Elections and share markets

Looming elections in the US (on 2 November 2004) have the potential to impact on share markets. In fact, 2004 is a big year for elections with polls in many Asian countries as well. The immediate 17% or so fall in the Indian share market in May, after a change of government, highlights the impact elections can have.

The US Presidential cycle

The chart below shows the average return since 1927 for US shares for each of the years within the four-year Presidential cycle (where year 4 is the last year of the president’s term and when the election is held in November).

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Source: Datastream and AMP Capital Investors

It can be clearly seen that year 3 is the strongest (as it is when the president stimulates the economy to aid his party’s election chances in year 4). Years 1 and 2 are the weakest as the president tends to withdraw economic stimulus in those years. During President Bush’s term, so far the cycle has been pretty typical (albeit more pronounced than normal owing to bursting of the IT bubble, corporate malfeasance, etc.), with very weak share markets in 2001 and 2002 (years 1 and 2) and a very strong gain in 2003 (year 3). Year 4 is typically a positive year for shares but not as strong as year 3. Even in years when the incumbent political party lost, the market still performed well in year 4 (with an average return of 9.6% compared to an average return of 13.6% in all year 4s). The Presidential cycle suggests this year should be reasonable for US stocks but below average gains may be expected in 2005 and 2006 (other things being equal).

The outcome probably won’t matter in the long run

History also suggests that whoever wins the US elections will not have a major impact on longer-term share market returns. Since 1945, US shares have in fact done slightly better (about 2% per annum) under Democrat presidents in the US than under the Republicans.

On this basis investors should not be too worried about a change in government. While parties in opposition might sound radical, once in government they are usually forced to adopt sensible macro economic policies if they wish to deliver rising living standards to their constituents. And in the US, Congress usually acts as a brake on governments adopting drastic policy changes. Furthermore, all sides in the coming US election are generally in agreement about the benefits of free markets and the need to maintain low inflation.

But markets don’t like uncertainty

However, past experience suggests elections can sometimes have significant short-term impacts on markets. This stems mainly from the fact that investors don’t like the uncertainty associated with the prospect of a change in government. The next chart shows US share prices from one year before to six months after US elections, beginning from 1976.

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Source: Datastream and AMP Capital Investors

While there appears to be little impact on average (as evidenced by the line labelled ‘average of all elections from 1976’), perhaps the elections of 1976 and 1992 are of most relevance as Republican incumbents lost to Democrats. What was evident in both those years was a degree of softness for nine months before the election, reflecting investor anxiety and then a relief rally once the election was over. After a few months, other factors then take over as key market drivers. In fact, the US share market so far this year looks very much like it did in 1992, with share prices moving up and down in a tight range partly driven by President Bush’s standing in the opinion polls.

The looming election in the US offers scope for short-term investor uncertainty for several reasons. Firstly, opinion polls point to a close election. In the last 50 years in the US, whenever a challenger has led the polls prior to the challenger’s party convention they have gone on to win. That was the case with Carter in 1976 and Reagan in 1980 and is now the case with Kerry.

Secondly, the challengers in both the US are relatively unknown and have some policies which may worry investors. In the case of Senator Kerry, aspects which may worry markets include proposals to wind back tax cuts for dividends and capital gains and fears he might be more protectionist and regulatory.

However, our analysis suggests that if there were share price softness into the elections, this would provide a buying opportunity. Actual policies are likely to be more balanced in their impact than investors might fear. Furthermore, the legislative houses in the US will impose significant constraints on what new governments can do (e.g. moves to wind back dividend and capital gains tax relief are unlikely to pass through Congress). Finally, the track record of Democrat governments has not been bad for shares.

Conclusion

Overall, while upcoming US election may result in short term market uncertainty, past experience suggests little lasting impact whether there is a change of government or not.

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