Election and the Markets

Posted by: Michael Williams on Friday, November 4, 2016

I appreciate the very "strong" feelings people have for the candidates and I am going to attempt to be as objective as I can when reviewing the candidates and how it may impact the economy and markets from my very humble opinion. There are certainly many other issues, all very important, but I thought I would just focus on the markets, economics, and finance. Before I delve into the market preview and the impact of the election on the markets, I think it is important that I preface my position. I have tried to write the market preview as objectively as I can, without any political ideology. It is true that I have voted both Democrat and Republican in the past, but I am not a member of either party. One could say I have been disenfranchised by both parties and have been independent for the last decade. The election brings forth many uncertainties when it comes to the economy and the financial markets. While it seems that Clinton is far ahead, if one reads ONLY the main stream media polling data - I believe there is a real possibility that Trump could win. Remember, it may be improbable, but not impossible. This is only my objective opinion. It seems that both parties have a rather large contingent of “hate votes”. Meaning, if I don’t like Trump, but I am voting for him because I hate Clinton OR if I don’t like Clinton, but I am voting for her because I hate Trump. Certainly, that is rather sad situation for our nation to be in. Additionally, we may see this also impact voter turnout, not based on how much one supports one candidate, but rather how much they don't support their candidate and their dislike for the either (why bother attitude). Both candidates are unpopular and we are seeing more of an anti-vote or protest vote than perhaps ever before. Regardless of who wins, the world and the U.S. will not collapse - regardless of what the chicken-little media would want us to believe. I have not read much on a break-down of each candidate on how it may/may not impact the economy, beyond some bias rhetoric. Presidents have little power over monetary policies, regardless of the rhetoric they spew, as that squarely rests on the shoulders of the Federal Reserve. However, they will attempt to drive board base fiscal policies, both domestic and trade. And if they are able to appoint Fed governors, that can change the economic conditions significantly. I will not get into social issues and immigration, since I am attempting to focus myopically on economic, market, trade, and finance. Those are very important issues as well and you should certainly consider everything when casting your vote. My attempt is ONLY to segregate out a segment and also offer a view on how the market MAY react.

Clinton Breakdown

Trade: Status Quo Clinton is a mainstream politician and certainly not a left-leaning progressive like Sanders or Warren. She has and will continue to support typical centralist type trade deals like NAFTA and CAFTA, she will support the TPP. She will, like all established centralist politicians of both parties, support the multinational businesses, Wall-Street, and corporate-welfare. Fed: Dovish Keynesian The Fed Chair, Vice Chair, and governors are all appointed by the President of the United States. President Obama has been the first President since the inception of the Federal Reserve that has appointed ALL current Fed governors. Note: Governors serve 14 year terms, in an effort that no single sitting president can “Stack the deck” with a single ideology. President Obama, due to timing circumstances has had the opportunity to do so. Under Clinton we will continue to see Keynesian economic monetary policy, any new appointed Fed governors will remain Dovish and Keynesian. We will continue to see easy monetary policy that supports more stimulus fiscal policies, while deficit funding entitlement programs. This means we should expect to see very low rates for the long term, increase money supply, and continuing Fed policies that monetize government deficit spending and debt financing (aka buying bonds and keeping yields low). An extreme and less likely view is we could see more fiscal powers handed over to the Fed under a Clinton administration. Something that the Fed and some Keynesian legislators have pushed for. This is more of a progressive agenda, and Clinton has not made clear her views on this. Taxes: Same to Higher In the financial markets, regardless of her rhetoric, we should not expect to see any transaction taxes or changes to “carry interest”. Her ties to Wall-Street and their contributions are well established and she does NOT have a history of championing any taxing of the financial markets. She is certainly not supporting a Sanders or Warren platform. Progressive taxing on income however, could very well see a steepening at the higher income earners. It is important to remember that capital gains, dividends, and interest income would NOT be affected by such policies and the 1% will not be impacted since most their wealth is NOT generated by INCOME. The “Buffett Rule” taxes income, not wealth, not capital gains, not interest, not dividends. It will hit the high-middle class income earners in the $100k - $500k bracket the most. However, these people are not major campaign donors, they are not major industry leaders, and effectively have little (if any) voice (aka lobbying) in the Belt-Way. We may also see larger tax credits and lower taxes on the middle to lower income bracket. Treasuries: Low Yield / High Prices The West will continue to see flat to negative short-term interest rates. We could very well see similar policies to “Operation Twist”, where central banks participate in bond purchasing at the long-end of the curve to keep the yield curve flat. This will continue to fuel speculative borrowing in the private/public sector investments. I suspect to see the NYSE Margin Index remain in the +$400 billion-dollar range and I would think after Clinton wins we could see margin increase to +$600 or even $700 billion range – if we have an elevated market. Treasuries will be hard press to decline, with the central bank continuing to buy treasuries. I suspect we could not only see yields fall further, but also see the Fed’s treasury holdings increase. Interest Rates: Unchanged to Negative Out Look As mentioned above, under such fiscal policies, the Keynesian monetary policies will follow suite to finance the fiscal expansions. The likelihood of a rate hike will diminish and the probability will increase that a rate cut and possible negative interest rates could come as soon as mid-to-late 2017. Markets: Bullish short-term more leverage Regardless of economic conditions on the ground, we will continue to see investments seeking yield or leverage risk taking (aka Unicorns). With financing rates at all-time lows and with the potential to go lower, we should see a boost in margin investments seeking both yields as well as growth opportunities. The market could see as strong rally initially from a larger inflow of margin backed investments. However, unless revenue increases to finance even low cost debt it will not be sustainable for any length of period. A drop of interest rates back to zero or even negative could inject another jolt higher for the market and even private sector markets could see inflows, but unless bank leverage ratios increase I can only see a 15-20% increase before markets stall (perhaps two years). Market rallies based on leveraged have finite capacity which is predicated on two principal factors, the ability to finance debt and the leverage ratios of the issuers. I would argue we are pressing up against current leverage ratios now, there is room but not much. Thus, I would expect under a Clinton administration a change to allow an increase in leverage ratios to allow for further debt formation.

