Head of Global Asset Allocation Ashwin Alankar explains the possible reasons behind the options market seeing riskier assets in a favorable light as some additional stimulus and lower risk of major changes in tax and regulatory policy are plausible post-election scenarios.
- The potential for a split government should lead to appropriate checks and balances, thus taking more extreme policy proposals that could damage the economy off the table.
- Even with the election all but over, the options market anticipates elevated volatility given the continuing pandemic, the federal government’s large debt overhang and yet-to-be determined Biden administration officials.
- The options market also expects equities to be a more likely source of attractive returns than bonds, with recent trends favouring the US, large-cap and tech remaining intact.
Options markets once again proved their prognostication chops by forecasting a narrower-than-expected US presidential election. As in 2016, our models interpreted signals emanating from options about the election’s outcome diverged from public polling, which in the closing days of the campaign had called for a relatively comfortable victory by Democratic nominee Joe Biden. These signals were derived from two baskets of stocks, with one expected to outperform under a Republican victory and the other under a Democratic win.
Now that the voting is behind us, we still believe it’s useful to leverage options market signals to determine what the post-election prospects might be for financial markets. Similar to what has occurred in cash markets since November 3, options are hinting at lowered downside for riskier assets.
This may come as a surprise given that stocks rallied in the two days preceding the polls’ closure on the expectation that a “blue wave” could lead to a large-scale stimulus package to support the US economy through the next stage of the pandemic. Yet while that near-term positive may have been diminished, so too have longer-term risks associated with one-party control of Washington, among them a more onerous tax burden and greater regulation.
Markets like certainty and tend to prefer policy moderation, and that may be what these election results are shaping up to give us. Furthermore, options markets dislike the lurking presence of tail risks, such as the potential hit to growth caused by more government involvement in the economy. As our research indicates, these tail events are key ingredients in determining long-term investment returns and are therefore best avoided, in our view.
The art of the possible
Should the results hold and Mr. Biden take the White House and the Republicans retain control of the Senate, the country may be in for an oft-maligned state of gridlock. We don’t view this as an unfavourable outcome. The necessity of a Biden administration to find common ground with a GOP-controlled Senate may result in a path of policy pragmatism, reining in some of the impulses of the Democrats’ most progressive wing.
While gridlock gets a bad rap for throwing sand in the gears of government, and thus could have adverse ramifications on both Wall Street and Main Street, empirical evidence tells a different story. Since 1950, equity returns during years of split government have, on average, outperformed those with single-party rule by 500 basis points (bps), annualised.
Be careful what you wish for
Investors, along with the Federal Reserve (Fed), have been cheering for another round of fiscal stimulus. With the next package possibly scaled down, one may ask why options markets are not seeing larger downside to riskier assets. While the economy likely needs additional support, we believe fiscal expansion fits in the category of “too much of a good thing.” Research indicates that, over the long-term, fiscal stimulus has a terrible track record of igniting sustainable organic economic growth. In fact, after just a few quarters, we calculate the fiscal multiple to slip below 1, meaning that for every dollar of stimulus spent, the economic return is less than one dollar. This is especially true for one-time transfer payments to households and businesses.
Not only is fiscal stimulus not a panacea, but reality also dictates that spendthrift governments must eventually deal with the accompanying debt overhang. In the US’s case, increasing levels of federal debt could eventually weigh on the value of the US dollar, which would ignite a downward spiral in the currency that results in imported inflation, lower consumption and, ultimately, fewer dollars in international circulation that are needed to service the country’s debt load.
We believe all parties in Washington recognise that another shot of fiscal stimulus is necessary as the pandemic persists, but a compromise figure in the neighbourhood of $1 trillion may meet the economy’s immediate need and be an easier pill to swallow by investors alarmed by the country’s increasingly egregious debt profile.
Equities (still) ascendant
On the asset class level, the options market appears to believe that attractive risk premiums continue to be found in stocks. Peeling the onion back an additional layer, options signal that recent trends should remain intact – that is, a preference for US over international, large-cap over small, and technology over all other sectors (especially financials, as lenders may be further hampered by persistently low interest rates). Further, we see more attractive emerging market opportunities in Asia than in South America. Other favourable trends we believe are likely to emanate from a Biden administration include more friendly trade policies and a split government leading to a much more moderate stance on anti-trust and other regulatory issues.
Bonds appear less attractive. While it has been called before, with 10-year US Treasury yields well below 100 bps, the four-decade rally in bonds may finally be over. Fixed income will continue to play an important role in diversified portfolios, but investors will need to calibrate their expectations for a new regime. Going forward, questions must be asked about bonds’ efficacy in hedging equity risk, including what the opportunity cost is of maintaining that hedge and what a realistic expectation is for income generated by bonds.
Volatility not vanquished
While options markets’ expectations for future volatility have fallen in the days following the election, risks remain. COVID-19 cases are on the rise in Europe and the US, with the former already reintroducing restrictions on commercial and social activity. Longer term, investors must account for the unprecedented amount of accommodation not only by the Fed and other central banks but by governments around the world. And while we believe Mr. Biden would push a more centrist policy agenda, the true tell-tale event will be when he picks his cabinet. This is another source of uncertainty for the markets.
With the asymmetric return profile of bonds looking, well, more asymmetric, hedging risk within a bond portfolio becomes all the more important. By taking on securities with higher risk premia, investors stand to generate returns closer to what they’d typically expect, but this requires taking on more risk as well. That risk can be hedged but at a cost. Regardless of the asset class, we believe investors are best served by keeping their hedges simple and doing their best to make sure those hedges behave as expected during a market downturn.
To end on a positive note, we should remind readers that not all risks are bad. The bullishness of options markets implies that upside risks remain. Conjecture has been bandied about that many people would be hesitant to take a vaccine developed on an accelerated timeframe. We suspect, however, that people want to feel safe and resume their normal lives, which could lead to greater participation in vaccination campaigns. Indeed, this may be a key ingredient in options markets’ improving view of riskier assets and the economy. This eagerness, coupled with several coincident indicators that point a to possible V-shaped recovery, may be enough to keep the wind in the sails of risker assets.