Wall Street is pricing in a landslide victory for Hillary Clinton, but if she starts to lag, there could be a big unwinding of stock and bond market positions, according to Bank of America Merrill Lynch's David Woo.
Woo said the market is also pricing in a split Congress, with Republicans controlling the House and Democrats the Senate. That would maintain the deadlock in Washington.
"You have a Democrat president, and a Republican controlled Congress which means you have gridlock in Washington. The market is pricing in this gridlock, meaning it's going to be that much of the burden of supporting the economy falls on the Fed," said Woo, head of global interest rates and foreign exchange strategy. That makes it harder to get agreement on changes in tax policy or for fiscal spending that could help the economy.
Woo said gridlock makes it hard for the Federal Reserve to raise interest rates very much, and that means the U.S. markets would continue to feel the benefits of the quantitative easing being done by other central banks. Central bankers in Europe and Japan have driven interest rates lower or negative, and investors have flocked to the U.S. credit and stock markets. Woo said that environment has led to the dominance of the risk parity trade, where investors see conditions that favor both stocks and bonds.
"The market is pricing in gridlock and Goldilocks, and the gridlock is good for risk parity. The point here is as we go into Election Day, whether you're basically supporting Hillary or Donald Trump, it doesn't matter. History tells us volatility goes up in the final stretch. The VIX has always gone up in the final month. It's a general rule, rather than exception," Woo said. That could create some unwinding of positions, but a jump in the polls by Trump could also have an impact.
"I'm not saying a market crash, but we could get a jolt, more than a jolt," he said. Risk parity portfolios are favored by hedge funds and can be highly leveraged. Woo said the volatility market is underpricing the election risk.
"My point here is there's a very good chance Hillary's lead is going to narrow and volatility is going to go up as we head into September and October. That is going to be a shock to the market, and risk parity trades hate volatility. We saw that on this past Friday — bonds sold off and stocks sold off. That's the kind of situation that becomes self-fulfilling," he said.
"Woo said there were two instances in the past five years where there was a big unwinding of the trade — in the 2013 "'taper tantrum" and last August when China devalued its currency.
"If you think about the most crowded trades in the world right now, the most crowded trades are risk parity trades," he said. "The biggest positions are risk parity positions and it's done on a very leveraged basis."
Woo said market history points to the potential for a huge Clinton victory. Ahead of presidential elections since 1960, the stock market behaved very differently when the presidential candidate won by a wide margin versus a narrow margin of Electoral College votes.
In the 90 days leading up to the election, the was up an average 8.4 percent when the candidate won with a margin of more than 80 percent of the Electoral College, according to Woo.
Those instances were in 1964, when Lyndon Johnson was elected, 1972 with Richard Nixon, and both victories by Ronald Reagan in 1980 and 1984. But when the margin was less than 20 percent, like in the 1960 election when John Kennedy was elected, 1976 when Jimmy Carter was elected or in both elections of George W. Bush, the S&P averaged a slightly negative return.
"Since July 5, the S&P has gone up about 4.5 percent. We're now at the midpoint mark of this 90 day rule. The last time the stock market was up this much at the halfway mark was when Ronald Reagan went on to defeat Walter Mondale in a landslide victory. The market is not only pricing a Hillary victory. The market is pricing in a landslide Hillary victory," said Woo.
Woo said there's a consensus view on Wall Street that Trump would be bad news for the market, and that he would bring on a trade war with China. "I don't believe that Trump is necessarily bad for business, " he said.
"The only thing we could say about a Trump victory is a lot more fiscal stimulus. If half the stuff he's talking about is true, the economy would take off. This would be the first time you get a fiscal stimulus when you're not in the middle of a recession," he said. "If we get a Trump clean sweep, this would be very bullish for the U.S. dollar but also very bearish for Treasurys."