Knowledge. Shared Blog

February 2020

Election Insights: Post Primaries, Options Market Signals Low Risk

Despite Sen. Bernie Sanders’ strong performance in both the Iowa caucus and New Hampshire primary, the options market is not signaling heightened risk. Head of Global Asset Allocation Ashwin Alankar explores one reason why, and what it could mean for investors.

Key Takeaways

  • Following the Iowa caucus and New Hampshire primary – where progressive Democratic candidate Sen. Bernie Sanders had strong showings – options market prices are not signaling heightened financial market risk.
  • The reaction could suggest that a progressive Democratic candidate would increase the odds that President Trump is elected for a second term.
  • Trump’s reelection could be a positive for equities markets but could also increase the potential for a spike in inflation.
View Transcript

Ash Alankar: Well, given we are big believers in data, what the data tells us, if you look at all election cycles going back to the 1920s, is during those election years equities outperform cash by about 450 basis points. But where things get a little more interesting, if you look at those election cycles where an incumbent is running, equities outperform cash by 700 basis points. And on top of this, you get this outperformance at lower equity volatility.

So, this all makes intuitive sense from the perspective, if you are deciding between two unknown candidates, you are confronted with much more uncertainty. Hence, you would expect volatility to pick up, risk premiums to widen, and this is exactly what you see in the data.

What the option markets are predicting right now is a Trump reelection. Ex ante, my intuition would have been a strong showing by either [Sen. Bernie] Sanders or [Sen. Elizabeth] Warren would be reflected by an option market that starts sending out signals of concern. We are not seeing that. We are seeing anything but that. Despite the strong showing by Sanders over the first two primaries the option market’s view on risk is quite sanguine.

So, maybe what the markets are telling us is a Sanders or Warren win make it ever more difficult to remove Trump from office and the markets then, all else equal, would define this as a positive.

On top of this, you may also see the House [of Representatives] swing in favor of the Republicans. This could then bring fiscal spending. This could then bring a drop in uncertainty, as the incumbent is at the helm and in charge of the White House. Which in turn would lead to improved business confidence, improved consumer confidence, which then all could bring the reflation scenario back into the picture.

When Trump won the 2016 election, reflation was what we were all talking about. We were talking about Trump’s policies on taxes, Trump’s policies on deregulation, Trump’s policies on pro-business growth, would all lead to increased spending, more demand, which would bring inflation back into the picture. And unfortunately, that hasn’t panned out because things on the global front, the global trade front got a little murky. But with the global trade picture moving in the right direction, Trump getting a majority now back in the House, which could happen, all of a sudden, all the stars align for increased fiscal spending, increased consumer confidence. All of that is inflationary. So, the reflation story remains much more intact, in our opinion, during the second term of Trump’s tenure than it did during the first term.

Inflation risk, in our opinion, is the greatest threat to the markets going forward, not only because we believe those stars are getting aligned for inflation to really surprise to the upside, but also for the fact that inflation right now is the most underappreciated risk by the marketplace. Everyone is talking about the death of inflation due to the very, very strong structural tailwinds, such as an Asian population, such as Amazon.com and digital technologies. And what history tells us is the most painful risks turn out to be those risks that everyone else is ignoring.

I don’t believe equities are priced to perfection. Historically, the fair spread between [the] U.S. equities earnings yield and 10-year interest rates is about 300 basis points. Given the low level of 10-year yields today, the market can support a fair P/E [price-to-earnings ratio] around 22. [The] forward P/E on the S&P 500® today is 19.5, so it is anything but expensive. As we pointed out before, during election years with an incumbent, equity volatility is meaningfully lower than average equity volatility. And so that is what we are seeing today. It is very consistent with history.

But we all painfully know there is no reason for history to repeat itself, so we have to keep our eyes open to the ever-changing dynamics on the election front, and during times like this where the market factors and the market risks are so fluid, these are times where active management often add a good deal of value.

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