If Bernie Sanders wins Iowa Monday and gains momentum, that would spook the stock market - CNBC

Democratic 2020 presidential candidate Senator Bernie Sanders (I-VT) speaks with reporters as he walks through the Iowa State Fair in Des Moines, Iowa on August 11, 2019

Alex Edelman | AFP | Getty Images

Iowa's Democratic presidential caucus Monday is a step toward narrowing the far-flung field of Democratic candidates, and investors could start getting worried if polls prove correct and Bernie Sanders emerges as the winner.

Iowa is just the first ballot, but a win by the Vermont senator could give him more momentum, and that certainly could get the market's attention. Analysts do not expect a sell-off just based on an Iowa win for Sanders, but if he begins to look like the nominee in more races, volatility could increase. New Hampshire's primary is the following week, and Sanders won there in 2016.

"I think the market really has run up for a lot of reasons, but they clearly have been pricing in a Trump re-election," said Lori Calvasina, chief U.S.equity strategist at RBC. "The betting markets are sending a positive signal on Sanders right now. The big sort of shift in trend is Bernie."

Still, strategists say the left-leaning candidate would have a hard time beating President Donald Trump if he were the party nominee, but the fear is there's now some level of risk that he could. Sanders is viewed as negative for the stock market, and he is in favor of significantly raising taxes on individuals and companies.

Long shot no more

Sanders had once been seen as a long shot, but he is now leading former Vice President Joseph Biden in Iowa polls by an average 24.2% to 20.2%, according to RealClearPolitics.com. Sanders is also leading Biden by a wider average 9.5 percentage points in polls in his neighboring state of New Hampshire.

"Anybody who has won two of the first three, they've all gone on" to be the nominee, said Daniel Clifton, head of policy research at Strategas.

Biden is leading in the third and fourth states scheduled to hold votes. He leads by 5.7 percentage points on average in Nevada polls ahead of its Democratic presidential caucus Feb. 22, and is ahead in the Feb. 29 vote in South Carolina, where RealClearPolitics.com puts him up by an average 17 percentage points. A much anticipated final poll by the Des Moines Register was not released over the weekend, due to a potential error.

"Iowa has picked the last four Democratic nominees. The early states, which are often disregarded as not important, create momentum for winners and really start to hurt the losers," Clifton said.

This year, there is an early "Super Tuesday" of primaries on March 3 in more than a dozen states, including Texas, North Carolina and California, a key state where Sanders now has a large lead. Those states hold 42% of the delegates, but Clifton said Iowa can be pivotal and provide important early momentum for candidates. He said the next pre-caucus poll on Saturday by the Des Moines Register will be important.

"This is why the volatility is around February, and not March. Super Tuesday has many investors making that bet," he said. "They're betting on March. You want to make your bet around February because there's a lack of realization that Bernie could win the nomination, and he's going to get a fresh bout of momentum if he wins those first states."

Super Tuesday options

There has been trading in weekly options betting that the market this week would see elevated volatility in the S&P 500 around the caucuses. There's also been a trade around Super Tuesday March 3, but the scare over the rapidly spreading coronavirus has brought its own hedging.

"There was a volatility premium built into next Wednesday. People would much rather buy options that incorporate the election-related events. Weekly options go out three months. March 6 options were listed about a month ago. That has Super Tuesday in it," said Patrick Kernan, CEO of Cardinal Capital, which trades S&P options. "Those options were significantly more expensive, puts and calls, relative to the options that expired right before it at the end of February."

Health care stocks have also been hit in part because of the potential rise of Sanders. Calvasina said normally with a health scare, those stocks should be doing well, but they have been trading lower, particularly managed care. The S&P health care sector was one of last week's worst performers, down 3.6%.

"That's been his signature issue …I think people really identify him with the health care policy," said Calvasina. "There's no virus-related reason that healthcare stocks should be down this week, these large cap, policy sensitive names."

Sanders and Sen. Elizabeth Warren are the most progressive and both favor "Medicare for All." Both also would ban fracking, or the shale drilling that has taken the U.S. from a major importer of oil to an exporter and the biggest producer in the world.

"Their policies are clearly not pro-market. Regardless of what the odds might be in the general election, they have a puncher's chance," said QMA chief market strategist Ed Keon.

Biden wants to preserve and expand upon Obamacare, with a private insurance option. He has also supported fracking, which is important to voters in key states such as Pennsylvania and Texas.

The coronavirus has dominated this past week's trading, and bond strategists say the sharp decline in yields has been the direct result of fears the virus will slow the world economy. But they also say investors could get increasingly nervous about the Democratic primaries and there are some investors using bonds as a safety play against election-related volatility.

"It's a reason not to push rates higher. It's a reason you're willing to be neutral," said Jon Hill, BMO senior rate strategist.

The Bloomberg factor

In the Iowa polls, Warren is fourth with 15.6%, behind former South Bend, Ind. Mayor Pete Buttigieg, at 16.4%, according to RealClearPolitics.com. Minnesota Sen. Amy Klobuchar is averaging 8.6% in Iowa's polls.

Former New York Mayor Michael Bloomberg is not in the early state races, and only shows up in time for Super Tuesday. Some strategists see Bloomberg siphoning off Biden supporters, helping Sanders, and he could become more high profile nationally after his big Superbowl ad buy this Sunday.

"Bloomberg has set up for Bernie winning and Biden crashing. If that scenario takes place, then it would be him and Bernie Sanders one on one in the back end of the states. It's never been done. It wouldn't be easy. He's getting 7% of the vote right now," Clifton said. "But he's the only one increasing in the polls."

Cornerstone Macro's Andy Laperriere said even though Sanders looks to be in the lead in Iowa, the situation is fluid and it's hard to tell what the outcome will be. "What looks like is happening is the progressive vote is coalescing around Sanders and feeling like he's got at least as good a chance as anybody else," said Laperriere, who heads U.S. policy at Cornerstone.

Laperriere said an analysis on FiveThirtyEight Politics shows a win in Iowa could give a big boost to either candidate but would push Biden closer to being the nominee. The analysis shows Biden doubling his odds to 80%, while the odds for Sanders would get a boost to 61% on an Iowa win.

"I think investor perceptions will do something similar to that. The market will be shifting its odds pretty dramatically about who will be the Democratic nominee," Laperriere said. "Sanders is much more of a risk to the market, but on the other hand, the perception is the odds of him beating Trump are low. Biden is less of a risk for the market, but the odds of him beating Trump are higher."

Tom Block, Washington analyst at Fundstrat, said Iowa could determine which of party's progressive candidates will be left standing.

"It appears Sanders is gaining momentum, and Elizabeth Warren is losing momentum. I think Iowa can be the defining moment for the race within the race," he said. "If Joe Biden gets wiped out in Iowa that would be a negative for him, but if he's competitive and they all bunch together, I think he can survive for another day."

Block said Bloomberg only comes in to the race seriously if Biden falters. Markets see the billionaire Bloomberg as much more market-friendly than Sanders or Warren.

"The landscape has significantly changed. You never before had a Super Tuesday like this that has California, Texas and North Carolina. History is changing with this year's primary schedule," Block said. "I think the biggest outcome of these early first primaries is going to be deciding whether Bernie has captured the progressive vote, and what is Elizabeth Warren's argument for staying in the race."

Investors may find Sanders' tax proposals less appealing than those of Warren. According to Cornerstone Macro's analysis, Sanders would push the highest individual tax rate to 52% while other Democrats would raise it to 39.6%, from the current 37%. Under Sanders' plan, the highest marginal tax rate would be 69.2%, compared with Warren's 53.5%.

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