Fragile markets vs. political risk

The following is an extract from our latest CIO update.

The US presidential election is possibly the key macro driver for the rest of the year. In our experience in dealing with the market impact of these geopolitical events, it is dangerous to assume we can predict the outcome.

As we’ve seen in the past few months, the best made forecasts can be thrown out by “events, dear boy, events”, as a former UK prime minister put it. At the time of writing, Kamala Harris is leading the race by a narrow margin. The bias in the electoral college means that she probably needs to be around 4% ahead on the national popular vote to win. A handful of swing states will sway the election.

An important difference between the two candidates is their attitudes towards international trade, where the presidency has significant executive discretion to impose higher tariffs.

On fiscal policy, the probability of a Democratic or Republican sweep of the White House and Congress is important. If that does not happen, we would expect fiscal stalemate to exert a drag on the economy in 2025. The Democrats have an uphill battle in the Senate, as they are defending twice as many seats as their opponents. But our US colleagues regularly urge us not to underestimate the likelihood of a sweep, with split-ticket voting in the US increasingly rare.

In the table below, we have sketched out the markets moves we expect in different scenarios. A Trump sweep would likely bring a return of tariffs as a policy instrument alongside tax cuts: in our view, bad news for US Treasuries, non-US markets and consumer staples; good news for energy and the US dollar.

A Harris sweep would probably reverse the Trump tax cuts and increase spending on social and environmental priorities. We think that would be somewhat negative for US equities, better for non-US markets and push yields up. Without tariffs in the mix, the fixed income effect is likely to be more muted than under a Trump sweep. If the government ends up divided, then fiscal policy becomes less easy to get through Congress.

This story will continue to ebb and flow until election day (and maybe, unfortunately, beyond). Throughout this period, our focus will be identifying the themes that the market is latching onto, rather than pinning our colours to the mast of an expected outcome.

Dissecting the summer squall

Early August brought extreme market turbulence: the VIX (often called the market’s ‘fear index’) jumped to levels rarely seen outside economic panics, credit spreads spiked, risk-off currencies rallied and yields fell. However, most of those market moves reversed as quickly as they unfolded.

What was going on: a low-liquidity, mid-summer squall or something more serious? Our answer is a bit of both.

To be clear, we were not anticipating this specific set of risks to crystallise when it did. But the volatility was in line with our thesis that markets are vulnerable to bad news and periodic disruptions as we get deeper into late cycle. The market narrative has shifted from slowing inflation as the main positive focus to worries about slower growth. Any disappointing macro data can bring the risk of a hard economic landing into sharp focus.

In the wake of the turbulence, it was striking that government bond yields remained significantly lower than in the second quarter. The market was saying that looser monetary policy over the medium term is the necessary condition for an ongoing expansion.

We believe the sudden selloff was indicative of how uniformly investors had bought into a benign economic outlook. The build-up of similar positions, most notably in high-yielding emerging market currencies, created a vulnerability. Some, but not all, of this froth has now been removed by the injection of volatility.

There was also a noticeable change in how assets interacted during this episode. Selling across equities and credits was accompanied by a strong rally of perceived safe-haven assets, such as government bonds. Unlike the broad-based, inflation-induced selloff in 2022 that dragged both equities and bond returns lower – kryptonite for multi-asset portfolios – this more classical growth-driven selloff saw government bonds cushion the blow by moving in the opposite direction. We believe that with the increased focus on economic growth risks, this negative correlation between bond and equity returns will be sustained.

Taking all this together, we remain neutral equities, and express our cautiousness by being underweight credit and long duration. We have taken some profit in the recent fall of interest rates, but still think there is more to come in terms of lower real yields.

The above is an extract from our latest CIO update.