FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION. PRICE POINT May 2016 Timely intelligence and analysis for our clients. Politics and Markets THE FINANCIAL MARKETS AND PRESIDENTIAL ELECTIONS EXECUTIVE SUMMARY T. Rowe Price cautions investors on making investment decisions based on expected election outcomes. Fundamental factors, such as oil prices, corporate earnings, and monetary policy, should outweigh political developments. The stock market has generally performed well during presidential election years, particularly when the incumbent party wins. Sectors such as health care and energy could be affected by proposals of leading candidates. The U.S. stock market has historically generated gains in presidential election years. However, T. Rowe Price managers caution investors against making investment decisions based on expected election outcomes, as more traditional issues typically determine market performance. Global growth trends, divergent monetary policies, volatile oil prices, corporate earnings, and geopolitical tensions are among the factors that are more important than political developments. It may be tempting for investors to try to link presidential election results to market outcomes, but there are really no consistent relationships between party affiliation and long-term investment success, says Eric Veiel, the firm s head of U.S. equity. Veiel adds, It s really hard to predict the outcome of politics, and even if you get the outcome right, it s even harder to predict the market reaction. So you re doubling up your difficulty. It s like trying to thread the needle twice. Larry Puglia, manager of the Blue Chip Growth Fund, cautions investors against letting the political environment weigh too heavily on their investment strategy
because stocks have performed well during most presidential terms or over longer time periods. Investing purely on the basis of which party is in power is not a fruitful exercise. Figure 1: Stock Market Has Favored Republican and Incumbent Party Victories Average annual principal return for S&P 500 Index in presidential election years: 1928 2012 12% 10% 8% 6% 4% 2% 0% Republican Candidate Wins Democratic Candidate Wins Incumbent Party Wins Incumbent Party Loses Source: Strategas Research Partners HISTORY PROVIDES CONTRADICTORY CLUES Indeed, you can find evidence supporting betting on either party. On one hand, from 1945 through 2015 the S&P 500 Index generated an annualized principal return of 6.7% over the course of Republican administrations and 9.7% during Democratic administrations, according to S&P Global Market Intelligence. On the other hand, since 1928, the U.S. market has fared better during election years when Republicans have won recording an average gain of 11.3% in Republican-year victories, compared with 3.3% when a Democrat won the White House, according to Strategas Research Partners. The severe decline during the global financial crisis in 2008 was the only bear market election year during this time. The S&P 500 Index advanced in 16 of the 22 presidential election years since 1928. Further complicating the picture, the S&P 500 Index generated an average annual gain of 11.6% when the incumbent party won over this time period versus 0.3% when it lost. In the 17 presidential elections since World War II, the index gained an above-average 9.7% when the incumbent party won, compared with a below-average gain of 2.2% when it lost, according to Ned Davis Research (NDR). Investors only have to look at last year to see why such historical results are not predictive. The third year of a presidential term has historically been the best year for market performance, yet the S&P 500 Index generated a gain of only 1.4% in 2015 (including dividends). For two-term presidents, the final year in office marked the worst market performance of their eight years in office, according to NDR. POLICY CHANGES COULD IMPACT MARKETS Investors would do better to focus on the individual policy initiatives represented by each candidate and how they could impact the economy and financial markets, according to T. Rowe Price investment professionals. The election could affect creditworthiness of companies operating in certain highly regulated sectors, such as energy and health care, says Andy McCormick, head of the firm s taxable bond team. If the new president and Congress were to change or repeal the Affordable Care Act, as some candidates have espoused, that would have implications across the spectrum of health care companies. Similarly, if we were to impose new tariffs on certain trading partners, that would likely impact manufacturers. PRICE POINT 2 2 2
Figure 2: Annual S&P 500 Price Performance in Election Years 1928 2012 40% 30% 20% 10% 0% -10% -20% -30% -40% Democratic Candidate Wins Election Source: Strategas Research Partners Republican Candidate Wins Election In fact, health care stocks have been underperforming since last fall partly because the issue of drug price controls has gained momentum from both political parties, Mr. Veiel says. The possibility of controls is definitely making investors more nervous. ECONOMIC THREATS Alan Levenson, chief U.S. economist for T. Rowe Price, says that most forecasters have not changed their U.S. growth estimates this year based on politics. But he adds: Certainly the election outcome is not immaterial for financial markets and economic prospects. We could see more financial market volatility that could affect the economy as the campaign progresses. In particular, leading candidates favor free trade restrictions and more protectionist policies that could harm U.S. and global growth, Mr. Levenson believes. In my view, trade benefits all economies that engage in it, he says. Generally, what trade allows is for economies to specialize in what they re good at and allocate resources well. So you get the broadest possible selection of goods and services available at the lowest prices. Mr. Levenson adds, Job creation depends on the labor intensity of the industries you re talking about. If we open up trade and export more of the complex, high value-added things we make, such as specialty chemicals, but we import more clothing and make less of it, then you add jobs in one area and lose them in another. What we want to do is make sure people who are displaced from one industry have the mobility and training to move into another industry to plug the leaks, if you will, that come from free trade. Mr. Levenson says he is concerned that whoever wins the election will have to deal with this issue as there will be more demand for trade protection because people have already been inundated with messages in support of that idea. It will take a lot to shift back to advocacy for free trade. Mr. Puglia says, The market probably would react negatively to the imposition of tariffs. No one wins in a trade war. PRICE POINT 3 3 3
MONETARY POLICY Amid global economic headwinds, Mr. Levenson expects the Fed to continue to move gradually in its pursuit of rate normalization, with one or two additional rate hikes this year. He generally discounts the influence of election year politics on Fed policy, particularly given that 2016 is an open election year. There aren t that many times during a presidential election year that it was appropriate for the Fed to raise rates, he says. In terms of holding off on raising rates, I like to remind people that it was a Republican Fed chairman, Alan Greenspan, who raised rates in the summer of 1988 within a week or so of the Republican national convention, so the Fed does what it needs to do. Republican George H.W. Bush went on to defeat Democrat Michael Dukakis in the general election. Democratic Fed Chair Paul Volcker also raised rates considerably during the Carter administration. Mr. McCormick believes that the big macroeconomic trends such as weak oil prices and global growth are driving rate levels. The election debates and even some of the candidates ideas are too far out in the future to have much impact on the interest rate picture today. And interest rates are so low globally that there isn t a lot that could be done now that would cause a dramatic shift. As the presidential campaign unfolds, speculation over how the outcome might impact markets and businesses will surely intensify. Mr. Veiel advises investors to simply maintain a diversified investment portfolio that could provide reasonable returns over time regardless of the political environment. PRICE POINT 4 4 4
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