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Pesos or Treasuries? How Will the Election Affect Investment Strategies

What are the sensible investment ploys for those institutional investors who think they have a better than 50-50 chance of predicting the election outcome?

The U.S. presidential election is a discomfiting time for those strategists accustomed to changing investment positions after minute analysis of the carefully measured comments of Ben Bernanke, Mario Draghi and other central bankers.  

Markets have a tendency to overinterpret what these bankers say, because at times so little of their true thinking is revealed.

However, when it comes to elections, the opposite is true. Politicians promise the earth to win over the electorate and then deliver much less.

Morgan Stanley encapsulates this slightly unreal world of political promises in a recent currency note, saying: “While we know what the candidates stand for, we will only know after the November 6 election day how much these policies may have to lean towards compromise. Hence, the long-term implication of the outcome of the election may be very different to the initial market response.”

A rational response is, therefore, to glean those promises that are more likely to be delivered, from the mass of more doubtful practicality —looking mainly at Romney’s promises, since Obama would broadly maintain the status quo. 

Mitt Romney, the Republican challenger, proposes a more business-friendly tax regime, including a cut in corporation tax from 35 to 25 percent— steeper than the promised reduction by Barack Obama, the Democrat incumbent, to 28 percent. Lower taxes for business are key to Romney’s pledge to boost the supply side of the economy, so one can assign a relatively strong likelihood to their implementation. These tax cuts would support U.S. equity prices across the board, by increasing corporate earnings.

Looking in more detail within equities, Romney’s promise to increase defense spending and encourage oil and gas drilling would benefit companies in the sector. The other side of the coin is alternative energy, championed by Obama but not by Romney, whose stock prices would suffer a hit if the Republican candidate won.

However, other possibilities look more uncertain.

Romney’s more hawkish line on quantitative easing (QE) could potentially prove fertile ground for short-term preelection betting — but the strategy has its flaws. If he wins, he is likely to appoint an inflation hawk to replace Bernanke when the Fed chairman’s latest term ends in January 2014. This could mean that QE ends earlier or is reduced in size in future years. Morgan Stanley says that if markets price in this possibility following a Romney victory, the yield curve would steepen: Investors would sell Treasuries further out along the curve in the expectation that these longer-dated bonds could no longer rely on the Fed life-support machine. A reelected Obama would, however, be likely to reappoint Bernanke or a chairman with similar views — allowing Treasury yields to remain low for a long time. Following this logic, many analysts believe an Obama victory will, by allowing a looser monetary policy, weaken the dollar, with a Romney triumph boosting it.

But if Romney wins, investors will not know for many months hence which chairman Romney will pick. Nor can they know for sure what he (the three front-runners are men) will do if appointed. Central bankers tend to respond relatively pragmatically to changes in circumstance, and the credit crunch and its aftermath have only increased this tendency — forcing them to overturn their previous assumptions in response to each new drama-filled year. In conclusion, taking views on Fed policy might prove too fanciful a bet.

HSBC differs from much of the received wisdom by suggesting that a Romney win could be bad for risk assets. “A combination of tightening fiscal policy, a Fed with a potentially diminished appetite for QE and China being named as a currency manipulator, is not a happy one for risk appetite,” it says. There is speculation that Romney would try to reduce the deficit next year; he has also said that on “day one” of his presidency, he would label China a currency manipulator. HSBC’s choice of weapon, in reaction to these possible outcomes, is to buy the dollar and sell the Mexican peso, because the Mexican economy’s high exposure to the U.S. gives it a strong positive correlation with U.S. risk assets. An alternative, based on the same logic, is to sell the Canadian dollar and buy the greenback, but HSBC says the dull, low-volatility Canadian currency “does not offer the drama” of the peso.  

But many analysts believe that when it comes to China, Romney's bark will be worse than his bite: In practice he will pursue a more nuanced diplomatic game than his tough talk implies, so that U.S. companies can continue to profit from China's low labor costs and promising consumer market.

To many analysts, such considerations pale beside the question of whether the U.S. can resolve its fiscal cliff problem — where taxes rise and spending falls automatically at the end of the year, absent any agreement otherwise — with enough rapidity to prevent a double-dip recession. A comprehensive deal would boost equities and other risk assets, depressing Treasury prices.

However, the resolution of this issue does not depend on who wins the keys to the White House. It depends on whether the winning party also clinches a majority in the Senate and the House of Representatives — a scenario that is looking increasingly unlikely.

For those institutional investors wary of making any kind of play on the U.S. election out of reluctance to base an investment decision on the uncertain consequences of an uncertain result, an alternative is to rely on the special field of technical market analysis peculiar to U.S. elections.

Deutsche Bank finds, for example, that after close contests — and there have been few closer than this — equities tend to rally. This reflects markets’ hatred of uncertainty, whatever that uncertainty may be.

Investors not interested in short-term tactical plays have plenty enough to ponder on the eve of the election. The next four years could see China seriously challenge the U.S.'s position as the sole economic superpower. If it takes on this challenge and succeeds because of a lackluster presidency, all assumptions about the dollar as the world’s reserve currency and U.S. Treasuries as the world’s premier safe haven assets could be in jeopardy. It is difficult to see any issue with bigger implications for institutional investors than that.

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