TRUMP Breakdown

Trump on the other-hand is a wild card. He is certainly not a Republican, Democrat, or even a typical politician. Regardless of your opinion of him, he brings significant volatility to the political arena. His proposals are anti-establishment – which only brings more unknowns (volatility). While real change is certainly welcome to the unpopular establishment political class that has dominated our nation over the last several decades, Trump is a big wild card. The biggest issue with Trump is the unknown, regardless of what he says or what the media paints him out to be – we just don’t know. Media is peddling fear; much I believe is over-blown and Trump has not done himself any favors with his unfiltered talk – the reality is I think he is far more mundane than what the media paints it out to be. TRADE: Protectionism Anyone (regardless of political ideology) would agree that much of our trade deals are one sided, mainly to lower import costs. No doubt we are an import reliant nation – we consume anything and everything, the world’s leading consumer. Thus, our trade deals are focused on lowering import costs at the expense of sacrificing exports. Trump hasn’t done an excellent job (or even a good job) at articulating this predicament. A nation that becomes heavily import reliant for consumption will only see debt increase, which translates to low job growth, low wage growth, and ultimately low GDP growth. A powerful and strong economic nation MUST have strong exports to create jobs and increase revenue from exporting goods and services. All objective economist support trade, the question is how is the trade agreement formed. While the media freely interchanges “Free Trade” and “Fair Trade”, they mean two completely different things. “Free Trade” means unrestricted trade that is usually duty and/or tariff free. Free Trade forces competition. While competition does bring forth innovation, lower prices, and usually larger choice, one can argue that it can (has) lowered income and can even hurt one nation (losing the trade war) by limiting job growth or even creating job losses. True “Free Trade” only works in nations in which governments have limited interventionism in business (no minimum wages, no hiring practices, limited regulations, etc.). While in an ideal world (not realistic), “Free Trade” is what all nations would seemingly like to strive to. However, that is not a realistic expectation, therefore we must look to “Fair Trade”. Trade deals must ALWAYS first serve the people of a nation. Trump has pointed out that many of our trade agreements benefit the businesses at the expense of the people. Mexico car manufacturing is a good example under NAFTA. In the most basic terms, a US company can move to Mexico and produce cars at a cheaper rate and then ship them to the US for sale – without US tariffs on those imports. Meanwhile if the US wishes to export cars MADE in the US to Mexico, Mexico taxes imports of cars at approximately 15%. This is what Trump considers a "Bad Deal". However, I would be remised if I didn't point out that the imported good (car) is cheaper, which benefits the consumer. What does this do? Trump would argue, and abet somewhat correctly the following: 1. It encourages business to move off-shore for lower costs of production, creating job losses in our country. 2. It prohibits exports of products because foreign nations charge import tariffs making our products less attractive to buy. 3. Lack of import tariffs encourages US retail to buy from over-seas at lower costs. Fact is, our trade deals do/have benefited companies and even consumers (purchasing cheaper goods), at the expense of jobs in our nation. One only has to look at the widening trade deficit to see this problem continue to expand. The reality is we can’t have our cake and eat it too. You want to buy a $500 60” Flat-Screen LCD TV from Costco, then it has to be made in a lower cost country. I am not sure what Trump’s plan is for trade, exactly – but he could usher in stronger trade restrictions and higher tariffs. This may help job creation, but it could also increase import pricing. Depending on how aggressive his position is, some have argued it could create a trade war in which the consumer starts to be impacted with price inflation from tariffs on imports. However, I am not sure how significant it would be as the US remains one of the world’s leading consumers. Nations will NOT stop trading with us, that is an unreasonable conclusion as those foreign businesses would greatly suffer if they could not sell their wares to US consumers. Conclusion, we could see price inflation on imported goods. However, we could see job retention or even growth depending on how trade deals are changed or enacted. FED: Lean more Hawkish Trump has been outspoken about the Fed. The US economy is ever more dependent on radical Fed monetary policies. We live in an ultra-low rate environment, while the Fed continues to monetize government deficit spending and debt financing. While this has helped the US economy recover, one can’t help but wonder how much of the Fed interventionism is supporting the recovery vs. private sector. Remove the Fed’s easy monetary policies and I would argue we would see interest rates spike, velocity pick-up, and inflation move up radically. We could quickly move into an inflationary recession environment, that left unchecked could turn