The US Election is The Driver in the Week Ahead

The near-term outlook for the capital markets will be driven by
the results of the US election on November 8. 
 The narrowing of the polls for the presidential contest reverberated through the
markets last week.   Equities
continued the sell-off that began in two weeks ago.  The S&P 500
failed to hold on to early gains before the weekend, and its sell-off extended for nine
consecutive sessions, something not seen since Carter was President.
Europe’s Dow
Jones Stoxx 600 has not posted a gain since October 20.  
The MSCI Emerging Market equity index has
risen in only two sessions since then.  Last week, both the German Dax and Japanese
Nikkei gapped lower twice, including the last session before the weekend.
Bond yields in
Europe and the US bottomed in the summer. 
The increase
accelerated in early-October, the tightening of election odds, and the fall in
stocks (and oil) helped steady long-term interest rates. 
We think that
there has been some light hedging and position adjustments, but not on the
scale of what likely will be seen on a Trump victory.  
 The wide bandwidth for news and its
7/24/365 nature may make it difficult, even for discerning individuals, to see
the forest for the trees, and to mix metaphors, distinguish the noise from the
As investors
and decision-makers, it is often required
that we make choices without complete information.
 This is no different.   The outlook for next
week, if not longer, will likely be a function
of the election outcome.  The cynics tell us that both alternatives are
poor and untrustworthy. Partisans tell us their candidate is superior.
While risk
assets were being sold and the security
of fixed income was sought, there were
two market developments that suggest investors were not so concerned about
Trump winning as it may seem at first blush. 
 First, the Mexican peso has been
sensitive to the vagaries of the US election campaign.  For several weeks,
when Trump’s comments saw his standing fall, the Mexican peso staged a strong
recovery and was best performing currency last month (2.75%).  However, as
Trump began doing better, the US dollar rallied 5.75% against the peso (October
25-November 3).
The US dollar
posted a big outside down day against the peso on November 3.
  It traded above the previous day’s
high.  It proceeded to reverse and
settled below the previous day’s low.
 There was following through dollar selling of the peso the following day
as well.  The peso was the strongest currency
before the weekend.  It appreciated nearly 0.80%.   Despite what may
have been interpolated from the equity
market slide, if market participants really feared a Trump victory was
likely, the peso would have sold-off, or at the very least, underperformed.

The second
important instrument that is telling us investors think a Trump victory is
unlikely is the December Fed funds futures strip. 
 The hypothesis is new of a Trump presidency would
roil the markets.  This market volatility would likely reduce the chances
of a Fed hike next month.  If one thought that Trump would win, the peso
would be lower, and the Fed funds futures
would not be so steady.

For the last 12 sessions, the December Fed funds futures have been closing
between 49.5 bp and 50.5 bp and recall that the bid-spread offer is half a
basis point.  
calculates this to be a 76% chance of a hike, while the CME estimates the odds
at 66%.

Our own work is in line with Bloomberg’s estimate.  Recall the futures contract settles at the average
effective Fed funds rate for the month.  What will the be that average in
For the first
14 days, let’s assume Fed funds averages what it has been in recent weeks, 41
Let’s assume the Fed hikes on December 14,
and on December 15, Fed funds average the
midpoint of the new range (50-75 bp) of 63 bp.  However, due to the
quarter and year-end, the Fed funds rate will likely fall on Friday, December 30.  The Friday rate
applies to Saturday, December 31 as well.
 A reasonable and conservative estimate is that the effective average will
slip 15 bp to 48 bp.
Add those
products together (14*41)+(15*63)+(2*48) and divide by the 31 days of the
month, (49.5 bp). 
The December Fed
funds futures contract has discounted 76.5% of 25 bp hike in the target range.  
Part of the
challenge for investors is a misunderstanding about polls in general, and the
narrative frequently told around the Scottish and UK referendums.   
The polls were wrong, we are
told, so polls are not helpful.  This
is not true.  In Scotland,
most of the polls done for partisan interest found the results they were
looking for, but the properly conduct fair polls showed the referendum was
going to lose.
In the UK, the last dozen polls or so showed a close contest.  The markets, including those like
myself who saw the murder of the UK MP as a cathartic event that would offset
the poorly run campaign of the Remain camp got it wrong.  The betting
shops got it wrong as some large bets for
Remain overwhelmed the most numerous bets favoring Brexit.
 Ironically, the polls seemed to have gotten it more right than the
gamblers and traders.
There is a
divergence in the poll analysis in the US that
has become pronounced since the FBI’s announcement on October 27 about the new development about Clinton’s emails. 
 Some, including, and RealClearPolitics see the
race as having tightened considerably.  The former has Clinton as favored
65.5% chance of winning, after peaking near 88% a couple of days before the third debate.   The latter has
Clinton ahead by 1.8 percentage points in a survey
of national polls.   The Financial Times caught this spirit in the headline of its weekend edition: “US election knife-edge as rivals weigh
early-voting data.” 
calculations of how the electoral college may breakdown, both put Trump less than 30 electoral college votes shy. 
 That means
that one large state, like Florida (which has leaned toward Trump and RealClearPolitics have favoring Clinton by 1.2 percentage points)
can give deliver Trump a victory.
There is
another set of respected poll work that sees it quite differently. 
 These include the New
York Times Upshot
, Huffington
, Princeton Election
.  They, like the peso and Fed funds futures, have been
unflappable.  Upshot puts the odds at 84% Clinton wins. She peaked at 93%.   Huffington puts it
at 98.4, and Princeton puts the odds at
Despite the
divergence of the analysis, none show Trump as the favorite, and most show some stabilization in the last couple of days, 
 We are inclined to see the recent market moves as a fundamentally-spurred technical correction.
 We suspect that that correction is over or nearly so. When the US
political uncertainty is lifted, the economic divergence can reassert
itself as the main driver.  Although
the job growth reported before the weekend was nothing to get excited about,
the uptick in hourly earnings growth to its fastest pace since 2009 (2.8%) is a
wholly desirable development.  It
makes it easier for the Fed to remove some accommodation,
but a 25 bp rate hike to 50-75 bp is hardly a tightening of policy.  
All bets are
off if Trump wins. 
 This is not said
out of partisanship, but a function of induction (how investors have responded to such prospects) and deduction (investors
don’t like the unknown or surprises.  A Trump victory is both on steroids).  Given the seemingly limited path Trump has to the White
House, two states on the East Coast, Florida,
and North Carolina will likely be
indicative of the election outcome.  Trump must win both or defeat is all
but certain. These may be known in the
Asian morning on November 9.   Trump must go on to win nearly every other
swing state, including Pennsylvania.
We understand
that Clinton would become President under a cloud given the FBI’s recent
announcement and the high unfavorable ratings. 
 If the Democrats fail to secure a Senate majority,
Clinton will have an even more difficult time of things.  On the other hand, Obama’s moderate nomination for the Supreme
Court may be more appealing to the lame duck session than a potential Clinton
nominee.  The same is true of the two vacancies on the Board of Governors of the Federal Reserve.  At the same time, the Republican-dominated Congress will loath to make any last minute concessions to Obama, having fought tooth and nail for nearly then entire two-terms, and this includes at Trans-Pacific Partnership trade agreement.  
As a Senator
and Secretary of State, Clinton was able to work across the aisle with
A Democrat Senate, and ambitions of the Republican leadership in
the House (assuming that does not change) may boost bipartisan opportunities. 
  A Democrat sweep of both chambers is not
particularly likely. In such a scenario, though the key driver may be bonds, which we suspect investors would sell
in a bearish steepening.  In the current environment, it likely would be


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