With the US presidential election on a knife’s edge and less than a week away, financial markets are watching with bated breath.
There is no shortage of reasons to panic. The two sides have outlined radically different visions of America’s economic future, with major implications for the rest of the world.
All this against the backdrop of rising tensions with China and the ongoing crisis in the Middle East. The price of gold – a common way for investors to hedge against uncertainty – has soared to record highs.
Many are speculating about what could happen to the stock market and the economy – both in the United States and here in Australia.
Obviously, it depends on a lot more than who sits in the Oval Office. However, a look back at history still tells an interesting – and perhaps surprising – story.
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Elephants, donkeys, bulls and bears
In the United States, both sides of the political divide are subject to some oversimplifying stereotypes.
Democrats are often seen as the party of active government spending, favoring policies that redistribute wealth through taxation. Republicans, on the other hand, have a reputation as the business-friendly party of small government, favoring more passive policies with lower tax rates.
So, it might surprise you to learn that if we zoom out and look at a large part of the last century, the US economy and its stock markets have actually performed better on two key measures under Democratic presidencies. what is
Research by Lobos Pastor and Pietro Veroni of the University of Chicago examined the period between 1927 and 2015.
They found that average growth in gross domestic product (GDP) under Democratic presidents was 4.86 percent. Under a Republican presidency, it averaged 1.7 percent.
During the same period, the US stock market’s “equity risk premium” was also 10.9% higher under Democratic presidents than under Republicans. In the years from 1999 to 2015, it was even higher under Democratic presidents – 17.4%.
This is the additional rate of return that can be earned by investing in shares above the “risk-free rate” (such as the interest rate on a savings account).
Why is it important to look at the risk premium rather than the total return of the stock market? Because it helps isolate the effect of interest rates.
The return on assets like shares consists of the risk-free rate from banks plus this risk premium. Risk-free rates are mostly set by central banks, which in most countries are independent of the government.
What effect could this have?
Whether this performance reflects good luck or good policies is very difficult to answer. If the effect was arising from higher policy decisions, this would mean that voters are repeatedly failing to reward good government.
Pastor and Veronesi argue somewhat differently – that when the economy is weak and stock prices are low, voters are more at risk. This may make them prefer the Democrats’ wealth redistribution policies.
The last three transitions from a Republican to a Democratic presidency support this theory. Bill Clinton was elected shortly after the 1990-91 recession, Barack Obama at the height of the global financial crisis and Joe Biden during the pandemic.
As the economy emerges from a recession, stock prices often rise. Pastor and Veroni’s paper shows that the election of Democratic presidents – and the good performance – comes at a time when voters’ risk aversion is high.
Highly interconnected economies.
Historically, monthly stock returns in Australia and the US have been highly correlated – my calculations show it’s even higher in election years.
Correlation famously says nothing about causation, only that when we see a change in one, we usually see a similar change in the other. This means that some of the effects we described earlier can be felt here (and around the world).
Expanding their long-term analysis internationally, Pastor and Veroni found that the average equity risk premium for Australian stocks was even higher under Democratic presidencies in the US – 11.3%!
Similar high returns were seen in the United Kingdom – 7.3%. And they were even larger in Canada, France and Germany – about 13%.
Two factors may help explain why what happens in America is so widespread. Stocks in these markets are owned globally. The US presidential election may reflect a cycle of global risk aversion, which in turn affects the local stock market.
These economies and financial markets are also highly integrated with the US in areas such as trade, making their economic cycles highly correlated.
Stock market boom?
Will a Democrat win in November boost the stock market? This is unlikely, for two reasons.
First, a Democratic victory would be a continuation, not a reversal, from a Republican president. It will not represent policy changes favored by more risk-averse voters.
Second, it would be a democratic victory in a booming economy. The US economy has been strengthening since the end of the pandemic.
It added 254,000 jobs in September, the strongest job gain in six months. It also grew at an annualized pace of 3% in the second quarter of 2024, down from its average of 2% over the past decade.
Other research also suggests some important caveats. On average, the short-term market reaction to the election does not favor either the Democrats or the Republicans.
However, one surprise Republican wins—that is, contrary to market predictions—are associated with 2-3% higher returns on election days.
One possible reason is that, unlike voters, equity fund managers are more likely to lean Republican. A surprise win by their favorite candidate can boost stock prices when the winner is announced.
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