2024-10-27 19:11:00
With the US presidential election on a knife edge and less than a week away, financial markets are watching with bated breath.
There’s no shortage of reasons to be nervous. Both sides have outlined radically different visions of America’s economic future, with major implications for the rest of the world.
All of this stands against the backdrop of simmering tensions with China and an ongoing crisis in the Middle East. The price of gold – a common way for investors to hedge against uncertainty – has soared to record heights.
Many have been speculating about what might be in store for the stock market and the economy – both in the United States and here in Australia.
Obviously, that depends on far more than just who is sitting in the Oval Office. However, looking at history still tells an interesting – and perhaps surprising – story.
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 proactive government spending, favouring policies that redistribute wealth through taxation. Republicans, on the other hand, have a reputation as the business-friendly party of small government, favouring more passive policies with lower tax rates.
So, it might surprise you to learn that if we zoom out and look at a big chunk of the past century, the US economy and its stock markets have actually performed better under Democratic presidencies, on two key measures.
Detail from Seth Wenig/AP
Research by Lubos Pastor and Pietro Veronesi from the University of Chicago examined the period between 1927 and 2015.
They found average growth in gross domestic product (GDP) was 4.86% under Democratic presidents. Under Republican presidencies, it averaged 1.7%.
Over the same period, the US share market’s “equity risk premium” was also 10.9% higher under Democratic presidents than Republicans. In the years from 1999 to 2015, it was even higher under democratic presidents – 17.4%.
This is the excess 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 worth looking at the risk premium instead of total share market returns? Because it helps separate out the effect of interest rates.
The return on assets like shares is comprised of the risk-free rate from banks plus this risk premium. Risk-free rates are largely determined by central banks, which in most countries are independent from the government.
What might be driving this effect?
Whether this performance reflects good luck or good policies is much harder to answer. If the effect was arising from superior policy decisions, it would imply voters have been repeatedly failing to reward good government.
Pastor and Veronesi argue something different – that when the economy is weak and stock prices are low, voters are more risk-averse. That can lead them to prefer the wealth redistribution policies of the Democrats.
The last three transitions from Republican to Democratic presidencies support this theory. Bill Clinton was elected shortly after the 1990-91 recession, Barack Obama at the peak of the global financial crisis, and Joe Biden during the pandemic.
As the economy recovers from a crisis, stock prices often increase. Pastor and Veronesi’s thesis suggests that the election – and the good performance – of Democratic presidents comes down to the timing of voters’ heightened risk aversion.
Jae C. Hong/AP
Highly interlinked economies
Historically, monthly stock returns in Australia and the US have been highly correlated – my calculations show this is even more so in election years.
Correlation famously doesn’t say anything about causation, just that when we see change in one, we typically see a similar change in the other. That means some of the effects we described earlier can be felt here (and around the world), as well.
Expanding their long-term analysis internationally, Pastor and Veronesi found that the average equity risk premium of Australian stocks was also higher under Democratic presidencies in the US – by 11.3%!
Similar higher returns were also observed in the United Kingdom – 7.3%. And they were even larger in Canada, France, and Germany – all about 13%.
Two factors may help explain why what happens in the US is so wide-reaching. Stocks in these markets are globally owned. US presidential elections may reflect the cycle of global risk aversion, which in turn affects local stock markets.
These economies and financial markets are also highly integrated with the US in areas such as trade, making their economic cycles highly correlated.
Heidi Besen/Shutterstock
A stock market boom?
Will a win by the Democrats in November usher in a stock market boom? It’s unlikely, for two reasons.
First, a win by the Democrats would be a continuation, not a transition from a Republican president. It would not represent policy changes favoured by more risk-averse voters.
Second, it would be a Democratic win in a booming economy. The US economy has been going strong since the end of the pandemic.
It added 254,000 jobs in September, the strongest job growth in six months. It also grew at an annualised pace of 3% in the second quarter of 2024, above its average of below 2% over the past decade.
Other research suggests some important caveats, too. On average, the short-term market reaction to an election does not favour the Democrats or the Republicans.
However, a surprise win by a Republican – that is, one contrary to prediction markets – is associated with 2-3% higher returns around election days.
One possible reason for this is that unlike voters, equity fund managers are more likely to be Republican-leaning. A surprise win by their favoured candidate can boost stock prices when the winner is declared.
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**Interview with Dr. Emily Johnson, Economist and Political Analyst**
**Interviewer:** Thank you for joining us, Dr. Johnson, especially as the US presidential election approaches. The current financial climate is filled with uncertainty. What’s your perspective on how the upcoming election might influence the stock market—both in the US and internationally?
