It may seem obvious that politics and macroeconomics are intrinsically linked forces, one always reacting to the other. Political decisions play a pivotal role in shaping broad economic outcomes and equally, the state of economy will influence how policy is shaped. This is because the policies crafted and implemented by governments directly influence key economic indicators and vice versa. Policies, including those on taxation, spending, and regulatory frameworks, not only drive economic growth and development but also have significant impacts on inflation, unemployment levels, and the overall health of the economy. However, some studies suggest that we may be able to draw more empirical statements about these interactions. Is there a direct actionable correlation between political events and stock market performance? Does the party in power affect how equity performs? What predictions can we make for how key political events will affect the market in the future? In this article we will explore the nature of these relationships, focusing on the United States, to unpack how they might be integrated into a properly risk managed investment strategy. Please keep in mind that past results are not indicative of future performance; any trading decisions carry a high level of risk and should be made with a high level of care and personal research. 

Significant political events, such as Elections and the State of the Union (SOTU) addresses, are indicative of the forthcoming direction of government policy and establish upcoming political priorities in the U.S. One study suggests that there may be some correlation between the dates surrounding these events and market returns. The study highlights atypical movements in the stock market, specifically citing returns of an average of 50 basis points (bp) on Election days and 30 bp on SOTU days, compared to the daily average of 3 bp. It goes on to state that the impact of political announcements on returns intensifies during challenging periods characterised by sluggish economic growth and increased overall market volatility, and there’s also a tendency for returns to start increasing before the announcements are made. The paper suggests that the observed market responses can be explained through mechanisms involving risk premium adjustments/early clarification of uncertainties, and the strategic determination and anticipation of government policy changes by the market. The core of the logic is; when there is an announcement the market acts to anticipate changes being announced. Elections introduce volatility in the same manner as the market tries to price in potential shifts in policy.  A study conducted by U.S. Bank looks at market trends during previous election periods to discern recurring patterns. The study claims that typically, the stock market exhibits more subdued activity in the 12 months preceding an election. 

Using data from the study it seems that the trend is noticeable in both equities and bonds markets: 

• Equities: In the year leading up to a presidential election, the average gain for equities is under 6%, compared to a more robust average of over 8% during non-election years. 
• Bonds: The return on bonds averages around 6.5% in the period preceding presidential elections, notably lower than the usual returns of 7.5%. 

We can further extrapolate that for post-midterm elections, markets often experience a swift rebound. However, this trend does not seem to extend to presidential elections. In the year following a presidential election, stock market returns generally decline, while bonds tend to exceed their average performance. The data suggests that market performance also varies depending on electoral outcomes. If a new party assumes the presidency, the stock market typically yields returns of 5%. In contrast, when the presidency is retained by the incumbent president or party, the average returns are slightly higher, around 6.5%. To visualise the influence of presidential elections on the market, consider the chart below, which depicts market performance 12 months before and after each presidential election since 1964. The data reveals that the S&P 500 Index often fares marginally better in the year following the election compared to the preceding year. 

We can also explore whether the winning candidate or their party affiliation plays a role how the stock market performs. Sam Stovall, the Chief Investment Strategist at CFRA, conducted an analysis of market performance across six political configurations: a unified government where the White House and Congress are controlled by the same party, scenarios with a divided Congress and a single-party White House, and situations where the White House and Congress are led by opposing parties. Among the various political alignments, the stock market tends to show its strongest performance when a Democrat occupies the White House and Congress is divided. The next best returns were observed when a Democratic president is coupled with a Republican-controlled Congress. This chart illustrates the historical performance of the stock market under these different political scenarios.  

Data source: CFRA 

However, Stovall advises traders to approach these figures with caution. He caveats; “It’s a good example of how you can have data tell whatever story you want,” he said. “If you want to favour the Democrats, talk about the presidency. If you want to favour the Republicans, talk about House control“. Which leads us to an important revelation: while politics do obviously play a meaningful role in economics there are no hard and fast rules when it comes to predicting market performance. Historical evidence suggests that stock performance tends to be broadly favourable irrespective of the political party in power, whether in the White House or in Congress.  

So, what should investors focus on? Regardless of electoral outcomes or political announcements, there are strategic steps you can take to steady your financial management strategy. First and foremost, it is advisable to prioritise diversifying your portfolio; this is particularly crucial during turbulent market conditions. By spreading your assets across a range of securities and industry sectors, you can mitigate the risk associated with market volatility. It’s also important to maintain a long-term perspective with your trades. Market prices will fluctuate, but impulsive, short-term reactions can undermine your longer-term goals. Effective risk management in trading involves setting clear limits and diversifying your investment portfolio to mitigate potential losses, ensuring that a single market fluctuation doesn’t disproportionately impact your financial stability. It’s crucial to conduct thorough research and establish stop-loss orders to automatically exit positions at predetermined levels, safeguarding against unexpected market movements. By focusing on the fundamentals and not allowing yourself to get sucked into short-term ‘all-in’ strategies you can hopefully limit the potential for significantly unfavourable outcomes.  

Reference 

Political Announcement Return by Yang Liu, Ivan Shaliastovich :: SSRN 

https://www.usbank.com/investing/financial-perspectives/market-news/how-presidential-elections-affect-the-stock-market.html 

https://www.cnbc.com/2020/11/03/are-republicans-or-democrats-better-for-the-stock-market.html 

Zachariah Walker

Content Writer at Finalto

All opinions, news, research, analysis, prices or other information is provided as general market commentary and not as investment advice and all potential results discussed are not guaranteed to be achieved. The information may have been derived from publicly available sources, company reports, personal research, or surveys. Past performance is not indicative of future performance. Trading carries risk of capital loss. Service available to professional clients only.