Republican presidential nominee Donald Trump's campaign is in freefall in the national polls. His campaign was struggling to deal with negative press regarding a poor first debate and a partial leak of his tax records even before last week's release of a video showing him making lewd comments about women. Now, with a recent WSJ/NBC poll putting him down by double-digits against Democratic nominee Hillary Clinton and the prediction markets giving him his lowest odds of the campaign season (a 13% likelihood of a Trump victory at the time of writing), the equity markets have started to respond to the prospect of a Hillary Clinton presidency.
The overall reaction has been mixed. Hedging costs have increased sharply in recent weeks, yet equity market valuations are nearing 15-year highs. One Seeking Alpha contributor published an article characterizing "Trump's Downfall" as a "Potential Bullish Black Swan" on the grounds that a Democratic sweep in D.C. will lead to fiscal expansion. On the other hand, USA Today now considers such a result to be a "market risk." This confused response isn't surprising given some of the startling results that economic models have predicted in the event that Mr. Trump was to implement his various protectionist campaign pledges. Oxford Economics, for example, calculated that his policies would cause the U.S. economy to be almost 6% smaller at the end of his first term than under a business as usual scenario. Some individuals and domestic manufacturers would benefit in the short term, but the broad American consumer would potentially fare worse under either candidate, and the equity markets have been driven by consumption until recently.
The GOP civil war
Mr. Trump's downturn turned into a full-blow meltdown this week, however, as several of his erstwhile supporters in the GOP have distanced themselves from his campaign. Mr. Trump's reaction has been to lash out at everyone via both speeches and social media, prompting the Wall Street Journal to write (subscription required) that he has abandoned any attempt to capture the political middle ground in favor of desperately trying to keep Ms. Clinton's supporters at home. This is truly a last-ditch strategy and it has coincided with early signs of a possible Electoral College landslide in favor of the Democratic candidate. More importantly, Mr. Trump's surging unfavorability ratings with only four weeks left in the campaign threaten to swamp down-ballot Republicans. These candidates for Senate and House of Representative seats find themselves increasingly caught between Mr. Trump's scorched earth tactics (his campaign is now spending as much time attacking those Republicans who have withdrawn their support for him as it is attacking his Democratic opponent) on the one side and Ms. Clinton's well-funded attack ads on the other side.
A November sweep?
The Republican Party is now facing the once-unthinkable prospect of losing its majorities in both the Senate and the House of Representatives even as Ms. Clinton secures a solid mandate for the presidency. Voter disenchantment with the GOP brand following Mr. Trump's latest travails has led to declining polling numbers for down-ballot Republicans. Nate Silver gives the Democrats a 55% likelihood of capturing the Senate in November, for example. Even this is too low, however, since Senate campaign polls tend to be less common than presidential campaign polls and the numbers don't yet reflect the current GOP civil war. I expect Democrats' chances of achieving a majority to only increase in the coming days, as a result (Predictwise already has that probability at 69%). Similarly, the odds of the Republicans maintaining their majority in the House of Representatives, which had been considered the only guaranteed result of the current election cycle, are declining. Predictwise now gives the Democrats a 29% chance of taking the House, up from 14% before the release of the Trump video and 9% just a few weeks ago.
A Democratic sweep in November would have major implications for the energy markets and, by extension, the broader equity markets, given the correlation that has developed between the two as the U.S. has become a major oil and gas producer. I see the phrase "black swan" frequently used by the media to describe events in the financial markets as investors look to become the next John Paulson. If we look at the definition put forth by Nassim Taleb, however, I believe that the November election satisfies his requirement that they be (1) extreme probabilistic outliers with (2) outsized impacts on the course of human development that are (3) rationalized by hindsight.
The extreme outlier nature of such a sweep has already been established. In addition to the low likelihood of a Democratic House that existed as recently as mid-September, the field was tilted in favor of a Republican successor to President Barack Obama during the current campaign cycle. When history professor Allan Lichtman recently said that a Trump loss would "upset the verdict of history," he was referring to the fact that his candidate-agnostic indicators (or "keys") predict a Republican victory. In other words, the GOP will have to try to lose this presidential election in order for Ms. Clinton to win, and it appears that Mr. Trump is on course to do just that.
Will Democrats strand fossil assets?
This raises the question of how Democrats will respond to holding their strongest political hand since before the 2010 midterm elections. Ms. Clinton's struggle to quickly defeat Bernie Sanders in the Democratic primary led to his wing of the party being given a strong role in the crafting of the 2016 Democratic Party Platform. To say that the result is hostile to the fossil fuel industry is to put it mildly. Among other things, the document calls for the Department of Justice to investigate fossil fuel companies for securities fraud resulting from alleged "climate change cover-ups"; for fossil energy production on public lands and in offshore waters to be replaced by renewable energy production; for major restrictions to be imposed on domestic hydraulic fracturing; and for the development of renewable energy instead of new natural gas power plants. While the document does not explicitly call for policymakers to strand fossil fuel assets, environmentalist Bill McKibben, who was named by Mr. Sanders to the platform-writing committee on his behalf, is a major proponent of the so-called "leave it in the ground" movement.
