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3 Important Things to Know about Elections and Markets

In the past 12 months, we have had the US election, the Dutch election, the French election and the UK snap election

Dan Kemp 23 June, 2017 | 1:57PM

People love to speculate on the result of an election and investors are not immune from this urge. In the past 12 months, we have had the US election, the Dutch election, the French election and now the shock close result in the UK snap election. In each case, investors have sort to position their portfolios for one or more possible outcomes and commentators have speculated on the impact of the results.

While it is rational to take new information and understand it, making changes to portfolios in advance, or just subsequent to, political events is fraught with behavioural risks that could have a lasting negative impact on portfolios. Our investment team is therefore encouraged to avoid speculating on geopolitics as elections and fundamentals are barely connected. This lack of connection can be shown in several ways:

Elections Results are Poorly Correlated with Returns

The US market is flush with data and has a regular four-year election cycle, so an effective exercise is to trace back to 1880 and understand the link between elections and the markets. This can be broken up in various ways, including the “left wing” versus the “right wing” and a “large majority” versus “no majority”.

election outcomes have had little bearing on returns, except following close elections

We can see that the debate between left wing and right wing has not been terribly important to returns, nor has a large majority. However, what would seem to be apparent is that the uncertainty of a close election can drag on returns.

Investors Overreact to Election Results

There are two possible ways an investor can interpret the above result. They can apply the speculators mentality and predict similar outcomes, or they can apply an investors mentality and interpret the results against the fundamental impact.

To explain the way an investor can achieve the latter, the same chart can be overlaid with the change in dividends subject to the election. This latter data point helps us to understand the health of the corporate sector, as a sizeable change in dividend policy would be a clear sign that elections matter. We can also understand the relative moves in both the fundamentals and prices to see if investors overreact or not.

We note a few observations from the results below. First, the health of the corporate sector typically remains intact regardless of the winner. Therefore, rather than predicting a crash or worrying about the ‘left versus the right’, an investor would be better placed remaining impartial to their natural behavioural biases and limit their trading costs.

As we look a little deeper, there would seem to be subtle evidence that dividend growth can be slightly slower following a close election. The historical average of 2.0% growth is below the long-term average of 4.2% in nominal terms, although not sufficiently so to justify the large price moves. However, this may simply reflect other circumstances such as the phase in the economic cycle.

Acknowledge the Wide Range of Outcomes

While the above is helpful in understanding the historical averages of both fundamentals and prices, it is also important to recognise the wide range of outcomes. By sticking to a fundamentally-driven approach to elections, we also find a situation where the range of dividend outcomes are largely unpredictable. For example, in 1884, a close election happened to precede a major recession, where dividends fell by -26% over the next four years. In 2004, during a similarly close election, dividends went on to grow by 47% through the 2004-2008 boom. Neither of these outcomes were wholly attributable to the election result and should be recognised as such. 

Is a Close Election a Game Changer?

The U.K. is the latest in a series of elections that gets the world talking. With the Brexit referendum last June and now a shock election result, investors are understandably trying to work through the clutter and figure out what will happen to corporate Britain.

While we must acknowledge the uncertainty, the logic from the above analysis can be applied anywhere – including the U.K. today. Is this time really that different? And will the election outcome really create a crisis? Maybe, maybe not. What we do know is that the risks are often overstated and investors tend to overreact. For this reason alone, the election result would seem more likely to offer a contrarian investment opportunity than to be feared of.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA