In Depth

Humble in Hofstra...One Debate an Election Can Make

Sep 26 2016 | 10:20am ET

Humble in Hofstra...One Debate an Election Can Make
by Neil Azous

Tonight's U.S. Presidential debate, infamously coined the “Humbling in Hofstra” by Mark Cuban, has the potential to reshape the world. Unlike the adage “one stock a market does not make,” our view is that “one debate an election can make.”

At the top-down investment level, this event will dictate asset prices over the next 72 hours more than any other catalyst. For the reasons we will layout below, our bias is to be short risk assets or hedged going into the event. 

Additionally, the event will kick-off a greater rebalancing exercise at the sector, industry, and single stock level which might take a few weeks to find an equilibrium.  

The Debate Setup

Firstly, this is an advertiser’s dream as over 100 million people are expected to tune in, the largest ever for a US Presidential debate.

The debate will run from 9 to 10:30 p.m. ET at Hofstra University in Hempstead, New York. 

Baby Boomers, Generation X, and Generation Y, can watch the debate on C-SPAN, Fox, ABC, NBC, CBS, Fox News, CNN, and MSNBC. 

It will also be streamed live on various social networks. That way, the millennials who cut-the-cord from networks have an opportunity to follow along as well.

Secondly, it is important to recognize the extreme view that non-US citizens take on Donald. J. Trump. They view Trump in a similar vein as the Dear Leader in North Korea – that is, highly concerned over the prospects of his ascent on the world stage and having access to weapons of mass destruction.

The key point here is that if there is going to be a change in viewpoints on Trump, it will be for the better, as it cannot get much worse internationally.

Finally, the political strategists, already bruised from being wrong on Trump for 18 months, are struggling to pinpoint what a win or loss looks like for either candidate in advance of tomorrow night’s debate. 

As evidenced by the widespread views expressed on the various Sunday morning talk shows this morning, they are all soul-searching at the moment.

The conclusion, especially after a surprise ‘Brexit’ outcome, is that paid forecasters, political strategists, media persona, and politicians are worthless in shaping sentiment and helping investors construct their portfolios.

Our View

Allow us to put one simple view forward.

Back on August 4th, pollster, and strategist, Frank Luntz said to Fox News in an on-air interview that if the election is about Trump, Hillary wins. Conversely, if the election is about Hilary, Trump wins. And, they both want it to be about Trump.

Fast forward to today and the argument still stands – Trump has to fight his natural instinct to be the story at tomorrow’s debate.

Put another way, if HRC remains the story for the rest of the run-up to the election, Trump’s momentum continues to build and the odds of him being victorious rises.

Validation of Our View

So how will we know if this simple view we just put forward is correct? Or, is there a way to see if Trump’s momentum from mid-August will carry over after tomorrow’s debate and into October?

The answer is YES.

Just like Trump took down 16 other opponents in the Primaries, we will see if he can topple a currency – the Mexico peso (MXN).

It is pretty clear that MXN has already watched the preview to the debate. Otherwise, it would not have traded at an intra-day all-time high last Friday.

Pause: Before we move on we want to emphasize the following. This observation is primarily for readers who do not follow currencies or emerging markets.

  • The Dollar-Peso (USD/MXN) currency cross trades on average $128 billion per day (Sources: BIS, Bloomberg). If you add in the related derivatives that trade on the MXN, the notional turnover is significantly higher. To put the degree of that volume in context, the NYSE equity market notional turnover is less than $75 billion per day.
  • What we are saying is that MXN is not an idiosyncratic currency situation like we saw this summer with the Turkish lira (TRY) in response to the failed coup attempt. As the #1 source of liquidity in emerging markets, especially in times of stress, it can impact a larger risk construct in the markets.
  • The point we are trying to make is that the very safety valve that professionals turn to in most cases when things go bad in emerging markets is the one instrument with the greatest risk.

Now, a lot of professionals we speak to believe that this is a sell-the-news event in USD/MXN and that the peso has weakened too much in advance of the election. 

Additionally, many are looking for an interest rate hike, currency intervention, or a combination of both, at this Thursday’s Banco de Mexico’s monetary policy meeting to support that view. 

We do not have a strong opinion on the meeting itself. However, we would say the following. 

Bets have been laid out already in Latin America. For the next 12-months, the interest-rate swap curves are pricing in rate hikes in Mexico and cuts in Brazil, Chile, and Colombia. 

Put another way, to say that investors have not already discounted these interest rate hike expectations already on account of the weaker currency would be misguided.

The key point here is that the risk is now for a disappointment from the central bank on Thursday, not action, as the action is already expected. 

