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The US Presidential Election Is Not A Brexit Moment

Monday, November 7, 2016 2:43
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(Before It's News)

There have been a number of comparisons drawn from the event risk around the upcoming US presidential election and the Brexit referendum earlier this year. There are a number of similarities, most notably in the market reaction to changing poll numbers prior to the vote, but also a significant number of crucial differences which make trading strategies around the US election different from those around Brexit. 

Trump Victory Triggers Risk Off 

The reactions of financial markets to polls that suggest an increased probability of a Trump victory have seen traditional “Risk Off” moves; sell stocks, buy bonds, higher implied volatility, buy gold. We are not going to discuss if these moves are reasonable, the pattern has been consistent and therefore it is reasonable to presume that in the short term this is highly likely to be the reaction we will see on Election Day as the results trickle in. 

This is similar to the reaction caused by increased probabilities of a “Leave” vote into Brexit, with risk assets also under pressure. As the votes came in with a significant bias towards “Leave”, risk assets were heavily sold, and this increased as the result became clearer. To put the move into context, interest rate futures began to price in a chance of a cut from the FOMC, when just days before there were calls for a hike at the next meeting. 

Black Swan Event

We have been asked a number of times, “How can we prepare and protect against a Black Swan event like a Trump victory?” It is not a Black Swan event. A Black Swan cannot be predicted. The very fact that one is discussing how to deal with a Trump victory means it is not a Black Swan. 

It is not even a “tail risk”. A tail risk is the risk of a very unlikely event according to a probability distribution. For example, the stock market moving 10% in a single trading session, since most observations have movements lower than 10%.

However, we are discussing an election with two parties in a race that’s perhaps 65-35. That is hardly a tail risk. The chance of some outlandish extreme policies from the candidates once they take office is perhaps a tail event, but this is at a minimum many months away. So this is not a tail event, and certainly not a Black Swan. Rather it is merely a period of volatility in markets that needs to be treated with the appropriate level of respect, but not undue scaremongering with respect to the consequences.

Reduced Consequences

A major difference in the dynamics of Brexit compared with the election is the potential consequences. This week we could see a change of government in the USA. Brexit was a complete change in how the UK would be governed for years to come. It signalled the exit of a major country from one of the largest political and economic unions ever seen. Most importantly, the process after the vote around how this would occur was (and perhaps still is) largely unknown. More than anything markets fear uncertainty.

Whilst there may be uncertainty around what the future may hold for the US if either Clinton or Trump wins, this uncertainty pales in comparison to the questions being asked in the Brexit aftermath. This arguably reduces the potential downside scenario and at the margin leaves us more inclined to “buy risk” on the dip.

Tougher Numbers

Whilst the “Leave” campaign only required >50% of the vote to trigger Brexit, the hurdle is much larger in the US. Even if Trump takes the “must win” states such as Florida and North Carolina, mathematically the Republicans still need to turn a Democrat state red in order to realistically be in with a chance of victory. Some polls have put the candidates very close to 50-50, but there is so much more at work than simply the popular vote.

Most predictions have something like a 35% chance of a Trump victory. This may appear low but is close enough to have the market jittery. The average margin of error is enough to make the result to close for comfort, as seen in the price action in equities this last week.

How To Trade On The Day

In our view the market will get increasingly concerned if Trump wins Florida and North Carolina. At the margin he is expected to win these states, but a Clinton victory in either effectively sinks his chances completely. Therefore the market will likely become concerned as the election is kept live. 

If there is a traditional risk off move on these results then we would fade it. A combination of the following would be our vehicles; Selling gold above $1350, buying the S&P 500 below 2050, or short selling VIX above 25 (VIX December futures above 22). 

 The right trade post Brexit was to fade the move, therefore even if a Trump victory does follow, the move is likely to reverse as markets realise the consequences are not as dire as they initially feared.

Conclusion

With respect to the prior bias of skews around the election, as well as other factors, we have been running small short positions on the S&P 500 and long positions in gold. These have performed well, however the next opportunity is to fade any risk off move this week, particularly intraday as the results come in. We are looking at entering short equity volatility trades prior to the election should volatility spike. The trade has merits on a standalone basis as well as complementing our current positions. For more information on the trades we are making please susbcribe via either of the buttons below. It is important to remember that despite the wave of media coverage and sensationalism, there are more factors at play for markets than this election. The FOMC and ECB meetings next month will likely be far more critical for markets than this week’s events, which as we hope to have demonstrated above, are not in the same ball park as Brexit or even tail risks, and certainly not Black Swans.

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