Dec 5, 2016

How I Hedge Against Donald Trump Before the US Presidential Election

2016 is a year of the possibilities. Brexit happened when nobody thought it is possible. Donald Trump became the President of United States when nobody thought it is possible. The recent US Presidential election caught the financial world by surprise again with the global bond market and emerging markets bearing the brunt of the backlash. Meanwhile, the USD and US stock market rallied to new heights, which is in a totally different direction from what most analysts predicted before the election.

Quoting from one of the analysts in the article:

"If Clinton wins, you get a big relief rally. If Trump wins, then you get a big sell-off. I think that from where we are today, until the bottom of that sell-off, you are looking at a good 10 percent easily. I think whether it goes deeper than that depends on the temperament that Trump displays after the election.."

The question at the top of every investors mind is probably how to manage the risks before the US Presidential election in the unlikely result that Trump wins.

Learning from my previous painful experience of how Brexit pans out, I formulated a more comprehensive game plan for the US election as compared to the Brexit one. Here is how I analysis the probability of the possible directions of the different asset class in the case of both candidates:

Clinton Wins: Everything will be as per normal
US Equities: Up
EU Equities: Flat
Emerging Market Equities: Up
Global Bond: Flat
USD: Slight Up
Gold: Down

Trump Wins: Financial Turmoil with a possible stock market crash
US Equities: Down
EU Equities: Flat
Emerging Market Equities: Down
Global Bond: Down
Gold: Up

Judging from the possible market reactions of both candidates, it is not hard to see that the USD is a probable winner. The US Federal Reserves is already prepared to raise interest rates for the month of December and will do so in a dovish manner in the near future. However, a Trump win will result in protectionist trade policies and a possible replacement of the Federal Chairperson with a much Hawkish one, which will result in a sharp jump in USD. This is what I wrote last month predicting the results of a Trump win, in which most of the results came true to pass.

Therefore, a strong allocation into USD makes sense as either candidates winning will result in the USD rising mildly or strongly.

An emergency cash is needed in the case of any Black Swan event. However, the outlook for bond looks relatively bleak with little profit to be made. Hence a short duration diversified global bond should be employed rather than a long duration one as a possible Trump win will wreck damage on a longer duration bond, which will defeat its purpose of a safety fund.  

The next allocation is trickier. Which equities should I invest in? Judging from the possible results, only emerging markets and US equities seem like the sensible choice as EU equities will remain relatively unpredictable due to the impact of Brexit and possible chaos from the Italian referendum which will happen this week. Meanwhile, emerging market equities had a good run since June and US equities had dropped quite a bit due to polls indicating that Trump is gaining on the Clinton's lead. US valuation is more attractive at that moment in time and a Clinton win will lead to a market rally erasing the fall due to the "Trump factor". In the case Trump wins, the relative safety net of a diversified short duration global bond fund and the USD should be able to erase the losses and gives us a cash buffer to invest US stock market which has fallen into a possible correction.

What happens next is to input all these factors into a spreadsheet and assume a possible profit/loss scenario for each scenario and try to derive the optimal allocation for making zero to a slight profit in both cases. The optimal allocation that I worked out is 50% USD, 30% Short Duration Bond, 20% US Equities.

The Results: Trump Wins!

US Equities:  +7%
EU Equities:  -1%
Emerging Market Equities: -5%
Global Bond: -3%
USD: +3%
Gold: -2%

The strong rally in US equities as a result of a Trump win basically went against all the prediction by many analysts and the strong expectation of a sharp rise in future interest rates basically demolished the global bond markets resulting in the biggest 2 weeks fall in a quarter of century with more than a trillion dollars being wiped out. Emerging market equities and currencies also took a big hit with the Malaysian Ringgit falling to an all time low. The portfolio performed unexpectedly well and beyond the small return I have expected in the case of a Trump win.

The financial markets and world events will always turn up surprises for all investors but it is the investor who has a plan for the unexpected will turn out to be the winner.

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