The American presidential election is on the 6th November. It’s an important event and it seems quite natural to wonder at how it will impact on financial markets. As foreign exchange traders we are might also be interested in finding out how it could possibly influence the value of the currency markets and more specifically of the U.S dollar. Some argue that the election will have no impact. For example the financial blogger Jeff Rose of Jeff Rose-Financials has said he sees no real change likely from the election, however, other commentators and analysts believe the event will influence the financial markets, not just as a result of the differing policies of the two leaders but also because there is strong evidence to suggest a link between presidential elections and cycles in the stock market. Obama advocates a tax and spend agenda – arguing austerity would harm the fragile recovery. He intends to continue to invest in education, infrastructure and Medicare using higher taxes – particularly on the wealthy and on sundries like capital gains, dividends, interests and estates. He will probably not revive the Bush tax cuts which are set to expire at the end of this year. Romney on the other hand wants to cut the deficit and avert a supposed ‘fiscal cliff’ scenario. He has vowed to reduce spending to 20% from its current level of 24% – of GDP (defence’s 4% remaining untouched however). He intends to focus on reducing the budget deficit and bringing down the country’s total debt. He will finance tax cuts by removing tax deductions and credits, particularly at the upper end. He intends to make U.S businesses more competitive by reducing corporation tax from 25% (currently the highest in the OECD). Assuming Obama wins there are several possible outcomes for the markets. Some argue that his agenda will mean continued overspending and the running up of deficits which would devalue the dollar, however, others argue that stocks will fall under Obama out of a fear of greater regulation and because of higher taxes reducing the availability of credit. Indeed this would seem to be the case if the Bush tax cuts were not revived. And if the stock market falls then you would expect the dollar to strengthen since it is inversely correlated. If Romney wins then some analysts think stocks will rise because according to one blogger: “markets usually respond favourably to a Republican win.” This would seem to indicate the possibility of a rally after a Romney victory with an uncertain reaction from the dollar which is usually inversely related to equities – so perhaps weakness. However, given his well-known pledge to remove ‘Helicopter Ben’ – Bernanke from the Chairmanship of the Federal Reserve this could impact on how investors view the outlook for monetary policy, and they might surmise that a less accommodative Fed chairman could signal a downturn for stocks as he would limit the availability of money. This would probably conversely lead to dollar strength. However, there are other methods and theories for assessing the effect of the election on the dollar which do not rely on policies but are based on broader cyclical phenomena. Yale Hirsch Presidential Election Cycle theory The most well-known cyclical study of the effect of the presidential election on financial markets is the Yale Hirsch Presidential Election Cycle Theory. This theory posits a relationship between the stock market and the four year cycle of the presidential term. Broadly speaking it argues that regardless of who wins the election the stock market tends to perform better in the second half of the president’s term in office, than in the first half. Let’s look at the theory in a bit more detail: YEAR 1 According to the theory in the first year of the president’s term stocks perform at their weakest and it is therefore likely to be the most bullish for the dollar. This is the worst year on average for the stock market. Average total return on the SP500 is 7.41% YEAR 2 In year two stocks also tend to perform poorly. For example there is evidence that markets reach bear market bottoms more often in this year than any other year according to the “Stock Trader’s Almanac”. Average total return on the SP500 of 10.21% YEAR 3 Year three is considered to be the best year for equities with an average total return on the SP500 of 22.34% YEAR 4 In year 4 stock market performance tends to be above average, with average total returns on the SP500 at 9.79% There are several interesting explanations posited as to why the cycle occurs. For example, the poor performance of stocks in year one is attributed to a mixture of disillusionment with the new President – after all the pre-election hype, and also because it is usually during this time that he introduces his least popular policies so as to get them ‘out of the way’ in the hope they will be forgotten by the time the next election comes round. These policies often involve increasing taxes or undertaking spending cuts, which often lead to stock market falls as they reduce the amount of available capital for investors to put in their portfolios. The rallies in the 3rd and 4th years can be attributed to President’s tending to favour more stimulative upbeat polices in the second half of their term. This is so as to improve their chances of re-election. Popular vote winning policies, or