Could a close race be bad for the markets?

Monthly stock markets returns leading up to and following all the presidential elections since 1960 reveal some interesting patterns that could have significant implications for trading.

Who will win the election?
I think Donald Trump will pull off a surprise win and that overly-complacent markets aren’t the slightest bit ready for it, just like Brexit in June.

Why will he/she win?
Earlier this year, I travelled though several US states just before their primaries and all the campaign signs along roads and private properties were for Trump and Sanders. There is a lot of anger and resentment toward the establishment among the general public at the moment. It’s the kind of mood that elected Rob Ford as Toronto mayor in 2010 and won the UK Brexit vote for the leave side, despite insults, threats and forecasts of doom from the establishment.

Close race to the finish likely
The US race is running a lot closer than many would have predicted earlier this year and is likely to be even closer than the polls are showing. Conservatives tend to do better in elections than the polls show because voters are reluctant to admit to pollsters that they are not politically correct. This effect may be even bigger in the US this year considering the insults and derogatory comments made by Hillary Clinton and the Democrats about Trump supporters.

It’s long been said that the stock market is a crucible where the hopes and fears of millions of people willing to put their money on the line interact with each other. As a result, stock markets are widely considered to be a strong reflection of people’s attitudes on the current economic and political situation, as well as forward looking, reflecting what people think the situation may be six to nine months into the future.

Markets’ performance in previous US elections
Monthly stock market returns leading up to and following all the presidential elections since 1960 reveal some interesting patterns that could have significant implications for trading.

This year’s election campaign features a clear division between those favouring more of the same politics that has dominated the past 25 years (where one of the Clintons was either president, a senator or secretary of state between 1993 and 2012) and a strong desire for real change (Donald Trump has never before held elected office).

In presidential election years with no incumbent, the Dow Jones Industrial Average declined 0.05% per month on average, underperforming the 0.78% monthly average returns in years with an incumbent. This suggests market uncertainty over who the incoming president may be and the policies they may change or introduce.

Presidential election years where the party in power was defeated had an average monthly return of -0.13%, underperforming the 0.85% average monthly return when the party in power was re-elected. This suggests that soft markets may reflect discontent with the direction of the country and a mood for change.

The 2000 and 2008 campaigns coincided with major bear markets and recessions. It remains unclear which came first in the minds of traders and voters or if they go hand in hand. It would seem logical though that the economy and markets would lead the polls. In other words, economic disruption causing markets to crash could be seen as reflecting failed government policy, driving a desire for change at the ballot box.

There are numerous other examples where change at the ballot box has emerged as a delayed reaction to economic and market turmoil. For example, the 1992 election followed the 1990 Gulf War-related recession and market decline; the 1976 election came in the wake of the 1974 major bear market, recession and Watergate scandal; the 1968 election followed the peak of a bull market in 1966; and the 1932 election followed the 1929 stock market crash which kicked off the Great Depression. The one major exception was in 1988, where the markets ignored the crash of 1987 as a speed bump within a bigger cycle.

 

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Market performance in 2016 and the election race
The year got off to a really rocky start in January, slightly worse than similar non-incumbent years like 2000 and 2008. Unlike those years, when stocks continued to crumble as they entered major bear market territory, stocks rebounded in late February and March and rallied through July. In August there was a small retrenchment on a combination of exhaustion and speculation that the US Federal Reserve could announce an interest-rate increase in September (which would be a rare event, since the Fed usually goes quiet during election campaigns).

The rough first six weeks of this year favoured Donald Trump and the Republicans, suggesting discontent with the current government. Since the middle of February, however, market expectations have been tipping toward the Democrats, as gains reflect a strong economy and general content with current economic trends and policies.

During the last six US presidential election campaigns, the Dow fell 7.4% on average in the first nine months of years where the party in power changed hands, and rose 6.8% on average in years when the incumbent party held power. This year, the Dow rose 5.4% between January and September, suggesting traders are encouraged by the US economy’s prospects and don’t appear to be in a hurry to kick the Democrats out.

Market action also favours the Clintons personally. The 3.25% return is most similar to 1992 when Bill Clinton was first elected president, while second-quarter monthly action this year is most similar to 1996 when Bill Clinton won re-election.

