Preparing for Rising Volatility
The second half of 2024 could see the current, localized election-related volatility go global.
When the Asset Allocation Committee met back in March, its outlook was optimistic.
Declining inflation had combined with a resilient economy. The coming 12 – 18 months offered the prospect of interest rates being cut against a backdrop of high and stable nominal growth—a very positive environment for risky assets.
The AAC has just reconvened to set out its third-quarter views. The recent cooling in U.S. inflation and jobs data has lifted the final cloud from our economic outlook, but our market and asset allocation views remain neutral at the broad asset class level and tilted to quality.
While we continue to see a reasonable probability of our relatively positive core economic scenario playing out, we also believe that the tails of potential market outcomes, particularly over the next six to 12 months, have become longer and fatter. In addition to the existing risks around stretched valuations on many markets, as well as geopolitical tensions and conflicts, we are concerned that the Federal Reserve may wait too long to cut rates, we anticipate heightened election risk, and we see limited pricing by investors for either scenario.
In the immediate term, we think risk premia are too tight and volatility is too low.
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Political Tremors
Which is not to say that volatility has been completely absent. It is out there, and it has been making appearances at the epicenters of political tremors.
The opening days of June saw three big elections results. The African National Congress (ANC) lost its parliamentary majority in South Africa for the first time since the end of apartheid. Claudia Sheinbaum was elected to continue the left-wing agenda of Mexico’s National Regeneration Movement with an unexpected landslide. And Narendra Modi’s Bharatiya Janata Party lost its parliamentary majority in India.
The JSE FTSE All Share Index of South African stocks dropped 5% as it became apparent that the ANC’s vote had fragmented into centrist, populist and hard-left groups, before a coalition agreement between the ANC and the centrist Democratic Alliance set off a robust recovery. The Mexican peso, a carry-trade favorite, has plummeted by 10% since Sheinbaum’s win. And India’s Sensex Index experienced daily swings of 3 – 5% as final election results sharply contradicted early exit polls.
Days later, elections for the European Parliament were underway. As Patrick Barbe and Ugo Lancioni wrote last week, the shock came not from the hard-right gains in these elections, but from President Emmanuel Macron’s decision to call a snap domestic vote in France, giving the Rassemblement National party a potential path to power.
The CAC 40 Index fell by 6% in one week. The spread of France’s 10-year bond yield over Germany’s has widened by more than 25 basis points. Risk premia are being priced back into eurozone peripheral bonds, too, with Italy’s spread wider by some 20 basis points.
Close and Not-Close Elections
The picture is very different in the U.S. market, even though, in less than five months, the U.S. must choose between two candidates for President and two parties with very different programs, in a vote that remains very contentious and too close to call.
The S&P 500 Index is pushing through record highs, and implied volatility for U.S. stocks is close to a 12-month low. This calm was the subject of an interesting note from Goldman Sachs showing that global ex-U.S. equities have been more than twice as volatile as U.S. equities over recent weeks, marking a new five-year high. Looking ahead, Goldman Sachs notes that implied volatility for global equities is 1.5 times higher than for the U.S. market. In addition, credit spreads outside of the eurozone periphery have barely moved.
However, it is possible that investors simply haven’t yet focused attention on the November election.
Raheel Siddiqui, our Senior Investment Strategist for Equities and an AAC member, has been looking into S&P 500 Index performance during U.S. election years since the Second World War, and has found a distinct difference between elections that are close and those that are not.
When elections are not close, the economic backdrop and the business cycle appear to determine market performance and the average pattern is a steady drift upward over the course of the year. When the election is perceived to be in the balance, however, average performance has followed a similar pattern of upward drift until September, at which point it has tended to deteriorate meaningfully and become more volatile.
A recovery usually follows once the result is clear, but the median peak-to-trough decline has been around 3%.
Localized Volatility Going Global
Along with many others, we came into 2024 noting that a record-breaking year for elections could be a source of market volatility. Since then, France has added yet another high-temperature vote to the list and, if anything, the localized volatility has exceeded our expectations. With the main event still to come, and with history as our guide, we see meaningful risk of that localized volatility going global.
This and other near-term tail risks inform the AAC’s broadly neutral views, and its search for appropriate portfolio diversifiers, in its forthcoming third-quarter Outlook. Stay tuned for its release in the first half of July.