The US election is becoming one of the next key considerations for equity investors.
Ironically, the state of the American economy and stock market could influence the election outcome. In the past, the lower the level of inflation and the higher the level of economic growth, the greater the incumbent’s share of the votes has been.
There is a common perception that the Republican Party is more pro-business, deregulatory and tends to support lower taxes and takes a more limited role in governance. The Democratic Party, on the other hand, is seen as more willing to regulate business, support higher taxes and play a more active role in government. The implication is that a Republican outcome should be better for stock markets.
However, the evidence does not bear this out. Over the past twelve elections spanning 48 years, the S&P 500 has delivered a higher average annual return under the Democrats.
At present, spread betting markets have offered relatively accurate predictions for the outcome of recent elections. The market odds for Barack Obama being re-elected continually fluctuate and these odds are very well correlated with the performance and level of the S&P 500. The latest (Intrade) odds of 57% (as at 4 September) suggest Obama will win. Any material fall in the US stock market would hurt Obama’s chances.
Some academics have theorised a link between business cycles and election cycles. Since the 1960s, the US economy has experienced seven business cycles with an average length of 75 months, or a little over six years. Unfortunately, this theory is not borne out in reality. Similarly, history shows that unemployment is a relatively poor predictor of election results.
Whichever party wins the US election, they will have some hard economic work ahead of them.
Future challenges – the fiscal cliff
Tackling what has been labelled the fiscal cliff in a way that does not do further damage to an already weak US economy is the biggest challenge faced by the next administration.
They will have a choice; they could let sequestration kick in, which will indiscriminately see tax increases and spending cuts across the board. The Congressional Budget Office has estimated that this would see the US economy shrink by 4% in 2013, which makes this an unpopular option. At the other extreme, cancelling the automatic tax increases and spending cuts would stoke the US budget deficit and perhaps lead to a further sovereign rating downgrade.
The Republicans want to cut spending significantly and avoid raising taxes, while the Democrats want more limited spending cuts combined with tax increases.
An ideal outcome would be to phase in tax increases and spending cuts over time, and target cutbacks in areas where the economy is least sensitive, to minimise economic damage. While both parties want to avoid the ‘fiscal cliff’, finding an agreeable compromise on the issue will be difficult.
If Congress fails to find a solution to the fiscal cliff, spending cuts and tax hikes will be enacted indiscriminately across the board under sequestration. And this could be extremely damaging if it adversely affects the most productive areas of the economy.
This becomes a higher risk if a clear election outcome is not achieved.
The market after the election – sector specific
How the US stock market performs after the election is also of interest to investors. History tells us that the stock market is likely to rally if the incumbent wins re-election. But, empirical evidence also suggests that the US stock market has historically delivered its strongest returns on the third year of an election term. This effect might be tied to the incidence of government spending within the presidential cycle, as most government expenditure occurs during the first and second years of an election term.
The biggest stock market effects this time, however, will probably be felt at a sector level – healthcare, financials and defence are sectors likely to be most affected by the election result.
Healthcare – the Affordable Care Act that was passed in 2010 (dubbed ‘Obamacare’) was designed to give 30 million of the poorest Americans access to healthcare. Opposed by the Republicans, it was criticised for being uncompetitive, inefficient, expensive and bad for the healthcare industry. They have challenged its legality as it makes buying healthcare insurance compulsory. The Act also expands the safety net of Medicaid, which provides healthcare for the poorest Americans. The election outcome is a key battleground that will have deep ramifications for the healthcare sector.
If Obama wins, companies that support Medicare and Medicaid should benefit, including pharmaceutical companies. It could also be supportive for jobs as additional hospital staff would be needed to cope with increasing patient numbers. Private health insurance companies would probably lose out.
If Romney wins, he may try to repeal the Act and replace it with an alternative. Companies from a variety of sectors that have lucrative contracts supplying Medicare (for the elderly) and Medicaid (for the poor), could be adversely affected. Pharmaceuticals would be negatively affected because there would be fewer medically insured people. Private health insurance companies on the other hand, would probably benefit – taxes, fees and regulation under the Affordable Care Act would probably be dismantled.
Financial reform – the Dodd-Frank Act passed in 2010 is the main financial service reform proposed by the Obama administration. However, it is complex and it has been difficult to implement. Romney has already vowed to repeal the Act if he is elected, criticising it for being overly burdensome. A repeal of the Act is unlikely, however. Wall Street firms have spent a huge amount of time and resources adhering to the new rules, so reform is still more likely than repeal under Romney.
Despite his threats, even the controversial ‘Volcker Rule’ that bans banks from proprietary trading probably is unlikely to change under Romney. Such a move would be politically unpopular following recent bank scandals. However, Romney would have influence over the Financial Stability Oversight Council, benefitting non-bank financial companies, such as asset managers and insurers. If Obama is elected, plans to shift OTC derivative contracts onto exchanges would benefit the clearinghouses.
Defence – attempts to cut programs, such as missile defence under Obama, would require strong Democratic control of Congress and polls suggest this is unlikely. If the Republicans take control of Congress, defence cuts would be tempered, even under Obama. Many companies could benefit under both Obama and Romney, which is a reflection of the geopolitical tensions that still pressure US policy at present, not least in the shape of the Iran-Israeli nuclear crisis.
Firms that specialise in drone aircraft for military surveillance are likely to benefit regardless of the outcome. Funding the development of cyber security also enjoys bi-partisan support. Additionally, US defence companies will also benefit from equipping the depleted weapon inventories of close NATO allies.
If Romney wins, it is likely that he would support weapons exports to compensate those contractors adversely affected as wars in Iraq and Afghanistan wind down.
A contentious point, many analysts feel that a Romney victory would be more likely to bring about military conflict than an Obama one, presenting a potential boon for the defence industry.
In conclusion, the evidence suggests that the state of the US economy going into an election can influence the votes of swing voters and help to determine an election outcome.
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