Market fluctuations galore as US election uncertainty builds

New analysis from Franklin Templeton company, Brandywine Global, has signalled a time of severe market fluctuations ahead due to uncertainty surrounding the outcome of the U.S. presidential election later this year.

Paul Mielczarski, Head of Global Macro Strategy at Brandywine Global, said G10 government bonds are looking somewhat favourable for investors.

“We expect slower nominal gross domestic product (GDP) growth across G10 economies. In turn, this slowdown will enable central banks to lower policy rates from restrictive levels, supporting bond market returns. Moderation of US growth together with less restrictive Fed policy should be negative for the US dollar.

“However, the market outlook is clouded by high policy uncertainty ahead of the US election. In the coming months, market fluctuations will become increasingly driven by opinion poll shifts. In our view, the most consequential uncertainty is around future US trade policies.

“When it comes to portfolio strategy, it is unclear if risks associated with election uncertainty are adequately compensated. Therefore, reducing portfolio risk may be prudent. Additionally, we believe it makes sense to focus on positions that stand to gain from the medium-term economic outlook and are less likely to be impacted by the US election outcome.

“We favour G10 government bonds, focusing on the U.S. and U.K. With inflation moderating across developed market economies, central banks in the eurozone, Canada, Sweden, and Switzerland have already cut policy rates. The Fed is priced for 175 basis points (bps) of rate cuts over the next three years.”

The macroeconomic update also suggested that, despite the uncertainty caused by the election, the U.S. central bank will deliver on market expectations regarding its plans to loosen rates.

“If our inflation view is right, the Fed should be able to deliver what is priced into the money market curve, starting with two 25bps cuts later this year. It is very unlikely that the Fed will need to hike rates again in this monetary cycle. But we could see a number of scenarios in which policy rates are cut more aggressively than what is priced in.

“In the event of a deeper slowdown in growth or a large sell- off in risky assets, bonds offer an attractive asymmetry and portfolio protection. We believe that any bond market sell-off resulting from a Republican clean sweep in November would be short-lived. The extension of Trump’s 2017 tax cuts is already expected by investors.

“It is unlikely that we will see significant net easing of fiscal policy, especially if broad-based import tariffs are imposed. A small minority of Republican senators could limit fiscal policy flexibility and block potentially unorthodox central bank appointments. A large negative shock to global growth would more than offset the short-term inflationary impact of tariffs.

“The outlook for currency markets is more complex. On one hand, the USD is expensive across a range of valuation measures. The U.S. economy is slowing and possibly converging with other developed market economies while the Fed is about to cut interest rates. These factors would argue in favour of being short the dollar.”

However, if Donald Trump were to win the election later this year, the U.S. dollar could see growth under a leader prioritising domestic over international.

“We have reduced our USD short position, in part due to the uncertainty related to the U.S. election. We also continue to like local currency bonds in Mexico, Colombia, Brazil, and South Africa. While bonds in Mexico and Brazil have recently underperformed due to medium-term political concerns, these markets and others offer historically attractive nominal and real yields. South African bonds have benefited from the formation of a national unity government.

“Abstracting from political uncertainty, macro fundamentals for emerging market (EM) local currency bonds are generally supportive. Inflation across EM continues to trend lower. The Fed monetary easing cycle should allow EM central banks to gradually normalize still elevated policy rates. We generally believe EM bond markets are less vulnerable to U.S. election shocks than EM currencies.

“Corporate bonds have benefited from strong inflows into credit products with investors focusing on attractive all- in yields. However, investment grade and high yield credit risk premiums are now low, and corporate bonds could be vulnerable to potential economic or market shocks.

“Opportunities remain within credit given the high all-in yields, but careful selection and active management is imperative.

“From a broad asset allocation perspective, we prefer U.S. agency mortgage-backed securities, which offer attractive spreads but with more defensive portfolio characteristics.”