The market is implying noticeably higher levels of volatility during the March primaries and the November presidential election.
Sentiment towards health care is negative, but the sector could surprise to the upside.
Whether it is caucus recounts, impeachment hearings, or torn up State of the Union speeches, there’s no way to escape political headlines this year. As a result, sentiment could briefly shift based on the next salvo of political schadenfreude. We are, after all, in a new volatility regime where geopolitics are fueling micro-bursts of volatility that upended rallies for a short period of time before calmer heads prevail—or monetary policymakers step in and offer support.
Because the so-called safety nets have a few holes, this regime is expected to continue. In terms of fundamentals, earnings growth is slow to negative, and valuations are expensive in the US market. On the macro front, economic growth is slow, inflation is tepid and deficits are large. In the end, however, political headlines are more noise than anything else. Campaign promises make for good evening news fodder, but without real legislative changes, the effects on growth and inflation are minimal.
At the same time, words can be hurtful: We have seen time and again that grandiose comments can induce volatility that drags on returns. The concept of volatility drag in a whipsaw market like our current one should be a portfolio construction concern, as supported by simple math: If you lose 10%, you then need to make 11% to break even. In this climate, it’s important to focus on downside risk mitigation.
Here, we examine three political trends that investors should be aware of as we head further into 2020.
Gearing up for Super Tuesday and beyond
By the end of March, 70% of the Democratic Party presidential primary contests will be finished, inspiring either clarity or further uncertainty for the crowded field. Perhaps the Iowa caucus results will be tallied by then, too. Much of the action will take place on March 3rd when 15 states head to the polls during Super Tuesday.
Given the large number of candidates and ambiguity around the eventual victor, the market is implying noticeably higher levels of volatility during the March primaries and also near the presidential election in November, as shown below by the CBOE VIX futures curve. After the election, the implied level of volatility declines.
Source: Bloomberg Finance L.P., as of January 17, 2020.
A few points of clarification: First, the curve is naturally upward sloping, as uncertainty increases the further you extend the time horizon. Second, to simplify our analysis, we ran the VIX futures curve prior to the coronavirus outbreak on January 17, 2020; the curve inverted after news of the virus due to the sizeable risk-off move. Nonetheless, the curve illustrates how the market is pricing in political trepidation.
Key takeaway: Watch out for headlines in March that could potentially impact sentiment—but otherwise, wait until the political results have clear policy implications.
Are elections risky?
According to historical data, the October to December timeframe tends to be a period of higher volatility than any other three-month span, largely because of systemic market crashes that have occurred in October (e.g., the crashes of 1929 and 1987, and Lehman’s bankruptcy in 2008). More recently, however, there have been smaller-scale drawdowns, such as the sell-off of October 2018, when the S&P 500® Index declined nearly 10% on the month and fell another 10% through Christmas.
There are no real reasons why the fall season brings more market “falls.” Some point to an omnipotent “October effect” but that theory has largely been debunked as a statistical quirk exaggerated by outliers, leaving it to have a mainly psychological effect.
Analysis of the October to December timeframe becomes more interesting when we account for US presidential elections. Through this lens, we see that volatility is higher in presidential election years during those already high-volatility months. As shown below, the average level of the CBOE VIX Index—known as the market’s fear gauge—is higher than in non-presidential election years.
Source: Bloomberg Finance L.P., as of January 31, 2020. Calculations per SPDR Americas Research.
While the typical volatility profile is hard to reconcile because it is not really supported by a fundamental or behavioral bias, the election volatility impact is easier to understand. Election outcomes can impact policy. When the executive and the legislative branches are both up for grabs, the result could be more gridlock or a distinct change in policy based on party lines.
Key Takeaway: It’s only February and our environment is already politically charged—so don’t be surprised this autumn if leaves aren’t the only things falling.
Polling results and health care returns
Political polling numbers have already impacted market returns in health care. Many Democratic presidential candidates are campaigning on large-scale health care reforms at a time when drug pricing, insurance plan coverage and the opioid epidemic are at the forefront of legislative discussions. That said, even if a Democratic candidate who campaigned for “Medicare for All” wins the election, the chances of passing the legislation in the near term are unlikely as long as the Senate is controlled by Republicans.
Despite the likelihood of legislative gridlock, markets are reacting. Massachusetts Senator Elizabeth Warren and Vermont Senator Bernie Sanders are the more progressive candidates regarding health care reform. As shown below, the return on health care stocks has suffered as their polling figures have improved.
Source: FactSet, Real Clear Politics, as of January 31, 2020. Past performance is not a guarantee of future results.
The current negativity towards health care sets the stage for the sector to potentially surprise to the upside, thanks to its fundamental backdrop combined with secular tailwinds. Health care firms are expected to post the strongest earnings and revenue growth in 2019 of any sector, and over the past three months, analysts have been ratcheting up their 2020 earnings-per-share (EPS) estimates for the sector. This has led to the second-largest increase in 2020 earnings by a sector, behind technology. Additionally, as shown below, health care stocks are trading below their 15-year average, based on various valuation metrics—a claim the broader market can’t make. 1
Source: FactSet, as of January 31, 2020. Past performance is not a guarantee of future results. P/E is Price-to-Earnings, Fwd P/E is next-twelve-month-price-to-earnings ratio, P/S is price-to-sales, and P/CF is price-to-cash-flow.
Key takeaway: Polling numbers can propel a candidate into being a frontrunner, but their impacts on company cash flows are uncertain and hard to predict because campaign promises are not the same as presidential policies. With this backdrop, investors can take advantage of the temporary mispricing opportunities driven by political sentiment and seek to benefit from the health care sector’s steady growth in a late-cycle environment. For more on this topic, see two recent posts from our team: Spotting Trends and Uncommon Sense.
2020 Portfolio decisions
We are in a new risk regime where bull markets can be temporarily whipsawed by micro-bursts of volatility—and political machinations may be responsible for the next brief drawdown. Ensuring that portfolios and investor mindsets are properly prepared may make this election cycle a bit more tolerable.
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1The S&P 500 Index valuation metrics across P/E, Fwd P/E, P/S, and P/CF are in the top 10th percentile relative to the past 15 years as of January 31, 2020. Source: FactSet.
CBOE VIX Index
A measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
S&P 500 Index
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