Up and Down Wall Street
The Black Swan Election
The unprecedented 2016 elections could yet throw markets for a loop. A Trump victory or upheaval in Congress could tank the Dow.
By Randall W. Forsyth
“Regrets, I’ve had a few, but then again, too few to mention,” Donald Trump said in so many words last week. After the latest reshuffle at the top of his campaign, My Way probably will remain the Republican presidential nominee’s theme song.
Even with the departure of his former campaign chairman, Paul Manafort (to the tune of “Crimea River” for his connection to pro-Russian forces in Ukraine), the real political news of the week wasn’t the seemingly endless chaos in the Trump campaign that dominated the airwaves.
Rather, writes our buddy Greg Valliere, the chief strategist at Horizon Investments, the big development is that Hillary Clinton looks as if she’s in trouble. “Her campaign looks theme-less and stale—and the Clinton Foundation is a growing liability,” he advises.
The respected poll (if that’s not an oxymoron these days) from Pew Research on Thursday had Hillary holding only a slim lead over Donald, 41% to 37%, which Greg says should be a “wake-up call.” He advised his clients at week’s end that “Clinton isn’t a lock—this race is tightening.”
We relay this, first, because this election has been like no other, and second, because of the investment implications. As our cover story last week suggested, the stock market’s march to new highs has been helped by the perception that Clinton, the candidate of continuity, or at least less uncertainty, would prevail.
Indeed, Greg says the tightening may not show up in the national polls for a couple of weeks. That’s significant, according to a research note from Alec Phillips of Goldman Sachs, because historically presidential polls’ predictive power rises sharply from here on in. Going back to 1944, polls’ forecasting ability beginning in late August is twice that of 100 days before the November election (late July and early August).
To be sure, poll results are to be taken with a shaker full of salt, especially after pollsters totally blew the call on the Brexit vote in the United Kingdom a couple of months ago. Perhaps that’s because polls “have consistently failed to capture the voting intentions of marginalized and antiestablishment voters,” write Tina Fordham and Tiia Lehto of Citigroup, and the betting markets haven’t been much better, as Brexit also showed.
Yet, they continue, relying on old-school models and mind-sets recalls Einstein’s putative definition of insanity: doing the same thing over and over again but expecting a different outcome. Looking to economic indicators such as gross domestic product and unemployment, or the incumbent’s approval ratings, has less validity in this unconventional year. Moreover, fiscal and monetary matters have declined in importance for voters, which in turn has meant less attention to these issues from the candidates—“a factor that could dismay investors,” they add.
That implies far less certainty about November’s outcome than the pundits and, more importantly, the markets have assumed. To be sure, the Citi team puts a 65% probability on a Clinton victory. But, it also observes, 35% probability events happen all the time.
If that isn’t enough, the presence of candidates beyond the two main parties could further roil the campaign. In a three-way race, one recent poll shows the Libertarian candidate, former New Mexico Gov. Gary Johnson, getting 8.4% compared with 43.1% for Clinton and 37.1% for Trump.
FiveThirtyEight, the data crunchers, add that the Pew Research poll showing Clinton leading Trump 41% to 37% also found Johnson with 10% and Green Party candidate Jill Stein with 4%. Even more interesting is the willingness of younger voters to embrace third-party candidates. Among 18-to-29-year-olds in the aforementioned Pew poll, Clinton led Trump 38% to 27%, with Johnson at 19% and Stein at 9%. Averaging five different polls, Clinton got 41%; Trump, 20%; Johnson, 17%; and Stein, 10%. Thus, the alternative candidates both scored in double digits, with Johnson close to Trump.
The significance, according to Citi, is that if the Libertarian Johnson can garner the 15% needed to be included in the televised debates, it could “introduce further uncertainty in the race in its final weeks.” The debates kick off on Sept. 26, which bumps up against Monday Night Football, to Trump’s professed chagrin.
Odds that the Democrats can win back the Senate also are increasing, according to Goldman. Republicans are trailing in five races and are ahead only slightly in a sixth, while just one Democratic seat looks vulnerable. The GOP now has 54 Senate seats to 46 for Democrats, so the Dems need to win just four to gain a majority if Clinton wins, and five if Trump emerges victorious. (The vice president is the president of the Senate and casts the deciding vote in a tie.)