into a devalued depressionary environment. Trumps heavy-handed comments are just that. The Fed governors have a long way to go to serve out their term and he will NOT have as much influence on the Fed. His threats are more bully talk, without the muscle to back it up. However, if he starts appointing more Hawkish governors we could see the Fed become less likely to lower rates. A periodic rate hike (once or twice a year) of 25 bps would be in the cards, IF (only if) Trump could appoint governors. This is a lower probability in the short-term, but there is an empty seat right now. It is important to note the Fed is not an actual democracy, as the Fed Chair can rule over the majority in an FOMC (Federal Open Market Committee). While this has never happened, it could. This is more saber-rattling without the saber to back it up. Also, any rate hikes or hawkish position will put extreme pressure of the financial markets (bonds and stocks). If Trump wins, we could see a knee-jerk move lower in the markets, that sends bond yields spiking on PERCEIVED fear. A 5-10% correction could certainly be realistic; however, this would NOT be a long-term trend – as his power in this realm is restricted far more significantly than we are lead to believe. The Fed will remain Dovish in their current configuration. TAXES: Low Corporate Trump wants to lower taxes, primarily business taxes. Any lowering in the corporate tax rate is good for economic growth for the following reasons: 1. Companies are less likely to consider moving tax jurisdictions. 2. Companies can actively compete in exports by lowering prices with the tax savings. 3. Companies could increase wages and/or jobs are margins increase. 4. Corporate profits would be on the rise, benefiting shareholders (pensions, endowments, retirement funds, etc.) 5. Dividends could/would increase, increasing yields. 6. Market values would increase. We continue to see companies leave our nation. Ford just announced moving their car production facility to Mexico. Ford will no longer be making ANY cars in the US, only trucks. We have seen a rise in tax-inversions, companies taking over foreign companies to move over-seas into more friendly tax jurisdictions. Our two border nations, Canada and Mexico have far lower corporate tax rates than the US and with NAFTA and other trade deals, it makes sense to move companies to Canada and/or Mexico. To keep any business in this country, the nation must create a welcoming environment. Whether we like it or not, we live in a global market place. Walk into any Wal-Mart and most of the products for sale are made over-seas. At the same time, lowering corporate taxes will reduce government revenue and strain the funding for entitlement programs and services. There is a trade off to consider. I am not sure how Trump would balance tax rates with his trade policies, that is a serious question that would need to be answered. Lowering taxes to keep or bring new businesses to the nation is one thing, protectionist strategies that punish those who leave and/or importers is another. It’s a balancing act that needs more detailed review. Conclusion is that lower corporate tax will certainly create jobs, increase revenue, keep companies from leaving, and boost the market valuations. If, how, when he could do it is another question. Treasuries: Lower Prices / Higher Yields Trump may not have the pull to change the Fed’s monetary policy and it will take time for him to appoint Fed governors, however his heavy-handed rhetoric can certainly generate perception in the short-term that can spike the yield curve and short-term rates. We have seen the Fed spend 8 years with a low interest rate monetary policy while simultaneously talking “hawkish”. It has become a running bad joke among those that trade in the bond markets, as the Fed has taken the “boy who cried wolf” policy to an extreme. However, initially – before the long-running joke – the Fed did “talk up” rates and set an expectation for rate hikes and the market reacted. It is very possible if Trump won we could see a similar action, with bonds selling off, rates moving higher and the yield curve steepening. How long and how far this would go would of course be based on perception and as each FOMC meeting passed with nothing happening, it would begin to flatten and decline. I certainly would expect a contentious relation between a Trump administration and the current Keynesian Doves of the Fed. All of which would only bring more volatility in the bond markets, not less. Markets: Short-term Bearish A Trump presidency is good and bad for the markets. The fact is he is an unknown. Let’s start with the bad. He certainly wants higher rates and a more Hawkish Fed, whether he can usher in any real change in that regard (as to monetary policy) is questionable at best. However, that could certainly jolt the bond market and that would trickle over to “cost-to-carry” (margin) and we could see a short-term sell-off in the market. As I said a 5-10% decline would not be unexpected. The up-side under a Trump presidency would be a combination of a lower corporate tax rate and how trade policies would bolster exports. This would not impact the market in the short-term and I would think it would take at least 12-18 months before we would start seeing any impact to economic data. This would also depend on how fast and how much he could implement such measures.

