Blog Posts — October 19, 2020

Presidential Election Stress Test Part III: Gauging the impact of a Trump win on your portfolios…

Sure, start with Big Tech, but don’t overlook Health Care!

In our first two posts on this subject, we discussed modeling the possible outcomes of the election and the potential ramifications of the Biden tax plan on Big Tech. In this post, we focus on the Health Care sector. A Trump/Republican win would likely put Obamacare in jeopardy—and that could have a large impact on the earnings of companies in that sector.

Much has been written about the dominance of Big Tech because of the Covid-19 pandemic. My colleague Diana Baechle recently posted a blog on the impact of the FAANGs + Microsoft in the US market. These six stocks make up 20% of the STOXX USA 900 index portfolio and drive 25% of its risk. They are included in the Information Technology, Consumer Discretionary, and Communication Services sectors (GICS Level 1).

A transitive stress test shocking each of these six stocks down by 20% results in an expected loss for the STOXX USA 900 of almost 10%[1]. The three sectors in which those six stocks reside—Information Technology, Consumer Discretionary, and Communication Services—contributed almost 70% to total portfolio predicted loss (see table below).

Source: Axioma Risk

Interestingly, Health Care came next with a contribution of -0.90, more than twice the contribution of the next sector. Health Care has been one of the beneficiaries of the pandemic for obvious reasons but remains risky given the lack of a positive vaccine result and a potential reversal in legislation around Obamacare post-election. The large impact on our portfolio from Health Care, even though none of its constituents were among the transitive shocks we imposed on the FAANGs + Microsoft in our stress test, begged further investigation.

Our first step was to create a series of individual transitive sector stress tests using the SPDR Sector ETFs as proxies for each sector, shocking each down by 20%, and measuring their individual impact on the STOXX USA 900 index portfolio.  

The table below shows the results, with the diagonal matrix representing the contribution to total portfolio loss from the sectors that were shocked. The off diagonals show the contribution to loss from the other sectors, using the correlation with the target sector calibrated over the previous three months. The top row shows the impact on the index portfolio.

As expected, the shocks to Information Technology, Consumer Discretionary, and Communication Services had quite an impact on the index portfolio, resulting in predicted losses of about -5%, -4% and -1%[2], respectively. But we again note that the Health Care shock also had an outsized impact (-5%)—one that was almost on par with the shock to Information Technology.

If we took a naive approach to estimating portfolio losses by simply multiplying our 20% shock to Information Technology by its weight of 29% in the index, we would come up with an expected loss of -5.8% on a weighted but uncorrelated basis. Yet the actual forecasted loss is only -5%, meaning that the Information Technology sector had some diversification benefits with other sectors. On the other hand, Health Care has a weight of 14% in the index and a 20% shock should result in a -3% loss on a weighted but uncorrelated basis. However, the forecasted loss under that scenario, once correlations are considered, is -5%, far more than our naive forecast, meaning that the Health Care sector not only lacks diversification benefits with the other sectors, but suffers from concentration bias.

The table below shows the cross-sector correlations from the three months calibration period used in the analysis. We see that Health Care has a stronger positive correlation with several other sectors than either Information Technology or Consumer Discretionary.

We simulated what ‘getting it wrong’ on each sector together with Health Care concurrently would do to the STOXX USA 900 portfolio. Each column in the table below has two sector shocks, highlighted with the red box, except Health Care, which only has itself as a -20% shock. The loss for Communication Services jumps from -1% in the individual shock scenario to -6% when Health Care is added to it. Consumer Discretionary and Information Technology more than double from -4% and -5%, to -9% and -10% respectively. Energy, real Estate, and Utilities, which showed very little impact in the individual stress test, now result in -5%, -6%, and -5.3% each, respectively. Financials, when paired together with Health care, saw its impact on the portfolio increase five times.

In conclusion, although the FAANGs + Microsoft are 20% of the STOXX USA 900 index, and contribute 25% of its volatility, investors would do well to focus a bit more on the Health Care sector to avoid being surprised by outsized losses. Getting any of the sectors “wrong” in addition to Health Care could lead to large, unexpected losses, and with Obamacare hanging in this election’s balance, the uncertainty surrounding this sector is quite high. Be aware of what a bet on Health Care means for your other sector bets.

[1] This transitive stress test used data from the three months ended September 30, 2020 to calibrate the correlations between these six stocks and the factor returns in our AXUS4-MH factor model to reprice all other stocks in the index portfolio.

[2] Communication Services has a low beta to the market factor and so has a diminished result, but still stronger than other sectors with higher betas, such as Utilities or Real Estate.