“This implies the most likely election outcome still appears to be divided government,” Goldman’s Phillips concludes. That would mean lower odds of a more-expansionary fiscal policy than under single-party control. (The odds favor the GOP retaining the House.)
THAT ONCE AGAIN LEAVES the Federal Reserve as the market’s primary focus, at least as far as its myopia lets it peer ahead. Yet even here, politics may enter into deliberations once thought to be confined to technocrats’ parsing data points on the head of a pin.
Last week had the Federal Open Mouth Committee in full session, with an array of central-bank officials voicing their views. That was in addition to the release of minutes of the July 26-27 meeting of the Federal Open Market Committee, the actual policy-setting panel of the Fed. What emerged is a continued split among FOMC members, from those calling for an increase in the Fed’s key policy interest-rate target from the 0.25%-to-0.5% range that was set last December, to those who want to continue to hold off on hikes.
Markets will be anxiously awaiting clarification from Fed Chair Janet Yellen when she delivers a highly anticipated address on Friday morning to the annual Kansas City Fed confab in Jackson Hole, Wyo. While there are 17 Fed governors and presidents, all with access to microphones, Yellen’s voice is more equal than the others.
She is slated to talk on the “Federal Reserve’s Monetary Policy Tool Kit,” but attention will certainly be focused on what she has to say about the shorter term, specifically what might (or might not) happen at the next FOMC meeting on Sept. 20-21.
“The hurdle is too high for a rate hike before the election,” according to rate strategists at Société Générale. Yet they note that New York Fed President William Dudley said in an interview last week that “the market is complacent about the need to gradually hike rates.” Dudley, former chief U.S. economist at Goldman Sachs, knows perhaps better than any other Fed official how market participants will infer such statements.
Still, the federal-funds futures market puts the odds of a quarter-point rate increase by December at a hair above even money, with the betting moving decidedly in favor of an increase only by next March (a 60% chance, by Bloomberg calculations). And the futures market is pricing in only a single hike all through 2017.
But those slim odds may even be too high. “A topic that likely will not be discussed explicitly, but that will influence all policy discussions at Jackson Hole, is the uncertainty raised by the U.S. presidential election and its associated drag on growth,” according to William Lee, Citi’s head of North American economics.
The bank estimates the drag may be slowing gross-domestic-product growth by an annual rate of 1.25%.
As that uncertainty lifts, the consensus view is that the Fed can go ahead with its long-promised rate increase in December. Recall that at the start of the year, central-bank officials were signaling four quarter-point increases. The current guess is for two hikes. It’s unlikely they’d be willing to go oh-for-2016. That also assumes that GDP growth gets back on track. The Atlanta Fed GDPNow forecast for the current quarter is 3.6%, while the New York Fed Nowcast estimates 3%.
“If Trump wins, our conjecture that a trade contraction would induce a recession sooner rather than later implies we have seen the cyclical high point for U.S. rates,” Citi’s Lee avers. In other words, no further rate hikes.
Much of the Jackson Hole discussion will be on new models for monetary policy, which has been pushed far beyond the bounds of previous practices, and yet has fallen short of producing robust growth (that is, other than in asset prices). As noted in this space last week, the result has been an increased interest in fiscal measures, notably infrastructure spending.
On that score, Bank of America Merrill Lynch economists Lisa C. Berlin and Ethan S. Harris write that federal, state, and local infrastructure spending in 2015 fell to its lowest share of economy in the postwar era, just 3.4% of GDP, with 60% at the state and local level and 40%, federal. Most of the money just went to replace depreciated assets; netting out depreciation, the spending was a mere 0.5% of GDP.
Not spending now merely postpones the inevitable, they note. In New York, it’s apparent how neglect and lack of maintenance only makes the ultimate cost higher. “It also makes more sense to borrow and invest now at near-zero interest rates when financing is relatively cheap, than to wait until rates are back to normal,” they conclude.
That would be in a rational world. Even in this crazy campaign, this still ought to be a major point of discussion.