That said, we think focusing on a “sell the news” event or the central bank’s actions is the wrong way to look at the peso. 

What matters is the next 72 hours. Besides, when it comes to emerging market currencies, five days until a central bank meeting with a major catalyst in between might as well be light years away. 

In fact, there is a strong case to walk in long on the USD/MXN despite how much the price has already moved higher on account of the risk associated with a Trump victory.

The case boils down to one risk factor – USD/MXN remains “convex.”

What we mean by “convex,” as sketched out above, is that we can see how Trump wins the debate, but have a hard time seeing how he loses it.

Meaning, every time he got lambasted in the Primary debates, either by a candidate or media persona, he polled BETTER in the days that followed.

If Trump does indeed control his natural instinct to be the story at tomorrow’s debate, then you have what is referred to in emerging markets as “liquidity convexity.” 

If you are wrong, you will be able to sell out of your long USD/MXN position, but if you are right there will be a significant illiquid spike higher in USD/MXN during the Asian night session.

And if even higher prices in USD/MXN sticks overnight, the professional community will be trading a Trump victory regardless of what some political strategist tries to spin to you on a media channel that pledged their allegiance to HRC way back when she came out of the womb. 

Validation of Our View Has Legs

We would like to point out one more “sticking point” should what we described above materialize.

What we mean by “sticking point” is that a positive performance by Trump is not a one-day event. A win by him has legs. The key point here is that the first debate has a large impact on sentiment in the polls.

See the table nearby for two-party presidential polling before and after the first presidential debate between 1960 and 2012. The table validates this view further.

The source of this table comes from Sabato’s Crystal Ball. On the About page, here is the opening description of this organization:

A comprehensive website run by the University of Virginia’s Center for Politics, Larry J. Sabato’s Crystal Ball features detailed and frequently updated analysis for elections across the country. The Crystal Ball keeps tabs on presidential elections, along with every Senate and gubernatorial race, as well as the tightest campaigns for the House.

The table is based on an average of the two-party presidential vote in polls in the week before the first debate and the week after. If the second debate fell inside the week after the debate, the period after the first debate was measured up to before the second debate date. The information is based on data collected by Robert Erikson and Christopher Wlezien for The Timeline of Presidential Elections. For easier comparisons across time, the data exclude third-party and independent candidates’ percentages.

The Trump-Unknown Borne Out in U.S. Dollar Strength

As you can see in the above table, the first debate matters and can have legs. 

Many have argued that a Trump Presidency would be bullish for the U.S. Dollar. 

The basis for that argument is that all three of Trump’s signature policy proposals – increasing deficit-financed infrastructure spending, a more restrictive immigration policy, and trade protectionism – are perceived as US dollar bullish. 

If you add in the second-tier proposals, starting with the repatriation of foreign profits that Trump recently proposed to be taxed at 10%, it is easier to understand why a strong performance by Trump tomorrow night is supportive for the US dollar.

With that in mind, the question becomes how does the broader risk construct react to the following?

  • The USD/MXN trading up to 22.00 or +10% higher by Wednesday.
  • The Canadian dollar, the other currency in North America most reactive to the reevaluation of NAFTA, also weakening and breaking the recent rectangle on the chart. 
  • China-related proxy volatility – the Dollar-Yuan (USD/CNH), Apple Inc. (AAPL), Nike (NKE), etc. Trade protectionism or the start of a trade war is the basis for the short US multi-national equity call on account of Trump threatening a 45% tariff on Chinese goods. You decide – does America levy a new tax on iPhones since they are manufactured in China? Or would China fight back on account of Apple having its headquarters in California?

The list could go on but at this point, it will be visible to the naked eye that the bid-tone to the US dollar starts on account of the Trump-unknown heading into the November vote.

The key point here is that this bid-tone in the US dollar, should the positive Trump outcome materialize, will coincide with the return of yield curves flattening. 

Additionally, at a minimum, we struggle to see how risk assets perform well tomorrow as professionals add a layer of short risk positions, hedging strategies or just shed some long risk.

The view on adding a layer of short risk positions or hedging strategies, or shedding some long risk has nothing to do with being bullish or bearish. It is on account of being responsible, especially after being caught off guard by ‘Brexit.’ Being caught with your pants down once like everyone else is forgivable by an investor, but being caught with your pants down twice in a four-month period makes you irresponsible, and prone to your assets under management being redeemed for poor risk controls.

 

Neil Azous is the founder of Rareview Macro LLC, an independent research firm, and editor-in-chief of Sight Beyond Sight, a financial newsletter built for global macro investing.


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