The final countdown

Markets hate nothing so much as uncertainty. With weeks to go before Election Day in the US, the jitters are evident in the markets for volatility premiums, rates and foreign exchange (see Chart 1). That said, the last few days have seen relatively benign moves in asset markets on the back of polls and shifts in betting market odds, which are pointing towards a significantly clearer election outcome (rightly or wrongly) than was the case in late-Sept. 

While no close-fought contest is truly predictable (remember the polls going into the 2016 US presidential election?), this alone shouldn’t be unnerving. Instead, what is different this time - and fairly unprecedented in modern history - is the tremendous amount of pre-emptive uncertainty over how and when the winner of the 2020 presidential election will be determined. 

The tail risks are material. The Covid-19 outbreak, sharp recession, and extreme political polarisation have all raised the stakes should the Nov. 3 vote produce an unclear, delayed or disputed outcome in the contest between President Donald Trump and former Vice President Joe Biden. The heavy share of mail-in voting due to the pandemic (and voting channel preference centered on partisan lines) coupled with extreme polarisation are major drivers behind why 2020 is shaping to be very different from previous elections.  

In the face of this highly fluid and uncertain situation, we share a framework-based approach to understand both the source and nature of tail risks,  which could manifest themselves in the coming weeks.  

All eyes on Nov. 3 (and then on Dec. 14)

We see the US election tail risks mainly as a function of: 1) the margin of victory, and 2) time to clarity on the election outcome as laid-out in the scenario matrix table below. 

History offers a number of precedents involving delayed or contested results, including the highly disputed presidential election of 1876, which was resolved through negotiation between the Democratic and Republican parties two days before Inauguration Day. Loopholes and ambiguities in the US electoral process add a layer of complexity to the scenario building. On balance, if the Nov. 3 contest does not produce a clear winner, we think the date to focus on is Dec. 14 (the electoral college convention), as responsibility for deciding the election outcome then passes to Congress. 

Markets currently project at least an 80 per cent probability that the election is resolved by Dec. 14, and while something like a repeat of a Bush vs. Gore scenario would cause market volatility, the prospect has recently been considered by many market participants. In any case, indications are pointing toward a clear winner emerging by Dec. 14.  A scenario that stretches beyond that date is a more distant prospect (for example, markets currently assign less than 8 per cent probability to something like a ‘Scenario X’), but a more drawn out process would magnify and prolong investor uncertainty together with constitutional and procedural uncertainties, and has potentially far graver implications for the direction of the US economy and markets.

 
The five scenarios in detail (plus a ‘Scenario X’): 

Scenario 1: Election night winner

• The outcome is clear as of Nov. 3
• Easily the most straightforward and least disruptive outcome, this scenario consists of one candidate winning an overwhelming margin in key states, based on in-person votes and mailed-in ballots counted ahead of Election Day. Everything happens on Nov. 3: a winner is announced, the loser concedes, and there is a clear electoral college victory (most likely a landslide in this scenario). 

Scenario 2: Election week winner

• Outcome becomes clear by Nov. 10-14, after 7-10 days of counting mail-in ballots to determine electoral college vote allocations
• In this scenario, the results of the election would not be immediately clear on Nov. 3, but would emerge after electoral officials spend the following 7-10 days tallying mail-in ballots. This implies that inclusion of the additional ballots yielded a clear victor based on the allocation of outstanding electoral votes (this could be by a landslide or by a close margin) and, importantly, that the loser accepts the outcome and concedes. We estimate the result could be achieved by November 10-14 in this scenario. 