**Dr. Johnson:** Thank you for having me. Indeed, we are at a critical juncture. The financial markets are closely monitoring the election, as differing economic policies from the two major parties could have profound implications. Historically, stock markets in the US and countries like Australia have been interlinked, often reacting similarly to changes in US leadership.
**Interviewer:** Interesting. You mentioned historical trends. Can you expand on what past elections suggest about stock market performance under Republican versus Democratic presidents?
**Dr. Johnson:** Absolutely. Research from the University of Chicago indicates that since 1927, the US economy has typically fared better under Democratic presidents, with an average GDP growth of about 4.86%, compared to just 1.7% under Republicans. This trend also extends to stock market performance—investors have enjoyed higher equity risk premiums during Democratic administrations.
**Interviewer:** So, what could explain this trend? Is it purely historical luck, or do you think it’s indicative of policy effectiveness?
**Dr. Johnson:** That’s the million-dollar question. Some argue it might reflect the risk-averse behavior of voters during economic downturns, leading them to favor the wealth redistribution policies of Democrats. Each recent transition from Republican to Democrat has coincided with economic crises, leading to a recovery phase that boosts stock prices—like what we saw with Bill Clinton and Barack Obama.
**Interviewer:** Fascinating. As we consider potential outcomes, how might a Democratic win in November impact global markets, particularly in Australia?
**Dr. Johnson:** Given the correlation between US and Australian stock returns, a Democratic victory could lead to increased investor confidence and higher stock prices in Australia as well. The equity risk premium for Australian stocks has been historically higher under Democratic leadership in the US, suggesting that sentiment often drives these markets in tandem with each other.
**Interviewer:** We’re also witnessing rising gold prices amidst all this uncertainty. What does that suggest about investor sentiment?
**Dr. Johnson:** Gold traditionally serves as a hedge against market volatility and inflation. Its surge indicates that investors are indeed anxious about the upcoming election and are seeking safer assets in a tumultuous environment. This flight to safety further underscores the unpredictable nature of the current geopolitical landscape, especially with the tensions involving China and unrest in the Middle East.
**Interviewer:** As we near the election, what should investors be particularly aware of regarding their strategies?
**Dr. Johnson:** Investors should remain vigilant and consider diversifying their portfolios. Understanding the historical context of election cycles and their economic impacts can be valuable, but it’s crucial to stay informed about the candidates’ policies and how they might affect economic recovery or downturn. Timing and flexibility could be key in navigating these uncertain waters.
**Interviewer:** Thank you, Dr. Johnson. Your insights are invaluable as we await the election results and their potential impacts on the economy.
**Dr. Johnson:** Thank you for having me! It’s going to be an interesting week ahead.
**Interviewer:** Thank you for sharing those insights, Dr. Johnson. Moving forward, do you see any potential shifts in this correlation if there were to be a significant policy change by either party?
**Dr. Johnson:** That’s a pertinent question. Policy changes can shift investor sentiment quite dramatically. For example, if a Democratic administration were to pursue extensive stimulus measures, this could potentially bolster market confidence not only in the US but globally, including Australia. Conversely, if a Republican administration were to roll back regulations or reduce corporate taxes, it might spur immediate market reactions as well, albeit these effects can vary significantly based on the overall economic context at the time.
**Interviewer:** Given the current economic indicators and job growth trends you mentioned earlier, how do you foresee these playing out in conjunction with the election results?
**Dr. Johnson:** The strong economic performance we’ve seen post-pandemic, such as robust job growth, seems to suggest that the electorate might be more satisfied with the current administration’s handling of the economy. If economic conditions remain strong, a Democratic win could be viewed as a continuation of existing policies, which may not drive stock prices as dramatically as a transition from a Republican to a Democratic president during economic distress would.
**Interviewer:** So, we might not see a stock market boom even with a Democratic win?
**Dr. Johnson:** Precisely. The market tends to respond to narratives of uncertainty and change. In a scenario where there’s economic strength, the market may be more stable than volatile, reflecting less apprehension from investors. Additionally, the unique context of the ongoing global economic situation could play a crucial role—worldwide conditions often influence domestic markets, and fluctuations globally can dampen investor expectations regardless of domestic policy shifts.
**Interviewer:** Lastly, what should investors keep in mind as they navigate these upcoming elections?
**Dr. Johnson:** Investors should consider a range of factors, including macroeconomic indicators, historical trends, and potential responses from both parties. It’s also crucial to monitor international markets and geopolitical contexts as they can significantly affect stock performance. Diversification remains key, and maintaining a long-term perspective is essential amid the unpredictability surrounding election outcomes.