The Election Signals Tough Roads Ahead

The market is ignoring the elephant in the room. In terms of the presidential race, most voters and economists think both presidents would be a bad choice. It will be tough for either candidate to get anything passed through Congress because he/she will not have a mandate. A mandate is when the president gets his way with policy because Congress wants to listen to the will of the people. In this case, both candidates are hated. If the Congress really wanted to listen to the people, it would hold another election with new candidates!

Normally I would expect this tumultuous situation to sort itself out in a draw which would lead to gridlock. The market likes gridlock because there is less policy uncertainty. It’s not that the market thinks the government can’t improve the current situation; gridlock eliminates the possibility that something bad will get done.

While gridlock usually is good, given the nature of problems ahead, it could be disastrous if the correct actions aren’t taken to solve them in a timely manner. Health care premiums are expected to rise by 25% on average and in some states over 30%, as you can see from the chart below. This will have to be dealt with next year with some sort of policy prescription. If Donald Trump gets his will and Obamacare is repealed, what will replace it? How will legislation get passed if the Democrats take control of the Senate? You would expect a Trump victory to bring the GOP the Senate, but given that Pat Toomey and other Senators running are not endorsing Trump, he can win and the Senate can simultaneously swing to the Democrats.

If Hillary Clinton wins, she will remain unpopular and have a tough time getting her patch-work fixes to Obamacare through Congress given the GOP will still control the House of Representatives. Secondly, Hillary wants to keep Obamacare in place to support President Obama’s legacy, so she may make changes that aren’t aggressive enough. With insurance companies leaving the exchanges, competition is declining which is leading to price hikes. If this goes unchecked, people will have less money to spend on everything else, so the economic drag will be far reaching.

Getting back to economic policy, as I said, a fiscal stimulus will be tough to construct. Economic growth is weak, the deficit is expected to rise to about $600 billion in 2016, and Congress might be divided. This is a recipe for problems not getting fixed. However, what’s even worse than this is that the Committee for a Responsible Federal Budget scored both Trump and Clinton’s plans and said neither plan will deal with the debt or help foster economic growth.

The chart below examines the effects of each candidate’s economic proposals. In 2017 Trump’s plan will add 1.7 points to GDP and Hillary’s will take 0.4 points off of it. Over the longer term Hillary’s plan will take 0.1 points off GDP and Trump will take 0.5 points off it. In my opinion, analyzing Trump’s economic plans are tough because he says he wants to cut spending yet his plan adds to the debt. In the best case scenario, Trump is able to cut regulations and a Republican Congress forces him to rein in spending. Given Congress didn’t counter president Obama, this seems improbable.

To summarize the current situation, while a potential divided government may look good on paper, it will lead to a government which is hand strung in dealing the economic weakness and skyrocketing health care premiums. Don’t get me wrong, I am not someone who wants the government to solve every problem; I prefer a hands off government. However, these problems are all self-inflicted, so they need to be dealt with somehow.

I described a situation which should cause excess volatility. This is not the current situation, as you can see below. Volatility is the lowest compared to the previous 5 periods leading up to elections. This chart is 2 months old, but there hasn’t been much change in the volatility. Currently the VIX is at 13.48 which is low based on historical standards.

The other aspect to keep in mind is who will win the race. This is another area of uncertainty because the polls are diverging. The ABC poll has Clinton up by 12 and the Investor’s Business Daily Poll has Clinton up by 1. The Investor’s Business Daily has the best track record based on past election predictions. Therefore, we are uncertain about whether the election result is certain. It is likely that the election will be close if we give the IBD more weight. These are a lot of uncertainties.

Conclusion

The lack of volatility in the market is due to Fed policy. Regardless of the reasoning, the market is ignoring the risk which is about to be realized on November 8^th no matter who is elected. This is a mistake. Therefore, having a defensive portfolio with gold and cash weighted higher than normal makes sense in this current environment.