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US economy

The midterm equity boost

With less than 100 days until the US midterm elections, there’s a lot of uncertainty about how the political situation will shake out. Statistical hub FiveThirtyEight gives Democrats a roughly 75 per cent chance of winning the House, but given how badly forecasters fared last time around, we should probably take any projections with a grain of salt.

What’s more certain, however, is how US stocks will fare. Around the midterms, equity returns have far outpaced those of non-election years.

UBS’s Keith Parker finds that between August and March of the last 17 midterm elections since 1950, the S&P 500 rallied about 14.5 per cent on average. In non-election years, returns during this same window averaged some 6 per cent. While US stocks tend to retract 1.4 per cent from the end of August through early October when midterms are coming up, they climb thereafter. About two weeks out, the performance gap in equity returns between election and non-election years starts to widen. By year-end, its even larger—a trend that continues for several months:

Beyond economic fundamentals, part of the run-up stems from the political discount investors price in ahead of the midterms, given the uncertainty about which candidate (and policies) will prevail. UBS calculates that before Americans head to the voting booth, the S&P 500’s price/earnings ratio settles about ten per cent below levels implied by its models. Once the victors are crowned, the discount gets wiped out and US stocks march higher.

Not all sectors feel the midterm boost. Ahead of the election, defensive stocks such as healthcare and consumer staples tend to do better than cyclicals, whose prices rise and fall with the overall economy. The same is true for high-quality bonds like US Treasuries and investment grade debt, which are seen as relatively risk-free options. After the election, however, growthier assets typically outperform again. Here’s Charlie Reinhard and Joe Fiorica of Citi’s Private Bank with the scoreboard six months before and after the midterms:

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The midterm rally in US stocks holds even if the political status quo gets disturbed, which is not uncommon — Deutsche Bank calculates that the incumbent president’s party typically loses about 26 seats in the House and 4 in the Senate. The six times since 1950 that the president’s party lost either the House, the Senate or both chambers, the S&P 500 gained an average 7.3 per cent from the end of August to year-end, just a percentage point higher than the average performance when the distribution of power remained unchanged. The results of the 2010 midterms partly explains this divergence. As UBS points out, the elections were a vote against President Obama’s Affordable Care Act and other progressive policies. And when House Democrats lost 64 seats, markets rallied nearly 20 per cent:

If Republicans lose the House this time around, the political stakes are potentially far higher. Republicans are betting Democrats will investigate President Trump’s tax returns, his dealings with Russia, and a litany of other grievances. Others speculate Democrats will give impeachment a go. Rather surprisingly, though, none of it may matter to investors.

We recently looked at how financial markets performed when the Watergate scandal engulfed the Nixon administration in the 1970s. In the six months before he resigned, the S&P 500 declined, US 10-year yields rose with gold prices, and the trade-weighted dollar fell. As we wrote, these gyrations reflected much more than domestic politics, but rather the breakdown of the international Bretton Woods system of fixed exchange rates and dual oil and inflation shocks. Citi’s Reinhard and Fiorica draw a similar conclusion when it comes to President Clinton’s impeachment. Strong economic growth in the late 1990s propelled the S&P 500 higher, despite the scandal consuming the country:

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Source: Haver Analytics
Source: Haver Analytics

The economic environment today is equally as supportive of higher US stocks, according to Deutsche Bank. While some measures of manufacturing are slowing, consumer confidence rose this month to the highest level in nearly 18 years. And in the first and second quarters of this year, earnings growth was very strong. Deutsche Bank says the S&P 500 will reach 3000 by year-end as equity multiples are not yet too lofty. Part of their optimism stems from the fact that even if Republicans were to lose both chambers, the tax cuts that have created quite a windfall for corporations aren’t going anywhere, and neither is the deregulation push.

History looks set to repeat itself.

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