Altus Insight: October, 2016

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor

Date: October 31, 2016
FR: Forrest Jinks
RE: Elections and the Markets

Editor’s note: The news of the FBI reopening the case of the Clinton email server may change final polls heading into the election and thus may change the odds assigned by the markets to the election results. However, the thesis below holds, with the downside risk of certain outcomes being underweighted by the markets.

After several months of focus on micro investing topics, today we will return to a more macro topic. The one thing that seems to be on everyone’s mind is the election. We will not be getting into the politics of the election but will take a quick look at how the election might affect public market returns.

Contrary to what many believe, the stock market has better post-election performance under Democratic administrations than Republican administrations (9.7% annual gains during Democrats, 6.7% during Republicans)[1]. While some of the variance can be written off to random timing, there is certainly enough of a difference between the two to understand that markets prefer Democrats to Republicans. Never more so than in this cycle. The markets hate uncertainty and one candidate is a complete enigma with a strong likelihood of unexpected actions if elected president, while the other is not only well known to the markets from their time in the public eye, but also has been close to Wall Street throughout their political career.

Beyond how the markets might perform over the next 4 years, of more immediate concern is the possible performance of the markets the day following the election. There are four different scenarios as I see it:

  1. Clinton wins the presidency, the Republicans hold onto the House and/or Senate: This is the preferred outcome of the markets and according to the pricing of the hedging instruments in the market, is viewed as by far the most likely scenario.
  2. Clinton wins the presidency and the Democrats obtain upset victories in BOTH the House and Senate: While highly unlikely (at least currently) this would also shock the market, as this outcome is not expected and would also match the market’s preferred but publicly anti-markets candidate with a political majority that actually is anti-markets, possibly leading to the imposition of non-market approved changes to regulations.
  3. Trump wins the election, Republicans hold the House and the Senate: This is the nuclear option for the markets.  The market has placed such a low probability on Trump winning the election that this event would result in a severe drop in the market the following day. Remember what happened when the Brexit vote went against the commonly accepted assumptions? Market pandemonium.
  4. Trump wins the election but the Democrats take either the House or the Senate: This is the least likely of the four scenario as a Trump win would almost surely indicate high turnout of anti Clinton voters, who will as a majority also vote against anything associated with Clinton, meaning down ticket Democratic candidates. The market would prefer this scenario to #3 above since it would normally provide a check and balance of one (or two) party in the legislature against the Executive party. However, because Trump has removed himself so drastically from establishment Republicans (and vice versa), this concern is not as relevant as it might otherwise be.

If I was more involved in the markets I would without doubt invest in some hedging instruments going into the elections. First, because the market is putting such a low probability of their least preferred option occurring (a Trump victory) hedging is inexpensive.

Secondly, and using the Brexit vote outcome as an example, I believe there is a greater likelihood of a Trump presidency than the majority of the market (and the press) believe. There are two reasons for this. For one, because a vote for Trump has been so castigated in the press and popular culture, I think there are a substantial number of people who when polled will not admit they are planning on voting for Trump but will still do so on election day. This happened with Brexit, an event/vote that didn’t have nearly the social stigma a vote for Trump has. This pocket of voters may have decreased over the past few weeks of Trump revelations and actions, but a substantial number of hidden votes still exist. I expect exit polls to likewise skew towards Clinton versus the actual voting numbers.

The second reason is the polls may not be as accurate as we would hope them to be. Generally, the media tries to at least act nonpartisan, but because of the acrimony of this election and the extreme unlikeablility of both candidates, the media has staked uncertain positions. The population composition of polls obviously affects the results of the poll with even a little change in composition possibly affecting the results by a net multiple percentage points. Polls are used to push agendas. With the media and pollsters having taken stated sides, these polls are more likely to be slanted one way or another than they may have been in the past. According to Gallup, in 2015 29% of the population identified as Democrat, 26% Republicans, and the remainder as independent or “other”. If the population set polled doesn’t match those identifications the poll is inherently flawed. Recent polls results have varied from Trump winning by 1% (LA Times) to Clinton winning by 8% (Reuters). Those results aren’t close. Since a larger percentage of publications seem to be pro Clinton, my sense is the race is closer than most people believe.

All of the above doesn’t mean Trump will win. Far from it. It only means the chance of a Brexit style surprise is higher than what is being priced into the market. If Clinton wins as expected, no harm, no foul, even if it ends up being closer than expected. But if Trump ends up winning under the current assumption of a Clinton victory…it could be ugly.

As a real asset investor stock market moves aren’t as big of a concern to me as they would be to stock centric investor. Market interest rates have a more direct link to investment real estate valuations through their direct correlation with cap rates. How a Trump surprise will affect interest rates, at least in the short term, is far from certain. One thing I feel is almost a certainty with a Trump election is the Fed will raise rates in December. They badly need to do something for the sake of their respectability in the market. Should the economy have an ensuing stumble, blaming it on Trump’s election is the perfect cover. In reality, market rates don’t move in lock step with the Fed rate. When the Fed raised rates last December, market rates ended up going down. A Trump surprise could lead to yields tightening as investors flee to safety.

Or, if foreign investors think the Trump election is bad enough, they will pull funds from the US bond market, which along with slow withdrawal of the Federal Reserve (and rates already creeping higher) would mean a sharp reduction in demand, thus pushing interest rates higher.

There are signs inflation is starting to heat up, increasing the pressure on the Fed to raise rates. The nightmare scenario for the Feds is that a Trump victory leads to a severe flight to safety even while they want to get ahead of the possible inflation ramp up. In this case the Fed rate increase won’t have an impact on market rates (just as they didn’t last year), the market rates will continue to feed inflation pressures, but with investors continuing to pile into risk free or low risk yield assets, the Fed will have effectively lost control of market rates at the very time they most need to control them. Many legions of smart investors have bet the farm on inflation staying low (and possibly even being deflation) for years into the future. On the other side, many legions of smart investors have continued to claim the low interest rates and quantitative easings of the Central Banks will eventually turn into raging inflation in the 1st world. With the world’s central banks currently facilitating quantitative easing at the highest rate since the bottom of the Great Recession, AND reserves held at the Federal Reserve by US banks quickly dropping (indicating an increase in lending and thus an increase in the velocity of money), maybe the inflation so long predicted is now on its way.

Which crowd of prognostication will be correct is impossible to predict, at least for someone at my pay scale. This leaves us trying to position our investments and our business to be able to withstand, and hopefully benefit, from either possibility. Nothing has changed in that sense and we continue to focus on quality cash flows with fixed long term debt. There is no question we have left money on the table over the past few years by going with longer term fixed rates, and maybe in time we will see our use of fixed rate debt as us leaving even more money on the table. But I also know that debt, by its very nature and tied to dependable cash flow, is a hedge in and of itself. Time will be the judge.

Happy Investing,

Forrest Jinks

Altus Equity Group, LP

[1] Business Insider, October 15, 2016