The Twilight Zone: Stocks And Volatility In The Age Of Political Anarchy

| About: SPDR S&P (SPY)

Summary

The political process is breaking down in the US and Europe as the electorate becomes increasingly polarized.

Uncertainty breeds instability which could send the VIX to 30 (at least) in the run-up to the US election.

A comprehensive look at history reveals how the S&P is likely to behave under different election outcomes.

The bifurcation of politics, and more broadly, of society has to stop.

I'm not sure if you've heard about this, but apparently, the US has a presidential election coming up.

Perhaps former pro golfer turned-television personality David Feherty said it best earlier this week. When asked by CNBC's right-leaning (albeit exceptionally affable) morning anchor Joe Kernen to describe the campaign for the White House, Feherty called it a "muppet show."

Indeed. Over the course of the last 12 months, we've seen more muppets on the campaign trail than you'd find in a Goldman banker's Rolodex. The veritable circus that's unfolded before the eyes of the American electorate has been nothing short of surreal.

Let's take inventory of all the bizarre and astonishing things we've seen so far:

  • A Bush ran and got the vote count equivalent of a comedian being booed off stage.
  • A soft-spoken, presumably mild-mannered African American neurosurgeon likened Syrian refugees to "rabid dogs."
  • A 74-year-old avowed socialist Senator came out of nowhere (well, I guess technically, he came out of Vermont), racked up more than $200 million in campaign funds via donations that he claims averaged just $27 each, and actually challenged a woman who is quite possibly the most entrenched member of America's political aristocracy in all of Washington for the Democratic nomination.
  • A Texas Senator became so frustrated during the primaries that he ended up engaged in a Twitter battle with a real estate mogul over whose wife is more attractive and that very same Senator was called "Lucifer in the flesh" and "a miserable son-of a-b@&*#" by the former House Speaker.
  • The most measured and well-spoken GOP candidate was called a "robot" by the governor of New Jersey during a national debate and then became so dejected after getting trounced in his home state that he almost quit politics.
  • One of the most respected stateswomen in all of recorded history - who was initially expecting a coronation rather than a campaign - ended up embroiled in a truly bizarre scandal involving tens of thousands of classified e-mails she may or may not have knowingly transmitted over an unsecure server and ended up the subject of an FBI investigation
  • And finally, a real estate mogul turned reality TV star, turned politician handily beat out 16 Republican candidates to win the GOP nomination on a platform centered around deporting 11 million people, building a giant wall on the Mexican border, slapping a 35% tariff on Chinese imports, and keeping certain religious groups from entering the country. There was even a debate in the UK parliament as to whether he should be banned from Britain.

So there, Britain. Brexit or no Brexit, America is #1 when it comes to political uncertainty. It's like the Twilight Zone.

But all sarcasm aside, the US election is really just a manifestation of an increasingly polarized world. I discussed this at length last month drawing on the latest from Citi's Matt King. Essentially, the world is becoming more and more bifurcated politically, economically, and in terms of capital markets. This dynamic breeds instability. Here's how Citi conceptualizes it:

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(Graphic: Citi)

And here's a look at the polarization principle at work in the US:

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(Charts: Goldman)

Obviously, we're seeing political polarization proliferate in the EU as well, largely as a result of bitter disagreements as to how the influx of Mid-East refugees should be handled. Put simply, the bloc is facing an existential crisis and it's polarizing politics. Have another look at the shift in the political landscape across the pond:

(Chart: Goldman)

And let's not forget about Germany, where the rise of AfD and Frauke Petry has conjured some - how shall I say - "uncomfortable" memories. One in 10 Germans now believes the country should be ruled by a new Führer. No, really. I'm serious:

That's from a study that The Local notes has been conducted by the University of Leipzig "at regular intervals since 2002." The University also found that 40% of Germans support banning Muslims from the country.

Okay, so what does this have to do with the economy and markets?

Quite a lot.

Businesses despise an uncertain political environment as it makes it difficult to plan for the future. Here's a look at a Duke survey of more than 1,000 CFOs:

(Table: Goldman, Duke)

Polarization also creates uncertainty for investors and traders. Just look at how schizophrenic trading has been around the UK referendum.

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(Charts: Deutsche Bank)

"We expect equity market uncertainty to climb during the next few months in concert with rising political uncertainty," Goldman wrote this week, on the way to taking an in-depth look at policy uncertainty and its effects on markets.

