Let’s start with this:
— Charlie Bilello (@charliebilello) February 15, 2017
Since Oct 11, 2016 the S&P 500 (SPX) is up about 10%, gaining $2 trillion in market capitalization, closing yesterday at new all time high with the index sporting a $20 trillion worth! You can argue the reasons for the gains and debate what would have happened if the election had been different (we will never know) but I am hard-pressed to think that the promise of financial and environmental de-regulation and lower taxes has not had a good bit to do with the unbridled enthusiasm for risk assets, with investors disregarding any and all risks.
Speaking of risks, is this market now climbing a wall of worry with what’s going on in Washington? This has to be one of the quickest scandals to ever hit a new presidency in the modern era. And that scandal has geo-political implications that might affect relations with allies, frenemies, and enemies, and therefore global trade.
Even more in the theater of the bizarre, we’re watching the President litigate the scandal with his own intelligence agencies in real time in the People’s Court of Twitter (here). In most investment regimes investors would be building in some sort of risk premium to compensate for the uncertainty that might result in a geo-political dust up or sudden turnover in Washington. Those things could affect global trade, commodity prices, currencies or even demand for U.S. Treasuries (which in turn could have dramatic effects on interest rates.)
So why isn’t it having an effect? There are a couple of reasons. First, markets are terrible at pricing in tail risk. They usually ignore it (rightfully so over the long term) until it happens. Second, there’s probably an assumption that no matter what happens in Washington, the make-up (and therefore the tax and regulation policies) of who’s in power will not change. (if not Twittering at 3am Mike Pence or Paul Ryan had to takeover under the craziest of circumstances, would the market sell-off or rally on that news?)
But, here’s the thing. We know how quickly media focus turns to the next election. And if these scandals continue and gum up the works of the new president and congress’ agenda (somewhat surprisingly based on the hype, very little actual policy has been changed so far) we may find ourselves deep into the run-up to midterm elections.
Why would that influence your investment portfolio? Simple, if the President is unable to deliver on the assumptions the market is currently making, especially of massive infrastructure spending and the creation of jobs in the U.S. in the first year, then it will become increasingly difficult to get anything done in a midterm election year in 2018 as Republicans might need to distance themselves from a President with low approval ratings. Remember, on of the big assumptions is the Republican White House working side by side with its super majority in both houses. But:
Since 1946, when presidents are above 50% approval, their party loses an average of 14 seats in the U.S. House in the midterm elections, compared with an average loss of 36 seats when presidents are below that mark.
To swing the house back the Democrats need 24. So how will the President and Congress respond if his approval ratings remain low and scandals continue? By going back to the populism. Here’s why:
The sharply polarized nature of Trump’s appeal—which has generated magnetic attraction for blue-collar and non-urban whites, broad opposition among minorities, and unusually high resistance among white-collar whites—has the potential to deepen this sorting process, analysts in both parties agree. The vividly contrasting voting patterns of 2016, with Trump posting big gains over Romney in heavily blue-collar House districts and Clinton improving over Obama in a broad swathe of white-collar districts, may have offered a fast-forward preview of how the House may evolve in coming years. “It was like looking decades in the future, and this is what it looks like,” said GOP strategist Liam Donovan, referring to the 2016 results. “If you just push down the gas and let it rip [on the class resorting], this is what it is going to look like.”
So that business friendly stuff like repealing Dodd Frank, lowering corporate taxes and gutting regulations for oil drillers? That’s what the market is assuming right now. But that ain’t gonna get votes in these changing districts. We were promised trade wars.
If that does happen, we might be right back to to a sub 2% gdp, job and wage growth well below the post war averages and an increasingly erratic global economy, or worse.
Which brings me back to the SPX. There will be little basis for new daily new highs, and the days of sub-teens volatility readings will be a thing of the past. Just yesterday we detailed a long vol strategy with VIX options (VIX on Vapors) a defined risk strategy eyeing the Fed’s March 15th FOMC meeting to play for a vol spike, as the Fed could certainly be a source of market volatility, especially if our a battle emerges between the President and a Fed who he has been very critical of in the past. In most market scenarios, the Fed on the cusp of what could be an aggressive tightening cycle would be the main concern for investors, but the craziness in Washington could son emerge. And what that means for some of the assumptions being made in the market rally? I suspect that the lack of volatility in the last 4 months could be more than made up for in the not so distant future.