Earlier I wrote about how the recent release of Clinton campaign emails by WikiLeaks contained numerous statements of support for the fossil fuel industry made by Ms. Clinton. However, as the Wall Street Journal points out, a Democratic sweep would reduce the number of Republican moderates in Congress, leaving President Clinton caught between her party's resurgent Sanders-Warren environmental wing and the GOP's resilient hardliners. If forced to ask for the votes to pass her domestic agenda from either her own party or the intransigent opposition, she will have no choice but to work with the former, which is especially likely to demand its pound of flesh in light of the new WikiLeaks emails. The Department of Justice has already launched an investigation via the Securities and Exchange Commission into how Exxon Mobil (NYSE:XOM), the country's largest natural gas producer, values its fossil assets in light of climate change - the same Department of Justice that is part of an administration that has recently been trumpeting that fuel as a weapon in the fight against climate change.
Finally, the rationalization is already occurring despite the election still being four weeks away. The recent ratification of the Paris Climate Agreement, or COP21, has led to predictions that the governments of the world's major developed economies will quickly take steps to strand fossil fuel assets so as to prevent the global "carbon budget" from being exhausted. (Concern about the state of this carbon budget is a central aspect of Mr. McKibben's campaign to keep fossil fuels permanently buried.) Germany's recent suggestion to ban internal combustion engines by 2030 has been similarly cast in these terms. The pressing nature of catastrophic climate change and the calls by environmentalists to take extreme measures to prevent it would almost certainly cause a Democratic sweep to be framed as a momentous decision by American voters to unite behind a common cause, much as the country did following Japan's 1941 attack on Pearl Harbor.
The exact impacts of a Democratic sweep on the energy sector would depend on the magnitude of such a sweep and whether or not the Senate filibuster is ultimately abolished, as some were predicting would happen even before the GOP's current civil war. At a minimum, I would expect to see renewed talk of the creation of a national carbon tax or cap-and-trade program. This alone would not necessarily have a major impact on the energy sector outside of coal miners and consumers. Major oil and gas firms such as Exxon Mobil assume the existence of a carbon price in their internal budget calculations, and the experiences of the European Union and California strongly suggest that the emissions penalty would be much too low to result in the stranding of non-coal fossil assets.
Less likely but of much greater impact would be a wave of federal investigations into oil and gas firms on the grounds that they buried evidence of climate change in the past and/or have failed to discount the value of their assets on the assumption of future policy-induced stranding. The Obama administration's investigations and subsequent levying of massive fines on international bank for subprime mortgage-related actions, which no less than The Economist labeled an "extortion racket," provide a possible roadmap for how investigations into fossil fuel companies would proceed. Exxon Mobil, Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) would be most at risk under such a scenario as America's largest non-coal reserve-holders. International companies could also be exposed to the long arm of the U.S. government, however (see Deutsche Bank (NYSE:DB)), in which case Royal Dutch Shell (NYSE:RDS.A), BP (NYSE:BP), and TOTAL SA (NYSE:TOT) could also be placed at risk. The investigations would represent an efficient route from the perspective of environmentalists since they would effectively devalue and strand assets without dealing with the knotty problem of overhauling U.S. securities law; the fines could be calculated to equal what environmentalists consider to be the "optimal" fossil asset devaluation, while the uncertainty so created would discourage future exploration and production. (Penalizing industry for actions that were not explicitly illegal at the time that they were taken will do that.)
Oil and gas holdings via ETFs/ETNs such as iPath Crude Oil Total Return Index ETN (NYSEARCA: OIL), United States Oil ETF (NYSEARCA: USO), and PowerShares DB Oil ETF (NYSEARCA: DBO) for crude and the iPath Natural Gas Total Return Sub-Index ETN (NYSEARCA: GAZ) and United States Natural Gas ETF (NYSEARCA: UNG) for natural gas will not necessarily represent a safe haven for energy investors either. One could argue that the stranding of assets via supply constraints rather than demand constraints would not reduce energy prices and could even put upward pressure on them, in which case securities linked to the prices of the underlying commodities could benefit. While true, oil and gas majors would likely respond to large de facto penalties for past exploration and production by ceasing activity in areas with the highest marginal costs of production, many of which also incur the highest volume of greenhouse gas emissions (e.g., Canadian extra heavy crudes). This would have the effect of bringing the market price down, to which policymakers would respond with a tax or other levy (much as President Obama proposed to implement earlier this year) so as to discourage a corresponding demand increase.
Even renewable energy companies could suffer under such a scenario in the event that natural gas became less plentiful and accessible. Batteries are still several years away at a minimum from being a cost-effective alternative to natural gas for overcoming the intermittency of renewable electricity pathways, and placing them in that role before such competitiveness is achieved would result in higher production costs and, by extension, reduced demand. The 2016 Democratic Party Platform calls for revenues from new levies on fossil fuel industries to be transferred to renewable energy companies as subsidies, however, in which case the negative impacts could be offset by expanded tax credits and other forms of support.
Black swan events are, by definition, highly improbable. I do not expect the Democratic Party to sweep the White House, Senate, and House of Representatives, although it seems likely to take the first two at this time. That said, the likelihood that the Democrats gain a majority in the House of Representatives has tripled over the last month and investors must now begin to consider the implications of such an event on the energy sector.
While Ms. Clinton has staked moderate positions on energy policy, and while party platforms are more wish list than roadmap, it is now feasible that the Sanders-Warren wing of her party will gain an unprecedented amount of influence over energy and climate policy in the event that such a sweep occurs. This would represent a potential black swan event for the energy markets for the reasons outlined above. Alternatively, it could also represent a potential long investment opportunity in some of the above tickers in the event that the market overreacts to the election result, especially given the larger number of Democratic Congressional seats that will be vulnerable in the 2018 mid-term election. Investors are advised to monitor election forecasts closely next four weeks to determine which response is the most appropriate.
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.