Election Front and Center

In my previous article I mentioned that betting on the market based on the election result is a bad idea because there's a lot of uncertainty. I’m still perplexed as to why the market rallied so much today when nothing is certain. If you did know who was going to win, I would only make a directional bet on the market if it was Trump. Hillary’s win was (mostly) priced into the market a day early, just like how Brexit was thought to not be happening until it did. It makes sense for financial professionals and economists to predict anything that provides stability. Predictions in favor of Hillary can help turnout for her. It’s not a matter of politics for this group of people; it’s a matter of job security. Very few are in favor of volatility. A Trump win would bring volatility.

The map below explains why I think the election is uncertain. Neither candidate is close to winning the necessary 270 electoral votes without winning a few tossup states. This means the election will boil down to turnout. Trump’s base is more likely to turnout, but Hillary needs to win less tossup states. I think the election has had an effect on people’s psyche where they think they know more than they do. Everyone has been blasted with coverage and had conversations about the election non-stop for a few months now. Just because you are an informed voter who has looked at the polls, doesn’t mean you know who will win. You can’t know something that’s unknowable based on the information we have in front of us.

map

If Hillary wins, the market will certainly have a relief rally, unless the result is contested by Trump which wouldn’t be a shock. The question on investors’ minds will then switch from the election to Federal Reserve policy, with the December meeting coming in a few weeks. The question is whether Hillary winning will make the Fed more hawkish or more dovish. There is logic to both sides of the coin.

The logic to the Fed hiking in December is that a Hillary election would be a bullet dodged in terms of market volatility. If the bad event doesn’t happen, the Fed is clear to raise rates. When Hillary wins the election it reaffirms Yellen’s position as Fed chair which is a positive for the market and may allow Yellen more flexibility with decision making. The logic is Trump winning is a bad event which needs a dovish response by the Fed and Hillary winning is a good event which needs a hawkish response.

This is the Brexit model. It’s ironic that I’ve been hearing commentators try to separate this election from the Brexit when they are using the same monetary policy model. One possible reason for this attempted separation may be because they don’t want Trump to win like they didn’t want the Brexit to happen. After the Brexit was voted, on the Bank of England cut interest rates and instituted a new round of QE. The currency weakness is caused by these policies, not because of the Brexit. Once again a central bank is fighting a fire by lighting a match to an explosive device and blaming an exogenous event for the economic problems it created.

I disagree with the logic created in this scenario. While I think Brexit is similar because of the election trends and market reaction, I don’t think it’s similar in terms of what monetary policy it leads to. In the Brexit situation, the same people were in charge of monetary policy regardless of the outcome of the election. In our election’s case that isn’t going to happen. I look at this way. If Hillary wins, the most dovish Fed chair in history keeps her job. If Trump wins, she doesn’t. Therefore, Hillary winning is actually the more dovish scenario.

I’m of the belief that the economic data will get worse after Hillary Clinton wins and the Fed suddenly realizes we’re in a recession so it has to act dovish. I don’t find it conspiratorial to question the data changes we’ve seen which is shown in the chart below. It’s tough to understand how the Fed’s Labor Conditions Index has been revised upwards 7 months in a row. We know there is a temptation for the Fed to support the incumbent. Either this is manipulation to help Hillary or an anomaly.

labor

The data can all be correct and the Fed can still make the argument for dovish action after Hillary wins. As you can see, the labor conditions index is negative year over year. The last time this happened was in 2007 prior to the last recession. The Fed’s own indicators are saying it should be dovish, so switching to this position will not be difficult. As I said, the Fed wants to be positive on the economy to help Hillary, but then switch to dovish to keep the economy afloat.

Conclusion

            The election is an unknown which means it has mispriced the risk event tomorrow by rallying preemptively. However, we will only see the risk play out if Trump wins. I think investors are mispricing the chances of a rate hike. The chances of a rate hike in December are currently 76.3%. If investors are so certain of a Clinton election, they should be dovish, not hawkish, because Yellen will stay as the head and the entire power structure will be maintained. Yellen has maintained interest rates near zero. It would only be logical to conclude that if the Fed didn’t raise rates this entire recovery, it won’t raise them as it is ending.

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