A contested US presidential election will trigger a flight to safety

It could create more volatility across the board and prompt the Fed to increase quantitative easing

Global equity markets endured their worst week since March, spooked by anxiety about tomorrow's US election and fears of a long dark winter dominated by Covid-19 and the return of economic lockdowns.

With both concerns coming to a head last week, the Dow dropped 6.5 per cent and the S&P 500 was 5.5 per cent lower. However, with market sentiment dependent on such volatile and unpredictable issues, the scope also exists for equally sharp recoveries should the market’s worst fears fail to materialise.

Certainly, the backdrop of rising Covid-19 cases has reset market sentiment to expect the worst in the coming months, France and Germany last week reintroducing national lockdowns and the UK to follow this week.

The International Monetary Fund upgraded many of its economic projections just over a fortnight ago, but some of these forecasts are already getting revised down again, even as US third-quarter gross domestic product bounced back, with growth rising 33.1 per cent on an annualised basis, up from the second quarter’s 31.4 per cent contraction.

The more immediate concern, however, is the US election. Markets had been assuming some form of a “blue wave”, or a Democrat clean sweep in which they take control of both Houses of Congress and the White House. This would underpin a reflation trade based on continued fiscal and monetary policy support and less chaotic policymaking, especially over trade.

Infrastructure spending in particular would be expected to get a boost, and it may even hasten a more coherent US response to the coronavirus. Yields have perked up in recent weeks on this assumption, with the 10-year Treasury reaching above 0.80 per cent, and with the yield curve steepening.

However, even with former vice president Joe Biden leading in both the national opinion polls and in a number of key swing states, memories of President Donald Trump’s surprise 2016 victory are still vivid. With hours to go, nothing can be taken for granted. The markets are understandably fearful of an outcome that is tight enough to see a contested result, leading to months of uncertainty.

Such a scenario would see a flight to safety, bringing yields lower and flattening the yield curve. It would also cause a surge into other safe havens and create volatility across the board. The Federal Reserve would probably also have to act, and perhaps fortuitously it is meeting this week. Should the election produce such an outcome, it could be pressured to expand its quantitative easing programme again.

Given how much negativity was priced in last week, however, it is probably worth considering the upside risks should the election outcome turn out relatively smoothly after all.

US earnings results in the third quarter have actually been relatively good, with 86 per cent of S&P companies beating estimates and anticipation of further stimulus measures would likely see a swift reversal in sentiment. Most analyst projections envisage a retest of the previous S&P high of 3,588 on a three- to six-month horizon.

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With market sentiment dependent on such volatile issues, the scope also exists for equally sharp recoveries should the market's worst fears fail to materialise

Sector-wise, green energy stocks, which have outperformed the market since June, would continue to thrive on a “blue wave”, while fossil fuel-based energy stocks would likely underperform. The IT sector may face some headwinds, and financials may have to cope with new regulations, but mainstream stocks should do well.

Commodity prices in general may also be underpinned by the likelihood of more environmentally focused regulations limiting supply and an expected rise in demand thanks to the economic recovery once the pandemic has passed.

So, all roads still lead back to the pandemic and will also depend on the outcome of the election this week. Given the lack of success in containing the virus through lockdowns to date, the onus remains on the discovery of a viable vaccine to deliver a sustainable recovery next year.

Approaching winter in the middle of a second Covid-19 wave, it is difficult to imagine such a recovery taking shape right now, but if a contested US election is avoided, then the prospect of a brighter 2021 once a vaccine is found should be little bit easier to embrace.

Tim Fox is a prominent regional economist and financial market analyst