With no shortage of political noise and the midterm elections quickly approaching, many investors have been asking what this means for markets. Putting political issues aside, we maintain the view that investors should work to separate the signal from the noise, and only make portfolio changes when the facts have changed. Midterm election years have historically seen worse than average returns, and these negative excess returns have typically come with a price of higher volatility.
Since 1970, midterm election years have seen average annual returns of 6.1%, versus average returns of 11.9% during the full period. Furthermore, volatility has historically increased as the midterm elections approach, with S&P 500 realized volatility an average of 1.8%pts higher on average in the three months leading up to November. That said, the equity market has typically enjoyed a relief rally from September through the end of the year, rising 7.1% versus an average return of 3.7% during the full period, as uncertainty recedes and investors refocus on the fundamentals. As such, the historical data suggests that investors should not necessarily seek cover as midterm elections approach, but rather understand the market dynamics that will be at play and position portfolios accordingly.
With volatility set to increase but the path of least resistance for markets still being higher, investors should maintain exposure to risk assets. However, as we wrote in last week's article, a focus on those asset classes and equity market sectors that have historically derived more of their total return from income seems prudent, as it should help dampen some of the volatility that investors look set to experience. That said, there are also ways that investors can take a more offensive approach and try to capitalize on this uptick in volatility. Historically, macro hedge funds have outperformed the broader hedge fund universe during periods of elevated volatility, while in aggregate hedge funds have provided investors with a lower-volatility exposure to equity markets. As such, a focus on both income and alternatives may be the best approach to take over the coming months.
Macro hedge funds tend to outperform in periods of volatility
VIX index level, y/y change in rel. perf. of HFRX Macro index
Source: CBOE, HFRI, FactSet, J.P. Morgan Asset Management. HFRX Macro index performance is relative to the HFRX Global Hedge Fund index. Data are as of 9/6/2018.