Broad Market Reaction

Clinton Win = Flat to Bullish Short-term and Bearish Risk Long-term. A Clinton win equals a short-term strengthening of the market with longer-term negative economic pressure. The market will rise on leverage debt far more than on real top-line revenue growth. We will see companies continue to play with the bottom-line, share-buy backs, and more debt formation. The Fed will keep rates low and continue to stimulate. The market could rise in the next year or two by another 10-25% - mainly on debt formation. Unfortunately, this will be just a massive expansion on the current bond/debt bubble and market bubble (debt purchasing). To keep it going the Fed and potentially Congress will take more radically action and policies to keep debt financing expanding. The bet is can a Clinton manage the decline of the bubble when it bursts.
Trump Win = Flat to Bearish Short-term and Bullish potential Long-term. A Trump win equals a short-term market correction, how fast and how bad is uncertain. Interest rates and the yield curve could spike in the short-term. However, long-term is a big unknown. Lower corporate taxes and better trade deals could certainly help the economy in the long-term. There would be a fight between the Fed’s monetary policies and the Trump admin, with the Fed holding all the cards. This could force Trump to make more radical fiscal policies and we have no idea where that would lead.

My View

I am not a fan of either candidate and from an economic/market standpoint (ONLY) there are risks with both candidates. I am concerned about how Trump would negotiate those trade deals and how they would impact the domestic economy, jobs, and trade – however I think they have the potential to be positive in the long-run, if done correctly (IMHO). Clinton’s increases on taxes and deficit spending can boost short-term economic activity and perhaps spur some job growth, but at what expense for the future. We would become more reliant on government financing, while continuing to see the debt mount. It will certainly “seem” better in the short-term, but at what long-term consequences. Clinton is the safe bet, but it is a “can kicking” bet when it comes to economics. The Fed and Obama’s policies has kept the nation from falling into a dark economic hole, but at a significant expense. How much more time can you buy and how much more debt can you add? At some point the private sector (real economy) needs to grow. Trump is the risk bet, there are a couple of good economic ideas dealing with trade and taxes. However, is he taking too radical of an approach? Economic policy changes need to be “eased” in to avoid jolting the markets and risking massive margin and debt calls that could trigger a short-term recession. From an economic view: > Vote Clinton if you want to buy more time at the expense of the future. Trusting that when the bubble bursts (because it will) they can manage it so it doesn’t hurt to bad. Time horizon (guess) 2018. >Vote Trump if you want to take risk today at the hope that changes in the future can reduce or limit the bubble bursting. This is a volatile bet, hoping that he can execute good ideas that will have long-term economic growth. Bad Data? I don’t know what to expect. I have started ignoring mainstream media polling for two reasons – one it focuses on national results rather than state results (which mater for electoral votes) and the other is the heavily biased journalism Pro-Hilary and Anti-Trump. If one only watches mainstream media, they are reporting that Hillary is just going to waltz into the White House. I am not so sure and I think one needs to be objective. Too bad we don’t have objective journalism in this country. Even Fox is ambivalent towards Trump. From some of the more objective state polling Trump is catching up (also review the IBD/TIPP poll which seems to be more accurate). I am certainly not rooting for either candidate, but to ignore Trump’s surge in some states is ignorant and wishful thinking. I have a feeling that Trump is doing far better than mainstream polling would have us believe.

