Electoral market volatility: help or harm?

With British and American elections both looming – 2015 and 2016 respectively – the Scottish independence referendum was a timely reminder of the market volatility electoral uncertainty can …

With British and American elections both looming – 2015 and 2016 respectively – the Scottish independence referendum was a timely reminder of the market volatility electoral uncertainty can breed. Pre-vote jitters around currency and capital flight caused a drop in sterling and a sell-off of Scotland-exposed shares.

Electoral commentary tends to emphasize how markets don’t like elections, but all volatility presents opportunities for the bold. Leaving aside specific policy implication, are elections more helpful or harmful for the investor?

Why elections are harmful

The biggest, general harm electoral uncertainty causes is in making business more risk-averse, up to a year in advance of the event itself. In July 2014, Deloitte’s quarterly survey found 65% of CFOs at large British firms with an appetite for risk, down from 71% the previous quarter. That figure will undoubtedly slip further as we get closer to May 2015.

What does that mean? Well, large firms spend less money on capital expenditure, take on fewer staff, and make less expansionary plans until they know the environment they’re operating in. The chief worry in this election is that if the Conservatives win there will be an in/out referendum on EU membership in 2017 – a major change in the British business environment; which would create another two years of uncertainty in the run-up to the referendum.

But elections also necessitate substantive investment decisions based on individual policy promises. For example, if Labour win in 2015 Miliband’s much-vaunted promise to freeze energy prices will be enacted. Anyone investing in the energy sector at this point is essentially making a bet on a Conservative victory. Most will simply abstain, potentially pulling capital out of the sector altogether until a result has been declared.

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Of course any investment decision carries a degree of uncertainty, an element of risk and ‘educated guess’ projection, but elections add in considerable levels of higher uncertainty, making many decisions, particularly in areas affected by manifestos, substantially riskier than normal. The result is that not only are businesses themselves more cautious in investing in themselves, but investors across the board are more likely to stay their hand – making the market as a whole more illiquid.

Why elections are helpful

On the other hand, if everyone else is being cautious, there are rewards for those willing to take risks. If you can get in while the market’s at a low ebb, there’s a chance to profit substantially with the post-election upswing. The trick is putting your money in the right place.

Usually it’s a case of betting on the winner, but there is some evidence that there are certain market trends elections always adhere to. Morgan Stanley analysis prior to Obama’s 2008 victory outlined potential beneficiaries from a Republican and Democrat victory respectively – investment bankers and coal win under Republicans, healthcare and generic pharmaceuticals under Democrats – but also noted that defense stocks outperformed the market +19% over the previous 8 elections irrespective of the party in power.

And there may even be broader structural trends that savvy investors can take advantage of. American financial analysts have noted a trend in the U.S. election cycle for a marked upswing in market indexes the 200 days after a midterm election. A 2010 report by the Leuthold Group found that in every election since 1942 the S&P 500 index had gains averaging more than 18% in the 200 days following a midterm election.

As with all data, why is a matter for debate. But what’s notable is that for all the caution before an election, there is a fairly reliable upswing once a result is declared, and, as with the midterm phenomenon, markets tend to remain buoyant while certainty reigns. It’s the other side of the volatility coin. Peaks and troughs, rough with the smooth, yin and yang – at least with elections you know where the flip will come.

Playing the long game

All volatility is temporary. And electoral volatility is no different. So for the long-term investor, the Warren Buffett in you, elections are just another blip. The dividing lines may be starker in the US, but in the west there has been a broad political and economic consensus for decades, coalescing somewhere around the center-right. The outcomes of elections are not as seismic as they are in emerging markets with emerging democracies – India, say.

You do have to watch for the odd radical trend. The influence of UKIP and the effect on Britain’s relationship with the EU is certainly something even long-term investors need to be wary of. And the nascent growth of the green energy sector is certainly dependent on the political coin. But by and large, in the developed west, it’s a matter of degrees rather than sharp turns.

So. Electoral volatility. Helpful or harmful? As with most things in life, it depends which side you’re standing on. The trick is picking the right one.

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