US presidential election: how will stocks react?

The United States will vote for a new president next Tuesday. Should investors care? They should certainly be on alert if Donald Trump somehow pulls off a shock victory, according to high-profile University of Michigan economist Justin Wolfers.

He is also co-author of a recent study which warned that a victory for the Republican candidate could result in US, British and Asian stock markets plummeting by 10 to 15 per cent.

His analysis was based on the reaction of financial markets during the first presidential debate on September 26th. Trump’s poor performance resulted in Hillary Clinton’s odds of election victory increasing from 63 to 69 per cent, much to the delight of financial markets.

US stocks jumped in overnight trading, with similar moves seen in UK and Asian indices. Oil prices rose, gold fell and there was a sharp fall in the Vix, the so-called fear index that tracks market volatility. The Mexican peso, which has been moving in the opposite direction to Trump’s poll numbers throughout 2016, jumped, as did currencies in Canada, South Korea and Australia currencies. These are all countries with which the US has free trade agreements, noted Wolfers in a series of tweets explaining his findings, and are “at risk” countries that could suffer from Trump’s protectionist policies.

Besides an equity market sell-off, his paper estimates that a Trump victory could catalyse a $4 fall in oil prices, a 25 per cent decline in the Mexican peso and “significantly increase expected future stock market volatility”. This “Trump discount” is comparable to those that accompanied the Brexit vote or the 2003 invasion of Iraq, the paper concludes.

Other firms have issued similar warnings. Forecasting firm Macroeconomic Advisers, which has also been tracking the correlation between Trump’s election odds and market movements, cautions that a Trump victory could see stocks fall by 8 per cent. Buiter estimates a Trump win would result in global policy uncertainty and trigger a one-standard deviation tightening in US financial conditions, thereby affecting global consumption and investment.

Economic growth

Others posit that it is premature to see a Trump victory as automatically negative for stocks.

Billionaire bond manager Jeffrey Gundlach has argued in recent months that a Trump presidency would be a big-spending one that would boost economic growth, something that would be "bonds-negative and stock-positive".

Ben Casselman of forecasting website FiveThirtyEight cautions against putting too much faith in Willem Buiter's estimates, saying that research into the effect of policy uncertainty on the economy is in its infancy, with the field not "nearly advanced enough to make confident assertions about how a single event like an election surprise would affect the global economy".

However, the main reason that investors should not worry too much about a Trump presidency is that it is an extremely unlikely prospect. Various prediction markets have lately indicated that the odds of a Clinton victory are in the region of 90 per cent, while Paddy Power recently said it was paying out early to punters who had bet on a Democrat presidency, saying: “It’s a done deal that Hillary is a nailed-on certainty to occupy the Oval Office.”

The flipside of this, of course, is that a dramatic market reaction is likely should Trump somehow upset the odds. The reason the initial market reaction to the Brexit referendum result was such a violent one is that no one expected it.

Similarly, the collapse of the Trump campaign in recent weeks means that a Trump turnaround is not priced into stocks. Some commentators suggest that markets are again being complacent, as they were in the case of Brexit, when betting odds wrongly indicated that a Remain vote was a done deal.

There is an obvious hole in that comparison, however. A raft of opinion polls indicated the Brexit result was too close to call, but bookmakers and financial markets discounted them, wrongly assuming that British voters would ultimately play it safe and opt for the status quo.

In contrast, the polls have consistently shown that Trump is well behind Clinton. Polls are not perfect, but there is no precedent for a huge comeback this late in the campaign.

Democratic sweep

Accordingly, strategists are increasingly cautioning that equity market nervousness about a Trump victory is being replaced with anxiety regarding a Democratic sweep – that is, winning control of the Senate and House of Representatives as well as the White House – and the “left-leaning, anti-business/market implications of that development”, to quote high-profile

Gluskin Sheff

strategist

David Rosenberg

.

The prospect of a Democratic sweep has also been raised by strategists at Credit Suisse and Goldman Sachs, the latter noting that stocks have typically declined over one-month and three-month periods following past “wave elections”.

Current anxiety regarding a Democratic landslide remains muted, however. Notably, the energy and financial sectors, both of which would be expected to come under pressure in the event of a Democratic sweep, have been the best-performing sectors since the first presidential debate in September.

There has been little discussion regarding issues such as drug pricing, financial regulation and energy, Strategas Partners noted last week. “That all changes if one party takes complete control. The market is not priced for this outcome.”

That’s because markets’ preferred outcome – political gridlock, with a Democratic presidency counterbalanced by a Republican Congress – remains the most likely scenario.

The Democrats are strongly favoured to retake the Senate, overturning the current Republican majority, but the House of Representatives is expected to remain in Republican control. Last week, betting on prediction market website PredictIt indicated the odds that the Democrats would control both the White House and Congress to be just 17 per cent.

Short-term volatility

Should investors be surprised by next week’s electoral outcome, whether that be via a shock Trump victory or a Democratic sweep. It’s safe to assume that some short-term volatility will result. However, the notion that long-term investors should closely monitor political developments is a debatable one.

Elections invariably prompt much chatter as to what particular political outcomes might mean for stocks, but divining the impact of past administrations on stock markets is not an easy task. It’s commonly remarked that over the last century, stock markets have enjoyed much better returns when the Democrats have been in power.

However, research going back to 1853 shows that returns under Republican and Democrat administrations are virtually identical, according to Dr Jonathan Lemco of fund giant Vanguard.

Lemco notes that some of the S&P 500’s biggest gains came during Gerald Ford’s ill-fated 1972-76 government, the main reason being that equities were extremely cheap following the vicious bear market that ended shortly after Ford took office.

Similarly, just as it was premature of Republican supporters to blame Barack Obama for the heavy share price falls that resulted in the early months of his reign, at the height of the global financial crisis in the first quarter of 2009, it would be simplistic to laud Obama for the subsequent tripling in share prices over his eight-year reign, given that this was made possible by equity valuations hitting generational lows in 2008-09.

International research supports the merits of an apolitical investment outlook. One major 2006 study, Political Orientation of Government and Stock Market Returns, analysed returns in 24 stock markets and 173 different governments. No obvious pattern emerged, the authors found, concluding that “international investment strategies based on the political orientation of countries’ leadership are likely to be futile”.

Research also shows that people’s political beliefs tend to cloud their investment judgment; right-leaning investors tend to underperform during Democrat administrations and left-leaning investors tend to underperform when the Republicans hold power.

The reason is that both sets of investors are more liable to believe that the world is going to hell in a handbasket when their ideological opponents are in office, resulting in them being jumpy and actively trading portfolios rather than sitting tight.

Different campaign

The current presidential campaign is different, in that Trump’s rhetoric and behaviour have alienated investors of all political hues.

“In almost every case back to 1880, equity markets have risen on the news that Republicans win elections and fallen when Democrats win,” according to Justin Wolfers, but 2016 is proving to be a “strong exception” in this regard.

Nevertheless, research indicates long-term investors should ultimately not lose sleep over political developments, says Vanguard; instead, they are better off focusing “on more meaningful factors when it comes to their portfolios, such as diversification and controlling costs”.