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Tom Osborn
Risk management
This article is part of Risk.net’s series of crowd-sourced scenario-generation exercises. Click here to download a PDF of the full results.
Halloween may be over, but the markets could be in for another scare next week when the US holds its midterm Congressional elections.
Current polling suggests the Republicans are on track to win a majority in the House of Representatives. And while there is more uncertainty over the outcome in the Senate, aggregators at press time suggest the Democrats will also lose their narrow majority in the upper chamber. A win for Republicans – amid febrile markets, fast-rising interest rates and still-rampant inflation – raises the odds of a long-threatened government shutdown, and a second Donald Trump presidency in two years’ time, legal troubles notwithstanding.
During October, Risk.net asked 43 readers how one of three different results in the US midterm elections would affect markets: the retention of control in both houses by the Democratic party; the Republican party winning control of both houses; or both parties winning control of a chamber each, and the emergence of a split Congress.
Respondents then predicted how their chosen outcome would affect four key market benchmarks – S&P 500; US 10-year Treasury yields; euro/dollar foreign exchange rate; and WTI crude oil – at two horizon intervals (year-end 2022 and 2023).
The (anonymised) predictions were fed into a platform run by our scenario-generation partner, Sapiat, becoming the basis for a wider set of market scenarios, with the impacts of the regimes simulated for an illustrative portfolio. US equities make up 20% of that portfolio; Europe ex-UK equities 7%; US government bonds 10%; and global ex-US government bonds 10%.
Click here to download a PDF of the full results.
Risk.net solicited market forecasts from among our readership for all three outcomes (see box: The results) – before our vendor partner, Sapiat, modelled them against a sample portfolio.
Respondents bucked the polling forecasts, with over 70% expecting a split Congress and the rest equally divided between a clean sweep for the Democrats or the Republicans.
Projected returns, should the Democrats retain control of one or both houses, are relatively benign, whereas Republican control suggests “a purely political risk – for example, a budget showdown resulting in a sharp shock to markets in the final quarter”, notes Laurence Wormald, Sapiat’s head of applied research.
That could leave equities with a long way to fall from their recent abortive rally, justifying the apocalyptic return projections that suggest significant tail risk in most equities sectors (see table A). The sector with the steepest tail risk – energy stocks – boasts an eye-watering potential quarterly loss of 63.3% during the fourth quarter of this year, using the 95% CVAR estimate. Financial stocks and industrials are not far behind, with 53.9% and 50.25% drawdowns respectively.
“However, this view does not imply continuing poor performance of the US equities market as a whole in 2023,” adds Wormald. Private equity and US real estate follow the same pattern with strong rebounds in the second half of 2023 after potential shocks in the next two months.
Equally, things don’t look much brighter at the tail, should the Democratic party manage to cling onto its majority in both houses (see table B). Using the same 95% expected shortfall measure, energy stocks still show a drawdown of more than one-third, with industrials and financials not far behind on just over 30% each.
Mean returns (figure 1) for the model are lower than long-term returns under all three scenarios – implying political risk is seen having an outsized impact on markets through the next two years whatever the outcome of the elections. There is also the possibility of a more pronounced downside risk in subsequent periods. The most notable difference is the negative mean returns for a wide range of assets across the board in the final quarter of this year under the Republican control scenario.
One former Federal Reserve economist sees two potential explanations.
“They keep saying they’re the fiscal conservatives – it’s not true. They actually focus so much on taxes that they’re not thinking about balanced budgets. And, ultimately, that’s the scary part: if the Democrats go crazy on taxes, spending – that’s not much better,” says the economist, now a risk manager at a global bank in New York.
To be sure, he adds, much of the projected returns are driven by the fundamentals of inflation and rates. At the time responses to the survey were solicited in October, US equities were enjoying one of their strongest months since the 1970s. The return projections in table A reflect the distance individual sectors might have to fall from a prior peak, using the 95% conditional VAR or expected shortfall measure of tail risk.
