Fiscal gridlock continues as election draws closer

The tug of war over uncertainties surrounding the US fiscal stimulus deal continues. After a buoyant start to the week in Asia on recurrent hopes of a deal being reached, risk assets were offered overnight as risk-off sentiment returned. This as stimulus hopes soured once again alongside mounting uncertainties over the chances of a bipartisan agreement.

Negotiations are ongoing but the two sides remain reluctant to compromise, with House Speaker Nancy Pelosi stating significant disagreements remain, while Republicans continue to look for a smaller package. The closer the election looms, the less likely it is that a deal can be reached prior.

The fiscal gridlock is dominating the day-to-day gyrations in risky assets and generating a great deal of noise on a headline basis, but with the US election in close quarters, many market participants are in wait and see mode. With the polls calling the election wrong in 2016 and the real-world margin of error being close to 6% for some state polls, conviction is low and investors/traders are treading water ahead of the election. The race could be far tighter than the polls are indicating.

The lack of conviction only adding to the headline noise making it relatively difficult to decipher what is truly driving risky assets in the run up to the election November 3 and the significant political and event risk that comes part and parcel. For traders the emphasis remains on staying nimble, maintaining optionality and taking position sizing down.

Turnout is likely to be the swing vote in the US presidential race, given just over half the population actually vote. Where an increasingly split cultural and political landscape sees the “left behind” rust belters and Midwest farmers pitted against the climate vote, anti-Trumpism and progressives in mobilising turnout.

With respect to turnout, a key contributing factor could come from younger voters. In the midterms, young people voted overwhelmingly in support of Democratic House candidates. The youth vote provides a crucial swing factor for a Biden victory, amid a concentrated effort by social media networks to re-energise younger voters, where green policy and racial equity are huge drivers for this cohort. This as Facebook, Instagram, Snapchat, and Spotify have all initiated their own voter registration efforts in a bid to drive turnout, particularly among younger voters. Although Biden’s youth appeal may be less than other democratic candidates, Trump’s disdain for climate change mobilises this voting cohort who demand action on climate policy, leaving them motivated to oust Trump.

However, unless these dynamics can drive a Democratic landslide on election night, the probability of a contested outcome remains high. The problem being, Democrats are far more likely to use mail-in voting. Certain battleground states exclude election officials from beginning to process mail-in votes until election day, therefore Republicans votes are likely to be counted first, leading to a potential election night “red mirage” in which Trump appears victorious before the mail-in ballots are processed.

The ability to seize upon that lead and sow chaos and confusion, with accusations of fraud surrounding the mail in ballots could then see the outcome contested. Distrust in the legitimacy of the result has already been roused. That distrust, alongside the societal polarisation which has been supersized by the impacts of COVID-19, sees division ripe for exploit, in many ways primed for undermining public confidence in the electoral process.

These risks support the notion of choppy, range bound markets until the presidential election is out of the way, as focus shifts toward the probabilities of a contested outcome, the home stretches in battleground states and the margin of error in polling.

Equities are likely to rally after the election, regardless of who wins, as long as the outcome is not contested – the unwind of those corresponding hedges and reduction in uncertainty alone will see the market trade higher in the event of a clean election outcome.

Conversely, if we see a contested election come to fruition markets will not be happy. Taking precedent from the 2000 US Presidential election, which was unresolved until early December when the Supreme Court ordered a stop to the Florida recount following a month long legal dispute. This year’s election could come with an even greater legal challenge should the results be a close call. In 2000, the S&P 500 dropped 9% before George W Bush emerged as the victor in early December.

Large hedges in the form of put options are in play through to December 2020 and if dealers looking to hedge, short futures on any post-election jitters, this could be a catalyst for more broad based weakness. As we have seen before, most recently in August 2020, dealer hedging has the capacity to exacerbate directional market moves.

However, taking a big picture view, the trajectory of both fiscal and monetary policy, which remains supportive, will outweigh the election result. Alongside the economic recovery path and the prospects of a vaccine/virus control, as several interim vaccine trial results are due to be released before year-end. Meanwhile there is some ground to cross with respect to the virus, COVID-19 cases are most significantly on the rise in Europe once again which will hinder an economic recovery that is already slowing.