“Increased volatility as we head into US elections & second quarters of earnings”

Marco

Today, we will discuss the upcoming US elections and their impact on the financial markets. Investors are always curious about how markets have performed under different administrations or during various years of a presidency. However, historical returns offer limited insight into why markets behaved the way they did and how they might perform in the future. Economic and inflation trends tend to have a stronger and more consistent relationship with market returns than election outcomes.

Election Uncertainty and Market Volatility

As we approach the November elections, increased volatility is expected due to market aversion to uncertainty. The implied probability of a Trump victory peaked at 69% a few days after an attempted assassination but quickly fell to 55% following Kamala Harris’ presumptive nomination. Unlike in 2016, markets are currently pricing in a Trump victory, though Kamala Harris remains a wildcard, making it too early to conclude a Republican win.

In the long run, it is policy, not politics, that matters most for the economy and markets. Two critical policies to watch are the trade tariffs on Chinese goods and the decision regarding the Tax Cut and Jobs Act (TCJA) set to expire at the end of 2025.

Trade Tariffs on Chinese Goods

President Trump implemented tariffs during his term, resulting in $75.9 billion worth of duties on Chinese goods. President Biden continued and increased these tariffs, bringing the total to $135.4 billion. This will affect companies related to Chinese exports, impacting both fundamentals and sentiment.

Tax Cut & Jobs Act (TCJA)

Since its implementation in 2016, the TCJA likely boosted short-term demand for goods and services by increasing after-tax income. Republicans are likely to extend tax cuts, while Democrats may allow selected areas to expire. However, its long-term impact remains unclear due to pandemic-related fiscal spending, raising concerns about the government’s long-term budget deficit.

Historical Market Trends

Investors often recall the “Trump Bump” seen in 2016, characterised by a post-election rally driven by expectations of tax cuts, deregulation, and increased infrastructure spending.

Equity Markets

Financials, industrials, and materials sectors gained from a pro-business environment under a Trump administration.

Bonds

The 10-year U.S. Treasury yield rose from 1.8% to 2.45%, anticipating higher inflation and rate hikes. Corporate bond spreads tightened, and high-yield bonds performed well due to expected economic growth prospects.

Commodities

Gold prices initially rose due to uncertainty leading up to elections but fell post-election. Oil prices increased due to OPEC production cuts and anticipated higher energy demand from Trump’s policies.

Currency

The US dollar strengthened post-election, with a 3.6% year-to-date increase.

Conclusion

In summary, while elections introduce uncertainty and short-term volatility, it is essential to focus on the underlying policies that will shape economic and market conditions, rather than simply headline news on who the winner is.

Bonds

With markets currently pricing 69 bp of rate cuts for the remainder of the year, further labour market cooling will likely be required to justify a faster pace of Fed easing. This probably leaves the market in a wait-and-see mode heading into the 31 July FOMC meeting. Until then, expect Treasury yields to remain rangebound. While US election risk remains in focus, recent rates market reactions to Trump’s odds of winning have been short-lived, possibly due to uncertainty around policy details, including the timing and form of tariffs vs tax cuts. The change in the Democrat presidential candidate also constrains the level of conviction on the ‘Trump trade’. We are inclined to maintain shortened duration of bond portfolios.

India’s newly elected government presented its first budget, which focused on fiscal consolidation, targeting a fiscal deficit of 4.9% of GDP in 2024-25, lower than the interim budget’s target of 5.1%. The target for FY26 remains at 4.5%. This has been mainly supported by a projected 11% year-on-year increase in net tax revenue for FY25. On the expenditure side, the government continues to focus on infrastructure development with capital expenditure at 3.4% of GDP for FY25, compared to 1.7% of GDP in FY20 after PM Modi returned to power for a second term. Ports and railways sectors are potential beneficiaries of this higher infrastructure expenditure. We are inclined to position in issuers that demonstrate improving credit trajectory and access to financing onshore.

The Hong Kong USD property developer sector delivered a relatively decent 4.9% year-to-date return despite the still challenging fundamental sector backdrop. The performance reflects improved technicals and support from parent stakeholders. Favourable policy changes and new-home price discounts drawing homebuyers have helped offset elevated mortgage financing rates and office vacancy overhang. For higher quality issuers, lower rental income is still sufficient to cover debt servicing. Weaker developers are staying the course on deleveraging, mitigating some risk in the event fundamentals fail to improve during the later part of the year. We are inclined to position in high yield developer perps with near-term refinancing visibility.

Hong Kong Office Vacancy Rate Remains High

Source: Bloomberg Finance L.P.

Equities

The Nasdaq Index has experienced a notable correction, driven by the quarterly results of the first few companies in the “Mag7” group. Investors were keen to determine whether the high valuations of these stocks were justified, given their significant influence on the markets. The Index corrected approximately 10% from its peak in July, with the Technology sector experiencing the sharpest decline of 15%, followed closely by the Communications sector. The Consumer Discretionary sector also faced a notable reduction, declining by 11%.

Despite the recent pullback, we observe that the Technology sector remains overvalued by approximately 20% in terms of its historical 3-year PE average, even after an 18% drop in its weighted PE ratio since the peak. Given this scenario, investors who were previously underweight in tech may consider gradually building their positions and engaging in tactical trades. However, caution is advised, as the remaining “Mag7” companies are set to release their earnings this week. Unless these companies exceed estimates and provide a positive outlook, along with a dovish stance from the FOMC, further corrections are possible.

Recently, US stocks rose following the release of the Core PCE Index, the Fed’s preferred inflation gauge, which indicated contained price pressures. This positive data could signal an easing of monetary policy by September, potentially providing some relief to the markets.

We have also observed a general money flow towards defensive sectors, with particular attention to healthcare, as its current PE ratio remains below the 3-year average. Investors should be cautious of a potential sector rotation should the “Mag7” report poor earnings or outlooks, coupled with a hawkish tone from the FOMC.

In conclusion, despite the majority of companies reporting earnings beats (around 80%), high market expectations have led to valuation dislocation, and we should anticipate further volatility. We remain inclined to position ourselves in key AI tech-related sectors, which are expected to benefit from current tailwinds. However, we maintain a cautiously bullish stance on the US market, anticipating heightened volatility as we approach the US election.