Macro Signposts | 30 October 2024
This week, I asked Libby Cantrill, PIMCO's head of public policy, to coauthor Macro Signposts and discuss the uncertainty surrounding the direction and magnitude of possible market reactions to the U.S. election.
Unless explicitly stated, views expressed do not constitute official PIMCO views.
Mixed Signals: Assessing How Markets Might Respond to the U.S. Election
By Tiffany Wilding and Libby Cantrill
Election Day in the U.S. is next Tuesday, and polling suggests we'll see a close contest between the Republican and Democratic parties. Months of high-stakes uncertainty around the future of Washington politics and policy have many investors on edge. Compounding that uncertainty are significant swings in U.S. economic data, questions about the pace and depth of upcoming Federal Reserve rate cuts, and developments in the Middle East and China.
The potential for market volatility around the election keeps some investors on the sidelines, while others lean heavily into their beliefs or hopes about the outcome. Yet research suggests that even a strong conviction about an election outcome or any potentially market-moving event doesn't necessarily translate into an accurate assessment of market reactions. Rather, investors with the flexibility to target and appropriately size opportunities in erratic markets may be better positioned to benefit from potential uncertainty ahead.
U.S. election remains competitive
In the race for the White House, national polls indicate an effective tie, though polling in all seven key swing states (while falling within the margin of error) has recently drifted in favor of former President Donald Trump. He also appears to have the edge in early voter turnout in the swing state of Nevada.
As we've learned from past elections, polls can err in either direction. They may be underestimating support for Trump, as they did in 2016 and 2020. Or they could be misjudging support for Vice President Kamala Harris, as they did with Democratic President Barack Obama during his 2012 reelection campaign. Much will depend on which voters turn out in force, and how accurately their participation is reflected in the polls.
Furthermore, as Josh Clinton, a political science professor at Vanderbilt, noted in a recent article, differences in how pollsters weight their assumptions could shift the Trump/Harris margin by as much as 8 percentage points. This election cycle has seen changes in weighting methods, such as greater reliance on respondents' previous voting behavior. This may make the polls less comparable to the polling margins between Biden and Trump in 2020.
Both presidential candidates are making their final pitches to the very small percentage of undecided voters across the seven swing states. If these voters cast their ballots based on the candidate's personality - such as temperament, judgment, and character - or if reproductive rights are a deciding factor, then they may very well turn out for Harris. However, if they focus more on policy issues such as inflation, the economy, and immigration, polls indicate they may swing toward Trump.
The race for Congress also looks tight - we aren't likely to see a landslide or "wave" election favoring either party. The Senate is likely to flip to narrow Republican control, which would place policy constraints on a potential Harris administration. The House of Representatives is a close call. Historically, the House goes the way of the White House during national elections, which is likely the case this cycle, too. Regardless, any party that controls Congress is likely to have only small majorities, which, in most cases, will function as guardrails for what exactly can be accomplished. For example, even in the event of a Republican sweep, the degree of fiscal expansion indicated by current market pricing isn't likely to occur.
Investing with conviction is not a simple matter
Hypothetically, even if an investor knew the election outcome with absolute certainty, it would still be difficult to gauge the direction and magnitude of the market reaction. First, many questions remain about the economic and trade policy proposals the candidates are discussing, including how these policies will be shaped and implemented in practice, and their longer-run impact on markets. The effectiveness of these policies will also depend on the makeup of Congress and court rulings if presidential policies are litigated.
Second, it's still hard to know precisely what is currently priced into markets. Recent price movements, which many observers are associating with the incremental improvement in Trump's polling, have occurred amid other important developments, including fading U.S. recession fears following stronger domestic data, greater expectations for broader fiscal stimulus in China, and developments in the Middle East.
This uncertainty jibes with an intriguing trading simulation called the "Crystal Ball" challenge, created by partners and researchers at Elm Wealth. The game considers this question: If investors magically knew Wall Street Journal headlines one day in advance, how much money could they make by investing in the S&P 500 and in 30-year U.S. Treasury bonds the next day?
It turns out that even with the next day's news in hand, most people perform no better than a coin flip in predicting market reactions to major events the day after the event. The researchers found that what distinguished good players from bad players wasn't their ability to consistently predict market direction all the time (daily moves can be driven by any number of idiosyncratic or fundamental factors), but rather their skill in sizing their positions when they did feel more confident.
The observations of the Crystal Ball simulation also jibe with relevant market events in the past. If we specifically look at the eight presidential elections from 1992 to 2020, we find that for bond yields and equity returns, the sign of the market performance one month ahead of those elections was not a good predictor of the market performance one month after the election (50% of the time, markets retraced). However, the market reaction one day or even one week after Election Day was a somewhat better predictor of one-year returns, with bond yields tending to retrace the one-day reaction around 60% of the time, and equity returns having a similar sign over the one-week and one-year time horizons around 75% of the time.
What's the bottom line?
Market movements around elections can be volatile and hard to predict. However, even amid significant disagreement and uncertainty regarding both the election outcome and market reactions, the upshot is that in light of potential volatility from the event - along with other macroeconomic and geopolitical uncertainties capable of roiling markets - investors may want to prioritize caution and flexibility. They can look to target higher-conviction opportunities as they arise while remaining mindful of risks. Uncertainty, potential volatility, and the dispersion in the outlooks for major economies worldwide should bolster a favorable environment for active fixed income investors.
Upcoming webcast: "Insights on the Evolving U.S. Investment Landscape"
Please join us for an analysis of the investment implications following the U.S. elections and the latest Federal Reserve meeting. PIMCO's Group CIO Dan Ivascyn, Head of Public Policy Libby Cantrill, and Global Head of Product Strategy Kim Stafford will discuss emerging opportunities and risks across financial markets and how we're positioning portfolios.
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