Risk Management?

My personal positions have been hedged (own extra puts against long-stock positions) for the entire year, since last December when the Fed hiked rates. The same has been true of the KFYIELD fund, over hedging against potential volatility. In my opinion the VIX below 12 has been a screaming buy this year with all the risk factors on the table. That means low implied volatility in your individual stocks are also a huge buy to hedge against down moves. Maybe I am overly conservative when it comes to the market, but with this election and some of the volatility on the world stage, I can’t help but be overly conservative. If you have NOT hedged your positions, you are taken unnecessary risk. I have spoken with and reviewed several investments for individuals and firms – and the clear majority is unhedged (unprotected). I reviewed one massive portfolio that was rebalanced last quarter with 30% in the 10-year at 1.6% and the rest in a S&P mirror portfolio at 2150 and none of it hedged. This quarter it is taking losses in bonds and equities – why would anyone do that heading into this election? This is not unusual and one can’t help but question the investor / adviser that would suggest such a position.

Support & Resistance

INDU 18,000 We broke below 18,000. If Clinton wins on Tuesday, we could see a short-term rally. However, a Trump win could send the market down to 17,600 or lower in knee jerk fashion. A Clinton rally would see resistance kick back in at 18,400 – the economy is not that great. SPX 2120 Similar the S&P 500 index is already under pressure and broke below 2120 and now 2100. Expect election jitters and volatility. We could visit 2040 or 2140 very quickly next week. NDX 4600 The tech heavy index has been battered with some bad earnings from some big names. Not all is rosy with some slow-down in top line revenue. I think a move to 4450 could happen, but election day can send this index all over the place. RUT 1200 The broad-based index fell below 1200 and that is not a good sign. Order flow has been exiting the market for the last month as investors would rather sit out this election. We could see a flood of buying opportunities in a Clinton win and a rally back to 1220 or even 1240. However, that is a short-term speculative opportunity play at best.
Conclusion I am not excited about the election and the underlying economic conditions are not strong. Same-store sales have been weaker, top-line revenue both foreign and domestic is weaker, today’s labor data – especially the Labor Participation was disappointing. Regardless of the talk – the Fed is NOT raising rates in December. Of course, they could stick it to Trump if he wins and jack rates 50 bps despite themselves -–but I doubt it (bad joke). I am shocked however at the risk that many are taking into this election with unhedged positions. I have seen two portfolios take massive hits already and now they are HOPING for the market to rally. Hope is an oxymoron strategy. We should expect the unexpected and protect ourselves for that. Can you afford to be uninsured into this election? If not – what is your broker/financial advisor doing for you? There are many issues to consider, hopefully I have given you an objective view about the economic, fiscal, monetary, and market forces that would come to bear under either candidate. We must consider all issues in an election, unfortunately most of the time media does NOT focus on the economic and market issues that I have reviewed. Of course these issues may not be as important to you, but they also need to be considered.

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