Hillary Clinton has been leading in the polls through to the end of August, so the strong stock market action may reflect speculation among traders that the Democrats will win again, leading to four more years of similar policies. There is a danger though, that markets are becoming complacent about the election. A lot can happen between now and November, politically, economically and in the markets. The recent UK Brexit referendum is a reminder that financial markets are not a perfect predictor of politics, and can even be wrong, particularly if the race is close.

If trends in polling were to change we could see significant volatility in the markets, with the potential that the usual mid-August to mid-October seasonal correction could deepen or be extended. On the other hand, if Hillary Clinton can carry the momentum through to election day, we may see less seasonal volatility than usual.

Post-election scenarios
General presidential-cycle thinking suggests that markets tend to underperform during the first year following an election. This is when new presidents tend to make the difficult decisions and less popular (but necessary) moves. These type of decisions are made early in their mandate, when they have more political capital and in the hope that any voters angered by early moves will forgive and forget by the time the next election rolls around.

The first few years following presidential elections since 1960 have been difficult ones for trading, with an average monthly return of -0.36%. Democrats have done better than Republicans on average, returning 0.88% per month versus a 0.16% monthly loss for the Grand Old Party. New presidents (0.02% average monthly return in year one) have more than likely underperformed returning presidents (0.8% average monthly return in year five) because second time around there is less uncertainty.

Looking at more recent ‘new president’ years, 1998 to 1989 had the best average monthly return of 2.1%. This however was a third term for the Republicans, while the first President Bush was a known quantity, having already served as vice-president for two terms as well as other high level positions.

The last two ‘first years’ for Democratic presidents also had positive average monthly returns:
1992-93 saw a 1.11% gain under Bill Clinton and in 2008-09 a 1.24% rise under Barack Obama, with Hillary Clinton in cabinet.  

The worst performance came in 2000-01 under the second President Bush, who presided over a major bear market and the fallout from the 9/11 attacks, which saw the Dow post an average monthly drop of -1.5%.

Based on historical trading action following presidential elections, we could see significant market volatility through November and December, but there’s a good chance of a positive market in 2017, should Hillary Clinton win. On the other hand, a Donald Trump victory could create significant political and economic uncertainty and cause market upheaval, both following the election and into next year.

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Trump effect on US rates and the Fed
Federal Open Market Committee members have increasingly been talking up the potential for an interest-rate increase this year and one is likely, regardless of who becomes president.

While a Clinton win would mean business as usual at the Fed, and probably seal the deal on a December increase, a Trump win could spark a big shakeup. Mr Trump has already threatened to replace Ms Yellen at the end of her term in 2018 because of her association with the Democrats. He has since gone on to accuse the Fed chief of keeping rates artificially low to support the economy and financial markets, in order to make President Obama and the Democrats look good heading into the vote.

While stock markets could by choppy following a Trump win, the Fed may come under more pressure from an incoming Republican administration to raise interest rates. It’s uncertain if Ms Yellen would finish her term as a lame duck under a Trump government, or resign earlier. It would appear, however, that Fed governor Lael Brainard, a key member of the dovish faction and permanent voter who came to the Fed from the Obama administration, could see her influence diminish. 

The Fed’s November meeting is less than a week before the election. Normally one would expect the central bank to hold rates but a move can’t be ruled out if the Fed wants to get in a rate hike this year and is worried about 2000 style post-election political chaos. Whatever decision the Fed makes in November, it’s likely to come under fire by one side or the other, with monetary policy under heavy scrutiny during this campaign.

The Mexican peso
US/Mexican relations have been one of the core issues of this campaign. The Trump campaign has been particularly hostile toward Mexico and Mexicans, calling NAFTA the worst trade deal the US ever signed and threatening to deport millions of Mexicans living and working illegally in the US. Mr Trump is also planning to build a wall between the two countries and has threatened to hold back remittances from Mexicans living in the US to pay for the wall.

Needless to say, the US election poses a significant risk to Mexico’s economy and because of this the Mexican peso has been rising and falling in opposition to the rise and fall of  Mr Trump’s prospects. The USD/MXN has been the most actively traded and in-focus currency pair through the campaign. This pair tracks how many pesos it costs to buy a US dollar, so when it goes up, it means the value of the peso is going down.

Through the summer, as polls narrowed, USD rallied against MXN but in recent days, with the Trump campaign apparently stumbling, USD has eased and MXN has bounced back. This specific forex market may be particularly active around the election results. A Trump win could send USD/MXN sharply higher, while a Clinton win could send USD/MXN in the opposite direction.

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