US election: are investors underestimating tail risks?

Name: The US Electoral College: how does it work and why does it exist?
Uploaded: 2020-10-29T14:00:20.000Z
Duration: 4 min 54 s
Description: The US Electoral College: how does it work and why does it exist?

Not only are markets not accounting enough for the threat of a messy, contested election, they are also assigning too low a probability to the possibility of a Democratic landslide

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US President Donald Trump gestures as he speaks at a rally in Carson City, Nevada, on October 18. Photo: AFP

Nicholas Spiro

Published: 10:00pm, 29 Oct 2020Updated: 10:20pm, 29 Oct 2020

When it comes to elections, political analysts follow opinion polls. Investors, for their part, pay more attention to prediction markets, where bettors trade futures tied to different outcomes. Just days before the United States holds its momentous presidential election, an average of national polls compiled by RealClearPolitics shows that the race has tightened over the past few weeks.

RealClearPolitics’ average of seven polls indicates that Democratic candidate Joe Biden’s lead over president Donald Trump has narrowed from 10.3 points on October 11 to 7.5 on October 28. This is still a comfortable margin, and one that has proved more stable than Hillary Clinton’s shrinking lead in the final stretch of the 2016 campaign.

Yet, the tightening in the race has contributed to a significant shift in betting markets, notably with regard to the probability of a “blue wave” whereby the Democrats clinch the presidency and both chambers of Congress. According to Predictit, a political betting site, the Democrats’ chances of a clean sweep have fallen from 62 per cent on October 7 to 54 per cent.

Investors, who as recently as a fortnight ago were pricing in a blue wave, are also revising their assumptions on the outcome of contests in some of the key battleground states, where Biden’s margins are smaller. Predictit bettors now see Trump winning Florida – the swing state with the most electoral votes – by a hefty margin, and taking North Carolina and Ohio, two other key states.

04:54

The US Electoral College: how does it work and why does it exist?

In the space of a little over a month, prediction markets have gone from betting on a disputed election result to anticipating a Democratic sweep, only to start pricing in a more modest Biden win. The uncertainty is exacerbated by markets’ failure to predict Trump’s upset victory four years ago, and the lingering feeling among investors that next week’s election could throw up a surprise.

The nervousness among investment strategists is palpable. On October 27, JPMorgan published a report tellingly entitled “What if Trump wins?” Yet, in assigning a higher probability to an outcome that is less extreme than the two other scenarios investors were betting on over the past several weeks, markets are again in danger of underestimating the tail risks.

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US election: are investors underestimating tail risks?

.css-1mniedq{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;} Not only are markets not accounting enough for the threat of a messy, contested election, they are also assigning too low a probability to the possibility of a Democratic landslide

Not only are markets not accounting enough for the threat of a messy, contested election, they are also assigning too low a probability to the possibility of a Democratic landslide