This year has played out two spellbinding narratives. The world’s capital markets have crashed and compelled us to ponder whether the end of capitalism is near. Meanwhile, the electrifying U.S. presidential election has transformed American voters from political apathy to activism.
How these two narratives closely entangled is revealed by John Authers, Financial Times’ investment editor, by comparing a chart of the S&P 500 Index with charts from political prediction markets. For months now they have been closely aligned. Judging by Intrade and the Iowa Electronic Market, John McCain's chances hit bottom and he began a two-month recovery on July 15 - the day that the S&P also hit a bottom and began a rally for the summer. It is not a secret that Republican Party’s candidate has been the Wall Street’s favorite historically.
Nevertheless, futures markets have pointed to the opposite direction as the election comes to its end. The odds are against McCain according to the futures contracts. For those who bet on McCain to become the U.S. president, the residual value of every dollar they put in is only worth ten cents now. In other words, the futures markets predict that McCain’s chance to become the U.S. president is less than ten percent. What caused the change in market sentiments to endorse a candidate from the political party deemed unfriendly toward the markets?
The early sign came in right after the demise of Lehman Brothers. The collapse of Lehman Brothers in September came as Mr McCain's chances had reached a plateau. Then, as Americans beheld the worst financial crisis in two generations, the odds on Barack Obama took off. Meanwhile, lately released economic data show mixed signals about the U.S. economy. The ISM index has fallen consecutively to 38.9 point from 43.5 point, indicating a deeper economic contraction. Yet, the value of dollar remains strong despite the dire prospect of U.S. economy or the ‘market-unfriendly’ policy proposed by Obama’s campaign. The dollar has surged along with the rising expectation for Obama’s bid for the White House. The correlation seems strong but what is the causation? Here are the possibilities.
First of all, the specter of recession preconditions the policy environment. The markets predict that Obama’s proposal for healthcare and unemployment insurance are too costly to be implemented even if he is elected as the President. Given that tax increase is political impalpable, the new administration is likely to issue more debt to finance the rising deficit. With foreign creditors such as China vehemently articulate their discontents over the sustainability of dollar assets, mostly Treasury bills. These countries are actively diversifying away from dollar assets. Therefore, the demand for T-bills will unlikely to sustain in the long run. This in turn will force the administration to scale back, if not scrap, the policy proposal that they simply cannot afford to pay for.
As the economy continues to contract, deflation has become more a concern than inflation. This gives more room to taunt the stimulus plan to expand infrastructure to stir the economy. Either McCain or Obama has spoken favorably for infrastructure expansion in their economic policy proposals.
Secondly, perhaps also the most neglected fact, is that Americans are buying the dollar as much as the foreign investors. Dollar has become the de facto hedge for everyone. According to a recent study, there is an inverse relationship between Dollar index and the overall weights of foreign companies in the portfolios of the mutual funds registered for sale in the United States. For example, the Dollar index falls as fund managers increase their holding in overseas companies in their portfolios to 26%. Similarly, the Index rises as these managers reduce it to 23.5%. Lately, these fund managers have been buying dollars. As the risk aversion prevails in the markets, the demand for dollar remains strong and buffets the value of dollar consequentially.
Last but not the least, this financial tsunami calls for a revision of the role of government in the market. The bailouts from the governments rescued the markets from self-fulfilling, downward spirals. It is a wakeup call for a capitalist economy like America with an embedded bias toward the role of government. The Republican Party has known for its laissez-faire approach and the Democratic Party tilts toward a bigger role of the government. As the governments’ initiatives effectively stopped the markets from hemorrhaging, investors grew to view the role of government differently and adjust their political preference accordingly.
On the other hand, deregulation in the 70s implicitly encouraged the financial leverage and prompted the spectacular growth of credit in America. Without disclosure requirement, the lack of transparency in derivatives also exposed the markets to systematic risk in the long run. Overtime, the complexity of financial instruments has grown to the extent that the risk of underlying assets is constantly underestimated, especially for securitized and structured products. Against the backdrop of financial turmoil, the Democratic Party’s call for financial regulation arrives as a necessary protection for the investors rather than an unnecessary intervention in the markets.