those which help people feel good often involve fiscal stimulus and increasing the amount of money in the system, thus leading to higher stock returns as there is more available money to invest. The Presidential Cycle theory appears to have some basis to it, because despite there being only a small sample size of observations on which to make conclusions, the correlation is so strong that according to a study by researchers at the University of Singapore who wrote a paper entitled “Mapping the Presidential Election Cycle in the U.S Stock Market,” there were statistically significant presidential election cycles in the U.S stock market during the greater part of the last four decades, and: “stock prices decreased by a significant amount in the second year and then increased by a statistically significant amount in the third year of the presidential election cycle.” Given the strong evidence to support this theory we can’t ignore its conclusion that the stock market will probably not perform well in the first year of the next president’s tenure regardless of who wins. Given the inverse relationship with the dollar, this would seem to suggest a rise in the dollar as the most probable outcome following the next election. Obama or Romney? In a study by John Nofsinger entitled: “The Stock Market and Political Cycles,” Nofsinger proposed that the stock market can predict the next president. He argued that when markets have seen high returns in the previous three years of the cycle the present incumbent is normally likely to remain in office, wheras when the stock market had been doing badly the president is more likely to change. If the theory holds true this time then it is most likely Obama will be re-elected given he has presided over a strong bull market in stocks for the last three years. Does the affiliation of the president who wins have an impact? Conventional wisdom suggests that the stock market would be expected to perform better when Republican was in White House than when a Democrat was incumbent. Republicans are associated with enacting policies which help the stock market such as cutting taxes and loosening business regulation wheras Democrats are viewed as having an anti-business tax and spend platform. However, despite these well-established characterizations a study conducted at the University of California revealed significantly better stock market returns under Democrat presidents than under Republican presidents. Pedro-Santa Clara and Rossen Valkanov published the results of their work in “The Presidential Puzzle: Political Cycles and the Stock Market.” The duo compared value-weighted and equal weighted portfolios under different presidents. They looked at excess returns over 3-month T-bill rates. They found that the value weighted portfolio showed an average return of 2% under a Republican regime whilst it showed an average 11% rate of return under Democrats. The equal weighted portfolio was even more telling, with a 16+% in favour of Democrats. Further investigation showed they were as a result of higher average returns and lower interest rates under Democrat administrations. A study of business cycle variables suggested the gains may have had something to do with Democrat policies which tended to ‘surprise’ the markets in the context of lower overall expectations. Despite the small sample size the correlation tested statistically significant, although there is still a small chance it could be a fluke occurrence, nevertheless, it remains another piece of evidence and to help build a picture of how financial markets might react to the election. Given the overall better chance of a democrat win, as shown both in current polls, the recent rise of democrat favourable sectors such as housing and the Nosfinger predictive model it is probable Barack Obama will be the next president. An Obama administration might have a mitigating effect on weaknesses in stocks expected due to the Yale Hirsch model because the markets tend to perform better under democrat administrations. This could limit the downside for equities and the upside for the dollar in the years after the election. Conclusion Given the available evidence we can sum up the likely impact on the foreign exchange markets of the presidential election in the following way: Firstly, it is likely Barak Obama will be re-elected. He continues to lead in the polls, has an overwhelming majority share of the non-white vote which is highly unlikely to be counterbalanced by extra white voters and as a result of the Nosfinger theory may also be re-elected because stocks have been performing well over the last three years. Obama policies are likely to involve the definitive end to Bush tax cuts as well as increases in taxes to investment sensitive demographics who may draw back from investing in stocks. A steadily increasing concern over his Keynsian spend philosophy in the face of a rapidly escalating fiscal cliff and global economic downturn may also hit stocks markets and lead to further loses. The cyclical Yale Hirsche theory indicates weaknesses in stocks, at least for the next two years anyway. Weakness for the stock market and heightened risk aversion are likely to benefit the dollar which could strengthen in value after the election and then during 2013.
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