Scenario 3: Bush vs. Gore redux

• A close race and litigation over ballot counting causes delays, which are resolved in the federal courts in time for the electoral college deadlines (Dec. 8, Dec. 14).  As a result, the election is resolved and a winner declared by Dec. 14.
• No clear winner emerges on Nov. 3, while tight voting margins and ambiguous counting procedures lead to widespread legal challenges by both parties. As during the Bush vs. Gore election in 2000, we expect to see prompt decisions from state and/or federal courts to help facilitate a quick resolution. Most likely this would go all the way up to the Supreme Court which, as in 2000, would aim to resolve disputes by the electoral college deadlines (Dec. 8 is the ‘safe harbor’ legal provision date and Dec. 14 the date of the actual meeting of all electoral college delegations), whereupon the loser would accept the result and concede. 

Scenario 4: Hayes vs. Tilden ‘short version’

• Litigation over ballot counting remains unresolved by the electoral college deadlines; Congress receives competing electoral results, but agrees on an election outcome on the statutory date of Jan. 6.
• In this scenario, despite best efforts by the state and federal courts, Congress receives contradictory sets of electoral votes by the electoral deadlines of Dec. 8 and Dec. 14, and meanwhile neither candidate has conceded. While rare, similar circumstances occurred back in the 1876 presidential election when Democrat Samuel J. Tilden captured a majority of the popular vote over Republican Rutherford B. Hayes, but several of the electoral vote counts were disputed. In the ‘short version’ of such a standoff, a joint session of the newly sworn-in Congress is called for Jan. 6 to determine which set(s) of electoral votes to accept, resolving the dispute(s); the ballots are then counted, and a winner declared the same day.

Scenario 5: Hayes vs. Tilden ‘long version’

• Same as above, except that the Senate and House cannot reach agreement and appoint a bi-partisan electoral commission. That commission resolves the election outcome by Inauguration Day, Jan. 20.
• Same standoff as above, but in this scenario, the joint session of Congress on Jan. 6 cannot reach an agreement on the disputed electoral votes. Instead, as in the 1876 election, to avert a constitutional crisis the Senate and the House agree to set up a bi-partisan electoral commission. This commission reaches its decision and resolves the disputed votes in time for Inauguration Day (Jan. 20). 

Scenario X: The unthinkable

• No winner, or a disputed winner, is declared by January 20. This includes a scenario in which an unelected actor is sworn in as ‘acting President’.
• The same as Scenario 5 up until Inauguration Day, but then, despite the electoral commission’s efforts, an agreement acceptable to both parties is not reached by Jan. 20. 
• Options from here might include the swearing-in of an ‘acting President’ (perhaps House Speaker Nancy Pelosi or Vice President Mike Pence). Failing this, a power vacuum would arise after President Trump’s first term in office ends on Jan. 20, under the requirements of the 20th Amendment of the Constitution. There are no historical precedents for such an ‘unthinkable’ scenario beyond Jan. 20. In addition, the Constitution is completely silent in terms of what happens next if such a scenario occurs. 

Conclusion

At the moment, the market sees anything resembling the more extreme scenarios above - No. 4, No. 5 or Scenario X - as very distant possibilities, and is not pricing these in. In addition, market moves in recent days suggest the likelihood of a clear outcome has risen as the wedge between polls and betting markets has narrowed. That said, 2020 has been a year of seemingly unrelated tail risks mixing together. For investors, the above framework is a useful tool to have handy as we move closer to Nov. 3. 

Overall, looking at the current levels of global asset markets, US presidential election outcomes (and increasingly, the implications for the fiscal and regulatory policy configuration after Jan. 20, 2021) seem to be one of the main factors now shaping market dynamics. In addition, we see signs that the global economic recovery is losing momentum, and that fiscal support is weakening (at least, for the moment), especially in the US. That said, monetary policy remains easy and is likely to become easier going forward. 

For investors, when it comes to the US elections, the key to anticipating the uncertainty and volatility that may ensue in the coming weeks is a thorough understanding of the various scenarios that are most probable, and along what timelines those are likely to play-out based on constitutional and procedural nuances in the US electoral system. Tail-risks are by nature unpredictable, but with the right analytical framework and access to the relevant tools the uncertainty can be addressed with certainty.