, since:

• It would be easier for one party to pass stimulus packages

• Biden's tax plan calls for raising the corporate tax rate back to 28%, which would affect corporate earnings

Outcome: short-term positive, long-term negative for EPS.

2. Biden Wins, Democrats Don't Take Both Houses of Congress

A blue wave sweeps Biden into the White House, but the Democrats fall short of taking both houses. This effect would be broadly neutral, since the probability of anything meaningful being passed through yet another divided government is very low. That goes for both a stimulus package, which is badly needed to prevent economic collapse, and an increase in the corporate tax rate.

Outcome: Broadly neutral, slightly negative.

3. Biden Wins Narrowly

This could be something of a nightmare scenario. A narrow Biden win would likely come down to mail-in ballots (which favour Democrats, generally) in a few key states, and those votes don't get counted on election night. It's hard to imagine Donald Trump conceding a loss when election night results had him winning or the race too close to call, especially when that loss hinges on accepting the validity of mail-in ballots.

This would cause a constitutional crisis, and likely a messy one. We're not experts in this field, but we imagine that the market would not react favorably to a drawn-out political balance over who the President is.

Outcome: Long periods of sustained volatility. This is the risk the market is seeing on the horizon.

4. Trump Wins, Democrats Control At Least One House of Congress

The positive here is that a hike in the corporate tax rate is off the table. The negative is that the ongoing cycle of stimulus negotiations failing would continue in the same pattern.

Outcome: Status quo, less the uncertainty of the election. 

5. Trump Wins, Republicans Win Control of Both Houses

This is a very unlikely scenario, but it happened in 2016 and the effect was remarkable. A unified government with an agenda to lower or eliminate taxes is very good for an equity market.

Outcome: Whatever your political inclinations, it's hard to see this as a negative for the equity markets. 

Our Outlook 

We know that presidential elections can move markets, we can see that this presidential election is already an inflection point in the market's progress, and we know that there are some negative outcomes on the table. We also know that, while polling methods have improved since 2016, Election Day always manages to bring some form of surprise. Therefore, we feel that there is a lot of downside risk on the horizon right now, and have recommended most of our clients increase their cash position.

We're watching the market closely and are looking for buying opportunities in the near future. In the meantime, however, we're very happy to have some money off the table while one of the biggest stories of the last decade resolves itself.

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If you'd like to talk about these events or discuss your portfolio, don't hesitate to reach out to us at 604.643.0101.

Cash Management Group

604.643.0101 | Email us

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