“Paradoxically – and weirdly – the problem with the month we’ve just had is it indicates the economy’s still going strong, which is usually a good sign for the market. But in this instance, it’s a very bad sign, because it means that inflation is going to keep running hot, and that’s really where the Fed needs to get it under control,” adds the economist.
Sure enough, that was reflected in the initial market response to the Federal Open Market Committee statement on November 2, which suggested a possible softening of future rate hikes. Those hopes were dashed during Fed chair Jerome Powell’s subsequent press conference, where he noted that rates would likely have to rise higher than previously forecast, given the persistence of inflation, even if the speed of those rises slows.
“Even if they do plan to slow down or decrease rates, they will have to keep signalling that they’re taking a very hawkish line, because otherwise they risk anchoring inflation expectations at a higher rate, which they don’t want,” argues the economist.
“And look at the historical record: if you look how long it took to get inflation this high under control – there is no developed economy that’s ever done it in the amount of time that the markets are currently expecting. If it were to, it would be a miracle. So, expectations right now in the market are completely irrational.”
On the evolution of US equity sectors, Wormald notes there is “a pronounced variation across sectors in 2023 performance expectations, especially the poor outlook under the Republican control scenario for the industrial and financial sectors”.
Under that scenario, those sectors do not recover during 2023, he adds, and are expected to show negative returns even into the first quarter of 2024, “suggesting a very uneven recovery and therefore elevated risks, should that election outcome materialise”.
Where might investors seek sanctuary, in the event of a Republican clean sweep? Under the mean return forecast for all asset classes (see table C), only advanced emerging market equities and China shares – stocks seen as a good inflation hedge, given the lower impact on components and raw materials exporters – and global commodities provide much respite.
As Wormald notes, however, returns do pick up through the first quarter of 2023 under a Republican control regime, with almost every asset class displaying a small positive contribution. Despite their initial negative mean return in Q4 2022, both US government and corporate bonds are expected to perform better throughout 2023 under this regime than under either Democratic control or split scenarios.
As per figure 1, however, the return distributions under this regime are far wider than those seen under Democratic control of one or both houses, getting progressively wider through year-end 2023 and into the first quarter of 2024 – indicating greater event risk to markets under this regime for the foreseeable future.
Of the 43-strong crowd of respondents, almost half were from the US. While 65% of US respondents stuck with the consensus outcome of a split Congress, a higher proportion (20%) versus the overall crowd offered forecasts for a Republican clean sweep – twice as many as favoured a Democratic hold in both chambers. A little over one-third of respondents were from Europe, with the rest of the world making up the balance.
Even looking at the consensus election outcome for a split Congress, Wormald notes strong divergences of opinion about market consequences. Respondent number 33, for example, takes the view that split control would be as bad for US equity markets as most others who forecast Republican control.
However, the same election outcome is viewed much more positively by an Asia-Pacific respondent, number 75, whose views suggest US market behaviour much more aligned with the most optimistic forecasters, who typically have predicted the Democratic control outcome.
“Some of this variation may be driven by contrasting views on euro/dollar rates, since the strength of the US dollar will undoubtedly be a factor in global markets during 2023,” says Wormald.
Looking for signals in the other financial factors that respondents were asked about is harder. There was a tendency for those predicting falls in oil prices through next year to swing in favour of Democratic party control of both houses, although the sample size of such voters is low.
Since the survey, however, the Biden administration subsequently indicated in late October it would buy oil at around $70 to replenish the US national petroleum reserves it has been running down to reduce gasoline prices – politically, as well strategically, some argue, in the run-up to the election – likely setting an effective price floor at this price point for some time.
During October 2022, Risk.net asked its readers which of three outcomes for the US midterm elections they thought most likely, and to offer a contingent forecast for a series of leading financial indicators. The scenarios built by Sapiat were modelled from these anonymised forecasts. Here, the firm gives a brief insight into its methodology.
Common to all crowdsourced scenarios is the assumption that forecasts from each individual respondent carry bias and uncertainty, but their effects can be removed when using a large set of responses.
Sapiat settings applied in this case:
Editing by Kris Devasabai and Alex Krohn
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