From Polls to Profits: Navigating Market Volatility During Elections

The Dynamics of Uncertainty and Volatility

Elections inject significant uncertainty into the stock market, often leading to notable fluctuations. As election outcomes remain uncertain, market volatility tends to increase before votes are cast. This volatility often continues post-election as investors react to the policy priorities of the newly elected government. Historical data supports this: according to research by Vanguard, market volatility increases by about 10% in the month leading up to an election.

The Impact of Predictable Outcomes

A clear margin of victory and the re-election of an incumbent typically reduce uncertainty, minimizing market volatility. However, predicting election outcomes is notoriously challenging. For instance, the 2016 US presidential election, where forecasts overwhelmingly favored Hillary Clinton, saw the S&P 500 futures plummet nearly 5% overnight as results came in, only to rebound the next day as the market digested the implications of a Trump presidency.

Electoral Systems and Market Fluctuations

The type of electoral system influences market volatility. Majority systems, such as the UK's first-past-the-post and the US electoral college, tend to be less predictable than proportional representation systems. This unpredictability can significantly affect stock market returns. For instance, the 2019 UK general election, which resulted in a decisive victory for the Conservative Party, saw the FTSE 100 index rise by 1.1% the day after the election, reflecting reduced uncertainty.

Short-Term Volatility vs. Long-Term Stability

Studies show that stock market returns exhibit over 20% higher volatility in the 51 days surrounding elections. Despite this, the compensation for bearing this risk is relatively modest. Historically, the long-term performance of shares in publicly listed companies seems less affected by the party in power. A study by S&P Dow Jones Indices found that the S&P 500 has averaged an annual return of 10.6% under Democratic presidents and 4.8% under Republican presidents since 1945, though other factors also play significant roles.

Economic Policies and Market Reactions

The connection between elections and the economy is well-documented. Politicians often implement economic boosts before elections to gain favor, followed by more stringent measures like inflation control through higher interest rates. This cycle can create predictable long-term trends in stock markets. For example, in the run-up to the 2020 US presidential election, both major candidates proposed substantial fiscal spending plans, which had different implications for various sectors. Biden's proposals for significant infrastructure and green energy investments buoyed related stocks, while Trump's emphasis on deregulation and tax cuts benefited financial and industrial sectors.

Sector-Specific Impacts

Election outcomes can have varying impacts on different sectors. Financial stocks tend to outperform ahead of elections due to anticipated growth-boosting policies. Conversely, sectors sensitive to government spending or regulation, such as defense, healthcare, and finance, may experience increased risk and suppressed returns due to economic policy uncertainty. After the 2020 US election, renewable energy stocks surged in anticipation of a Biden administration prioritizing green energy policies.

Inflation, Interest Rates, and Economic Outlook

Elections often lead to shifts in inflation and interest rates, directly impacting economic conditions. For example, the anticipation of increased government spending by a new administration can drive inflation expectations higher, influencing the central bank's decisions on interest rates. Higher interest rates can suppress stock market growth by increasing the cost of borrowing and reducing corporate profits. Conversely, policies aimed at curbing inflation through fiscal austerity can lead to economic slowdowns, affecting market sentiment and investment decisions.

The UK Perspective

In the UK, the immediate aftermath of elections shows that Conservative victories typically lead to positive changes in the FT30 index, while Labour victories often do not. However, over the long term, there appears to be no significant difference in stock market returns under Labour or Conservative governments. Analysis by Schroders reveals that UK equities have delivered annualized returns of 10.8% under Conservative governments and 10.4% under Labour governments since 1970.

The Role of Geopolitics

Elections influence not just domestic policy but also geopolitical dynamics, which can significantly impact global markets. For instance, the 2016 US election led to changes in trade policies, such as the US-China trade war, which affected global supply chains and market sentiment. Similarly, Brexit, driven by the 2016 UK referendum, created substantial market uncertainty and reshaped economic relationships within Europe and beyond.

Trade Policies and International Relations

Election outcomes often herald shifts in trade policies, impacting international relations and market dynamics. For example, Biden’s victory in 2020 signaled a potential shift towards more stable and predictable trade relations, which eased investor concerns compared to the uncertainty under Trump's aggressive tariff policies. Conversely, elections in emerging markets can have outsized impacts on commodities and currencies, as seen in Brazil’s 2018 election, where the victory of Jair Bolsonaro led to a surge in the Brazilian real and local equities due to his pro-business stance.

Fiscal and Monetary Policies

Elections also affect fiscal and monetary policies, which are crucial for market performance. Democratic administrations in the US, for example, typically favor higher public spending and social programs, which can stimulate economic growth but also lead to higher deficits. Republican administrations often prioritize tax cuts and deregulation, which can boost corporate profits but may increase income inequality. The UK's fiscal policies under different parties similarly show contrasting approaches to public spending and austerity, influencing market sentiment and investor confidence.

The Broader Implications

The short-term effects of elections are evident, with studies indicating doubled stock market volatility during election weeks. This effect is more pronounced in closely contested elections, narrow victories, and changes of government. Additionally, surprise election results, such as the 2016 US presidential election, tend to trigger more substantial market reactions. The market’s response to President Biden’s 2020 victory, where the S&P 500 gained 1.2% the day after the election was called, highlights the impact of election outcomes on investor sentiment.

The Global Influence

The impact of elections is not confined to the country holding the election. US political cycles often serve as proxies for global political uncertainty, affecting equity returns and increasing volatility in other countries. For example, the outcome of the 2020 US election influenced global markets, with significant moves in Asian and European markets as investors adjusted to the anticipated policy shifts.

Conclusion

While elections introduce short-term volatility into the stock market, their long-term impact on market performance is less clear. Investors should be mindful of potential short-term fluctuations and sector-specific impacts while maintaining a long-term investment strategy. By staying informed and prepared, investors can navigate the uncertainties of election periods without letting emotions drive their financial decisions. Historical data suggests that despite short-term turbulence, the stock market tends to recover and continue its growth trajectory over the long term.

?