Jonathan Davis

Markets love lame ducks

Investors do best when US presidents are too weak to fulfil policy promises

Markets love lame ducks
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Next week’s too-close-to-call US presidential election must make a big difference to the way stock and bond markets perform over the next few years — or so you might think. Yet experience suggests that investors should probably stifle a yawn rather than place too much significance on whether Obama or Romney comes out ahead. In practice, markets rarely assign as much importance to the outcome as politicians and their supporters think they should.

For this there are some sound historical reasons. One is that hardly any politician ever succeeds in implementing everything he or she has promised in order to get elected. In the United States, the ability to deliver on promises is additionally constrained by occupants of the White House having to work with a Congress that is often of the opposing political persuasion. However fierce the campaign rhetoric, the checks and balances of the US constitution often produce muddle-through outcomes that party activists hate but markets tend to like. On the rare occasions when a president is given a chance to legislate while his own party has a majority in both the House of Representatives and the Senate, the results can be disastrous.

That’s one reason why, paradoxically, investment returns tend to be better when there is gridlock in Washington. If there is one thing markets instinctively hate, it is politicians coming to power with free rein to introduce ill-thought-out legislation. That’s a reason why markets typically perform better in the third and fourth year of presidential terms, when little legislation happens but promises are two a penny, than they do in the first two years — the narrow window in which newly elected presidents strive to implement their policy commitments. Years dominated by harmless pre-election posturing are relatively less damaging to wealth creators and corporate earnings.

Since 1925, the United States has had 15 presidents. The average stock market return in the third year of their terms over that period (19 per cent) is nearly 2.5 times greater than the average return in their first years (8 per cent). That applies to both Republicans and Democrats. In fact, even though Republicans are supposed to be more -business-friendly, stock markets tend to do better when a Democrat is in the White House.

That statistic disguises the importance of expectations, however. In years when Republicans are elected, shares tend to do better in anticipation of the outcome, but disillusionment sets in later. In Democratic victory years, the market dislikes the prospect but find the reality more comforting as the new incumbent typically fails to deliver: for example, on plans to tax the wealthy harder.

Another distinction is even more important. Incumbent presidents are hard to beat: of 14 who have sought re-election since the 1920s, only three (Ford, Carter and Bush senior) have lost. In fact, of all the possible combinations, a re-elected Democrat produces the best stock market outcome over the 12 months before and after his election. A known quantity, even one who quickly becomes a lame duck, is often to investors’ liking.

This perspective, offensive as it may seem to the politically active, throws a new light on the prospects for this year’s election. The 2012 campaign has been bitterly fought, yet its most striking feature from a market perspective has been the marked and continuing divergence between the narrative presented by opinion polls (an ever tighter race, -Romney gaining last-minute ground) and that reflected in the behaviour of markets and betting exchanges.

Consistent with the pattern of an incumbent Democrat seeking re-election, Wall Street has risen since the parties chose their candidates this summer, and only since the late Romney surge has the market fallen back. On the betting exchanges — whose track record of calling election results is notably superior to that of the pollsters — Barack Obama remains a comfortable favourite. In part, that reflects the fact that punters focus on the critical issue of who stands to scoop the electoral college votes in the seven or eight key swing states, rather than on the overall popular vote, which (as Al Gore discovered in 2000) does not always accord with the final result.

Just as important is that the Democrats may hold on to a Senate majority. With Republicans still in control of the House, that in turn holds out the prospect of yet more gridlock — an outcome that many economists fear will commit the US to a new recession, given the urgent need to reach agreement on reducing the $1 trillion-a-year fiscal deficit that is Obama’s most visible legacy and which has defeated all previous attempts at bipartisan solutions.

Surely, you might think, that cannot be the best outcome for investors this time round? Don’t rule it out. There is of course no law that says the betting exchanges or the markets have to be right. Maybe Mitt Romney’s performance in the first debate was a Nick Clegg moment, catapulting him to a victory thought highly improbable only a few weeks ago. Optimists will cling to the hope that Congress can finally agree something sensible about the US debt mountain, whoever wins.

Investors can only suspend judgment and hope for the best. The man whose actions will have the biggest impact on future investment returns is Ben Bernanke, the chairman of the Federal Reserve, and his name is not on the ballot paper. One of Romney’s few clear commitments, however, is not to reappoint Bernanke when the latter’s term expires in January 2014 — and that really could be the harbinger of something significant for the markets if it ended the Fed’s controversial money-printing policy.