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Does it really matter? US presidential elections reliably produce great drama on a four-year cycle. They dominate the airwaves, the internet, and take over conversations not only in the US but all over the world.
But do markets care about the identity of the man or the woman at the helm of the world’s largest economy? The answer is that they still do — but that the identity of the man or woman in charge of the Federal Reserve, the US central bank, might now matter more.
It has been a year of extraordinary drama in the campaign, but it has been a dull one on the markets, with the biggest excitement so far stemming from a sell-off in early January triggered by concerns about Chinese growth. America’s separation of powers further complicates the answer to the question. It is not as though the president holds unlimited sway over economic policy. And there is the complication of a small sample size. There have not been that many elections or that many presidents — only 12 since the second world war.
Boost in the third year
Despite all these difficulties, the presidential cycle has a clear effect on markets and traders can attempt to exploit it. The third year of a presidential term is better for the US stock market than the other three combined. Meanwhile, gridlock — where the president ends up having to deal with the opposing party when at least one chamber of Congress is in different hands — can be good for bonds.
Jeremy Grantham, the founder of the GMO fund management group in Boston and a noted market seer, has written widely on the presidential cycle. Entering the Second term of Barack Obama, he found that that the seven months from October 1 to April 30 of the third presidential year show an average monthly return of 2.5 per cent. This goes back to 1932.
That 2.5 per cent per month return is equivalent to an average gain over these seven-month periods of 17 per cent. Meanwhile the remaining five months of the third presidential year, before the election, see a strong average return of 0.75 per cent per month.
Compare this to the much lower returns achieved over three years — the remaining 36 months of each presidential cycle see average gains of only 0.2 per cent per month.
The effect is undeniable. Crucially, there is also a rationale for it. Presidents tend to spend their first year in office, when they have most political capital, enacting reforms that may have a negative initial impact, but that will pay economic and political dividends later. So the first year is poor. By the third year, they are gaining some of the advantages from the early cycle and doing nothing to rock the boat.
Meanwhile, the uncertainty created by presidential campaigns has not begun to bite. Come October of their penultimate year in office, markets often have a harder time (virtually all the most famous market crashes in history happened in October), while the new election campaign is beginning to dominate headlines and create uncertainty. That leaves a period a little over half way through a president’s term as the “sweet spot” for investors. As the dates of US elections are fixed in the constitution, the entire cycle is readily predictable.
A second consideration for those who want to use politics to time the US market is control of Congress. There is a profound difference between a president whose party runs both chambers, and one who faces a battle to get any particular idea passed into law. President Obama lost control of the Senate just as he entered his final two years, having already lost control of the lower house.
There is a cynical view that markets like gridlock. The rationale is that gridlock tends to mean that nothing drastic happens, and that there are few surprises — all good for markets, which are fundamentally apolitical. However, the reality is more complex. What to Expect When You’re Electing, a fascinating study by a group of academics, Scott B Beyer, Luis Garcia-Feijoo, Gerald R Jensen and Robert Johnson, found that bond markets indeed welcome gridlock, as it makes it harder for presidents to be fiscally irresponsible (either by cutting taxes too much or by borrowing too much).
But equities are more directly attuned to the social mood, and to economic growth. These are more likely to be positive when government has a clear sense of direction, and when Americans have a clear sense of the policy they want to see enacted. With many equity investors clamouring for infrastructure investment — something that remains unlikely while Congress and the presidency remain in opposing camps — gridlock is likely to be a drag on bonds.
Democrat vs Republican
What about the political affiliation of the president? For most of the last century, the Democrats have been counter-intuitively by far the more successful party, at least when the stock market is their gauge. But this means little. Franklin D Roosevelt in 1933, and Barack Obama in 2009, took office at the bottom of historic bear markets, which had started under Republicans. This skews outcomes.
Also, leftwing politicians, of whom markets are generally afraid, can have a counter-intuitive effect. Markets sell off in advance of a left-winger coming to a power, and tend to have discounted all the negative effects by election day. That leaves stocks with nowhere to go but up. This has something to do with US stocks’ strong performance under Democrat presidents, and also underpinned two historic buying opportunities.
In 2002, international capital fled Brazil as it appeared that Luis Ignacio Lula da Silva, regarded as a dangerous leftist, might win the presidency. Once elected, Brazilian stocks rebounded spectacularly. Dollar-based investors, gaining also from the gain in the Brazilian currency, would have made almost 2000 per cent by the Spring of 2008 before he left office.
And in early 1975, with the UK mired in a stagflationary recession under the Labour premier Harold Wilson, the FTSE-30 enjoyed the best month in its history, more than doubling in the space of seven weeks. Tony Benn, the most outspoken leftwinger in the cabinet at the time and a bête noire for the stock market, was mentioned in three separate stories on the front page of the Financial Times on the day that rally started. All hope had been lost, stocks were absurdly cheap, and ready for a huge rebound, even while generally anti-market politicians remained in office.
But what matters most? Central bankers. Market analysts spend so much time trying to predict what the Fed will do next for a reason. Control over the price of money is all-important. A tightening of interest rates, or a signal from the Fed that it is considering it, means that inflationary pressures are rising, and means investors should shift towards assets that shield them from inflation. Of course, presidents and Congress do get to choose the Fed’s governors, but are not able to interfere with the central bank.
This, according to Mr Grantham, explains why the presidential cycle has worked poorly under President Obama. The Fed has become more important, and more aggressive, and this has drowned out political effects, at least for the time being. It was easy to explain the relatively poor performance of the third year of his first term; after all, he came into office just as the stock market was hitting rock bottom after the Lehman Brothers bankruptcy, and it was therefore not surprising that his first year saw a big rally.
But the second term, in which his third year was the most unimpressive so far with stocks roughly flat, is harder to explain. That year started with the Fed finishing its “QE” purchases of bonds and ended with its first rise in target rates in almost a decade. According to Mr Grantham: “The Fed can move stock prices. In the old days it was about all they did. They helped along year three, and their efforts in year three would feed through into the economy in year four. Which it did.”
Now, he says: “They are constantly looking for excuses to push down on interest rates and drive asset prices higher to get some wealth effect. I don’t trust them any more to play the easy presidential cycle.”
As far as the markets are concerned, the world’s most powerful person is Janet Yellen, the chairwoman of the Fed. She will continue to be, whoever is installed as president next year.