Investors should look beyond short-term risks as the chance of a contested election looms large

Boxing gloves

Bill DeRoche, Chief Investment Officer at AGF is the latest to step into the ring with our US election from the ETF perspective comment column.

How can investors position their ETF portfolios to best profit through the US election process?

As the US elections quickly approach there are several important points for all investors to keep in mind. First the markets are resilient and US business leaders will be quick to adapt to any policies that are enacted in the coming months. Politicians also recognise that a strong economy is key to winning elections. Throughout the last few months markets have signalled that they are comfortable with either Presidential candidate. With that said, that are quite a few uncertainties hanging over the market that will most likely lead to higher volatility in the short term as these uncertainties play out. Obviously, who wins the Presidency as well as the Senate are near the top of the list, but the chance of a contested election also looms large. Though these uncertainties are real, investors should look beyond these short-term risks. Regardless of the current headlines, a new Congress will be seated in January and with a President sworn in at that point, we expect the focus will be on protecting the economic recovery.

Beyond the risks associated with our elections we continue to contend with the risks associated with the global pandemic. Though a stimulus bill appears unlikely now until after the elections, the markets have signalled that they still expect more stimulus on the horizon. The delay in enacting a stimulus bill is concerning as several companies have enacted layoffs and more furloughs. Markets have conveniently looked beyond this short-term concern expecting additional economic stimulus, whether solely in the form of monetary support or a broader fiscal package, the outcome of the election and the path of the recovery will heavily dictate the tact from Washington.

Compounding these short-term risks is the pace of the market’s recovery since the lows in March of this year. We have experienced one of the fastest market recoveries ever from the downturn earlier this year. Most of the return has been attributable to expansion in the earnings multiple, pushing valuations to unusually high levels, though the dividend yield associated with the equity market continues to look attractive relative to treasuries. This presents a real dilemma to investors. Looming stimulus and low interest rates for the foreseeable future suggest equities could continue to trend upward, but conversely, elevated multiples also imply lower future returns for equities over the longer term.

Given this backdrop, we urge investors to try and look beyond short term portfolio positioning for the election and ensure their allocations to the various asset classes have been rebalanced back to their targets given the extraordinary moves – both up and down - that we have experienced in the markets this year. Additionally, we believe there is a risk of further market volatility, so we encourage investors to consider tactically reducing or hedging their equity market exposure to help protect their portfolios and reduce potential downside risk given the market’s elevated valuations and continued economic uncertainties.

For those investors determined to do some short-term trading ahead of the elections there are several factors to consider. First, investors would need to accurately forecast the outcomes of the election and foresee the impact the election results might have on security prices. And elections can bring surprises. It is instructive to remember that some quite violent short-term moves followed the 2016 election notwithstanding the longer-term upward trend.

With that said, several brokerage houses are offering baskets associated with each Presidential candidate that are expected to outperform if the relevant candidate should win. Not surprisingly the baskets have several tilts that I will discuss next.

What sectors are most likely to be impacted?

We analysed 10 issues that we felt were most likely to impact the markets. They were:

  • Healthcare Reform
  • Global Pandemic
  • Tax Policy
  • Anti-Trust Action
  • Regulation
  • Climate Policy
  • Welfare Reform
  • Infrastructure Spending
  • Defense Spending
  • Trade Policy

The sectors we think are most likely to be affected by the election outcome are those where policy between the candidates differs the most. Energy is clearly the most obvious sector with the Democrats continuing to encourage reductions in fossil fuels while favouring more renewables. Industrials would be expected to move if changes were enacted to tax, wage, regulation and trade policies. And Financials would be expected to react to any anticipated changes in the regulatory environment. We believe the key areas to focus on would be securities that would be impacted the most from changes in tax policy, China policy, trade policy and defense spending.

What are the biggest risks for investors during a time of political change?

When we consider the 10 issues listed above, we believe any changes in tax policy will potentially have the largest impact on the overall level of earnings across the equity market. Given the level of government spending that has been adopted to combat the pandemic, taxes will need to rise at some point in the future. Given the fragile nature of the economy due to the pandemic we think it is unlikely either party would raise taxes until we are clearly out of the woods in order to avoid inducing another economic downturn.

What sectors are most likely to do well?

The consensus view as reflected in the polls as well as in the betting markets expects a Biden victory. Market participants would expect current prices to reflect this view. Individuals looking to profit from any short-term repositioning prior to the election might consider a contrarian view reflecting a surprise victory for President Trump. The most obvious beneficiary of a Trump victory would be the energy sector. Industrials should benefit from continued lower taxes, wages, and regulation as well as a more restrictive trade policy. Financials would also be expected to benefit from a continued less constrained regulatory environment. The expectation for the other sectors is more mixed and would require investors to evaluate individual securities to determine the impact the expected policies of each candidate might have on those securities. Irrespective of the election outcome, we expect the trend towards sustainable investment and ESG to continue. An increasing number of institutional investors and advisers are integrating ESG and sustainable investment metrics into their portfolios, looking at this area both in terms of risk management and as a potential long-term alpha source.

Why are ETFs a good vehicle for portfolios during a time of change?

ETFs are a cost-effective way for investors to implement macro-economic views while mitigating the risks associated with stock specific issues. ETFs reduce the costs associated with trading a basket of securities and allow easy straightforward implementation of trade ideas through a minimum number of trades. ETFs allow investors to trade a basket with a single ticker reducing the accounting and tax management issues associated with portfolios that hold many securities. During periods of rapid change investors can quickly pivot the macro exposures in their portfolios through offsetting ETF pair trades. ETFs have become a ‘go-to’ vehicle for professional investors looking to manage the large-scale risk exposures that are common across similar securities. With the wide array of ETF products now available all investors can create a well-diversified portfolio with a manageable number of positions. Importantly an expanding range of Liquid Alternatives ETFs also allows investors access, at a competitive price, to some alternative investment opportunities; hedging capabilities and more specialty asset classes that were previously only available to larger institutional investors.

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