Pricing for election risk

Equities have been very resilient in the last couple of months, shrugging off worsening macroeconomic data. The consensus continues to expect a quick, V-shaped, recovery. We are more circumspect. Indeed, in addition to the pandemic, the US presidential election is likely to soon become another source of potential volatility.

Not entirely irrational

It may be confusing to see equities near their highs when the world is facing its largest economic shock since the Great Depression. But this kind of decoupling is not unusual. In fact, something similar occurred in 2009. While US unemployment peaked only in the third quarter of 2009, the S&P 500 index touched its low point in March, six months earlier. By the time the proportion of unemployed people peaked, US equities had already jumped 60% from their lows. This is what appears to be happening this time round, just at a faster pace.

If the consensus is right and companies experience a V-shaped recovery in the next 12 to 18 months, then it may not be so irrational to see equities at current levels.

It’s not just about COVID-19

The above V-shaped scenario needs two important assumptions. First, as we discussed last month, one has to believe that the “new normal” will be very similar to the prepandemic world, at both the macro and micro levels. This means that economies will be able to generate the same level of output and that companies will be capable of producing the same earnings as before, whatever COVID-19 measures are in place. While not impossible, we remain sceptical given the significant increase in government debt and the stress balance sheets have come under.

Second, a V-shaped recovery scenario implies that no surprises will spoil the party. Again, this appears optimistic in light of the upcoming known unknowns (US presidential election or EU-UK trade deal) and any other event that might challenge the status-quo (geopolitical tensions,natural disasters or oil price crash just to name a few).

Headline risk is high

As the presidential campaign gets underway, we expect further announcements on potential policies in coming weeks. These, combined with the usual pre-election polls, will likely shift investor sentiment and drive volatility higher. At the sector level, we expect healthcare, technology, financials and energy to be in the eye of any potential storm. Some construction companies may also profit from any infrastructure-spending proposals.

Focus on the long term

In the run up to the US election, we are not inclined to change to our views. We expect short-term opportunities to present themselves as the two candidates unveil more details on their respective political agenda and sentiment shifts. But until then, we believe that investors should remain focused on their long-term goals, using portfolio diversification as a hedge against uncertainty.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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