Here's an excerpt from Allison Nathan's interview with Nicholas Bloom, the William Eberle Professor of Economics at Stanford University, Senior Fellow at the Stanford Institute for Economic Policy Research, co-director of the Productivity, Innovation and Entrepreneurship program at the National Bureau of Economic Research, and the creator of indices which measure economic policy uncertainty for the world's major economies:

Higher uncertainty tends to weigh on investment, which then weighs on employment and, ultimately, economic activity. So rising EPU is a strong predictor of lower growth. Uncertainty is so damaging for investment because the firms that are most responsive to higher uncertainty are also responsible for a large share of economic activity. In particular, US firms with 1000 or more employees tend to be more sophisticated and forward-looking than small businesses or the average consumer; these firms account for roughly 60% of US investment and employ more than half of the US workforce.

There is a strong correlation between policy uncertainty and stock market volatility, both realized and implied. We find that the VIX and US EPU Index have a correlation of 0.58. However, we find that correlations with S&P 500 implied vol are greater at the longer end of the vol curve (1+ year) than at the short end (30 day). This is intuitive if you consider that policy uncertainty is often longer-term in nature; for example, the prospects of Trump as the US president or an EU breakup generate substantial longer-run uncertainty that should be reflected in longer-term volatility.

Needless to say, volatility has picked up of late:

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So where are we headed in terms of the fear factor going into the election? Well, if you extrapolate from the UK experience surrounding Brexit, much higher. Here's Goldman one more time:

How high could a surge in US EPU [economic policy uncertainty] take the VIX? A simple back-of-the envelope calculation suggests that the current level of the UK EPU Index is consistent with an increase of 80 or so points in US EPU. Tying this back to the VIX, we arrive at VIX levels in the high 20s to low 30s, akin to levels during the Euro crisis or the 2011 US credit rating downgrade.

(Chart: Goldman)

Right, so uncertainty breeds volatility and volatility is bad for stocks. Got it. But what does the record actually show in terms of US equity (NYSEARCA:SPY) returns around presidential elections? For the answer, we go to Wells Fargo.

Here's what the picture looks like in the period from November to January, broken down by party and also disaggregated further by election year:

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(Charts: Wells Fargo)

And here's how stocks held up during the first year after an election:

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(Charts: Wells Fargo)

Essentially then, a Republican victory is good for a short-term bounce, but history suggests that if you want your stocks to be higher a year from November, you'll vote for Hillary Clinton. Here's Wells:

Reversing the tendency shown in November to January, new Democratic Presidents have been associated with higher returns in their first year in office. New Democratic administrations have been affiliated with an average return of 11.7% (max return of 46.6%, min return of -14.3%), with only 2 years of negative returns. New Republican administrations, on the other hand, have witnessed an average 1.3% return in their inaugural year (max return of 27.3%, min return of -13.0%), with 5 instances of negative returns.

Voters aren't buying it. As Bloomberg reports, according to an online survey conducted June 15-18 using a nationally representative opt-in panel of 2,001 registered voters, including 945 with money in the stock market, investors overwhelmingly trust Trump over Clinton:

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(Chart: Bloomberg)

Perhaps those who participated in the poll didn't get the memo:

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(Source: OpenSecrets, with my additions)

Finally, let's look at the budget. Here's Deutsche Bank:

US presidential election will go full steam over the next few months. How will a Clinton win, or a Trump win along with a Republican controlled Congress affect budget deficit, rate and yield curve outlook? Although it's difficult to predict fiscal policies in years ahead under a new administration, history suggests federal budget deficit tends to be higher and Treasury yield curve tends to steepen under Republican presidencies. All else being equal, conventional wisdom says that a higher deficit would lead to more government bond issuance, pushing yields higher.

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(Charts: Deutsche Bank)

As I always say, I'm not necessarily here to promulgate my opinion. Rather, I enjoy putting the pieces together and providing analysis that you might not otherwise run across. I think the above accomplishes that goal.

What I would opine on, however, is the extent to which polarization is detrimental to the political process, the economy, and markets. If the US and Europe can't find a way to heal the increasingly fractious nature of politics and facilitate healthy social interaction among an increasingly diverse population, none of the above will matter.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.