How Investors Can Hedge November’s Election
As the 2020 US presidential election approaches, anxious investors seek protection against increasing market volatility. Since traditional “safe-haven” assets such as gold and U.S. Treasuries fail to provide protection against stock market losses, traders should consider a range of different hedging strategies to cushion against any losses in the election’s lead-up and aftermath.
The S&P 500, a gauge of 500 large-cap US companies, fluctuates more frequently in election years that non-election years as uncertainty rises. While the stock market has historically returned an average of 8.5% a year, in election years this decreases to six percent, leading to reduced earnings potentials. Primarily investors fear that delayed or contested results could upend markets. As more people opt to vote by mail due to the coronavirus pandemic, officials might spend more time processing the ballots, which could disrupt results. Moreover, President Donald Trump’s continued assault on mail voting and his refusal to accept election results aggravates uncertainty in the market.
“We could see a protracted post-election struggle in the courts and the streets if the results are close,” warns Professor Richard L. Hasen at the UC Irvine School of Law. “The kind of election meltdown we would see would be much worse than 2000’s Bush v. Gore case.” When no clear winner emerged from the presidential election of 2000, the stock market to plunged by 1.6%. To protect their portfolio against a similar market drop, traders should find new hedges, such as emerging market currencies and bonds, to prepare for possible volatility.
Historically, investors have sought shelter in traditional “safe havens” like gold and Treasury bills in times of market instability. The recent economic turmoil caused by the coronavirus pandemic, however, changed the role of these traditional asset types. In September, gold prices plunged by more than five percent, sinking to under $1900 per ounce, marking their lowest finish in two months. Meanwhile, 10-year Treasury yields remained steady due to the Federal Reserve’s open-ended asset buying programme which reduced fluctuations in this market. At the moment, the 10-year treasury yield is below one percent, making it harder for investors to generate as much income from this security. Since there is so much volatility in the stock market and relatively no volatility in the bonds market, treasuries act as a less reliable hedge. Moreover, the Fed’s willingness to tolerate rising inflation poses a negative effect on bonds as inflation can erode their value.
Traditional “safe haven” assets offer little protection nowadays in times of relative volatility. “For those looking for hedge protection, this typical basket of defensives is functioning about as well as fire insurance that covers just one bedroom in the house,” indicated JP Morgan analysts. “The performance of safe assets this September has been the worst in at least a decade during a major equity market drawdown.” As traditional “safe havens” have performed mediocrely, investors must find different hedging alternatives to limit their downsides in the upcoming election results.
Many investors look to profit from volatility and to hedge against a potential market sell-off by purchasing future contracts for the CBOE Volatility Index – or VIX, which is commonly referred to as the fear index. Currently, the VIX futures curve is in backwardation, signaling that investors expect much more volatility in the shorter-term, in the months after election day. Strategist Garrett De Simone advises that “this front-month, higher level of volatility should drop relative to the back month, providing a very profitable short volatility trade for those investors willing to take the risk.” Although future contracts can help investors profit and brace against a possible election turmoil, the rising costs of these derivatives, caused by traders seeking to hedge against uncertain presidential elections, oblige many of them to consider other instruments.
Another approach involves emerging market currencies, whereby traders place bets against currencies such as the Mexican peso, Turkish lira, and Indonesian rupiah —which move in tandem with risky assets like stocks — and profit from their depreciation as a hedge against falling stock prices. Pilar Gomez-Bravo, a director of fixed income in MFS Investment Management, asserts that she has profited from US stock prices dropping in September by betting on the Australian dollar and the Norwegian krone falling since they are correlated with the US stock market. In comparison to purchasing VIX future contracts, which are trading at a premium, investors can profit from FX volatility since it is less expensive to own.
While emerging market bonds are riskier than US government bonds, they still offer the potential to offset equity risk and the possibility to profit from higher yields. Chinese bonds, which are the second largest bond market, offer yields close to three percent over US Treasuries. Instead of solely relying on Chinese bonds, risk adverse investors can consider a “basket approach” that provides even more diversification opportunities, whereby they have access to high-quality bonds in various emerging countries like Singapore, Peru, and Israel. PIMCO analysts advise that this strategy better imitates the US bond market, which can offer ample opportunities to hedge against the upcoming election chaos.
The unknowns of the upcoming presidential election worry investors who can no longer flee to the safety of bonds or golds. As many revaluate the role of traditional safe havens and as the costs of VIX future contracts continue to rise, risk-averse investors might wish to consider alternative instruments like emerging market currencies and bonds to hedge against the stock market volatility following the election results.