Nine months before the presidential election, investors are already thinking about how financial markets might respond to the outcome of the vote, and how they should trade to prepare for it.
Stock markets have soared to record highs in recent weeks, while government bond yields, which underpin interest rates for consumers and companies, are down from a recent peak in October. Despite the uncertainty of making political predictions, money managers are already contemplating how the election could alter the mood in markets.
Red Wave, Blue Wave, or Divided Government?
The combination investors see as the most likely to spur a shift in financial markets in November — and therefore the scenario that traders are spending the most time thinking about — is a so-called red wave, where former President Donald Trump returns to the White House along with a Republican sweep of Congress.
When Trump won the presidential election in 2016, and Republicans maintained control of the House and Senate, expectations of lower taxes and a looser regulatory environment juiced growth expectations and major stock indexes rose. Those policies, which cut the government’s revenue and raised its borrowing needs, also propelled a sharp rise in government bond yields.
In the event of a red wave, investors expect something similar. “I think directionally you will see something that rhymes with it,” said Erik Weisman, chief economist and a portfolio manager at MFS Investment Management.
A blue wave — a Democratic sweep of Congress and President Joe Biden’s reelection — is seen as less likely, and is therefore getting less attention, although that outcome could also lead to increases in government spending and higher borrowing costs.
And should the election result in a divided government, as it is now, then the prospect of further legislative gridlock would probably temper any response in the markets.
“What is going to matter is a red wave or not,” said Mike Gladchun, an associate portfolio manager at the fund manager Loomis Sayles.
Trading the Interest Rate Gap
One of the most talked about election trade ideas echoes a strategy that is already popular and tied to the expectation that the Federal Reserve will soon begin to cut interest rates.
“If there was ever a time to bet early, this would be it,” said Gladchun, who added that while he is not making trades on the election just yet, he is already having investment conversations about it.
Over the past six months, investors have been betting on a widening gap between short-dated interest rates, which are closely tied to the Fed’s policies, and longer-dated yields, which are also influenced by growth, inflation, and how much the government needs to borrow.
If inflation continues to cool and the Fed begins to cut its benchmark interest rate, as many expect this year, short-dated market yields would normally be expected to fall. Meanwhile, the strength of the economy and concerns about government borrowing are expected to keep longer-dated rates high.
A red wave would be another reason to bet on a growing gap between short and long rates, investors say.
“It would be too early to put this trade on if it was the only reason, but there are many reasons it already makes sense without thinking about the election,” said Calvin Tse, head of research at BNP Paribas. “The election is a potential positive tailwind to the trade.”
Still, there are risks to devising trades so far before an election, not least that Trump is still fighting legal battles on multiple fronts, including over his eligibility to even appear on the ballot.
Preparing for Volatility in Stocks
Stock markets could prove harder than bonds to predict, with investors saying they currently prefer trades that would profit from higher volatility instead of betting on a specific direction in prices.
While lower taxes and deregulation would probably be welcomed by corporate America, higher bond yields — and, therefore, higher borrowing costs — would not. It’s also tricky to forecast how the Fed would react to stimulative fiscal policies if the economy continues to hum. (Trump said recently that if he was elected, he wouldn’t reappoint Jerome Powell to another term as Fed chair.)
That could prompt volatility in the bond market, too.
The Stronger-Dollar Trade
Another idea being discussed is whether to bet on a stronger dollar. Trump has said he would impose new tariffs on imports, which tend to boost the value of the dollar by making it less attractive to spend on foreign goods.
At the same time, some investors worry about the effects that Trump’s authoritarian sympathies could have on the perceived strength of the U.S. legal system, which underpins the country’s status as a global financial hub.
“To the extent Trump is seen as not good for the rule of law, then that is not good for the dollar,” said Weisman of MFS Investment Management. “Do you want to own U.S. assets in a world where the rule of law may not mean quite as much as it used to?”
This article originally appeared in The New York Times.
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