Election-Related Volatility: 5 Things Investors Should Know

In this article we review: 

• How well presidential elections predict stock market returns
• The election process and market volatility
• The impact of international exposure on equities
• Elections, the Federal Reserve, and bonds
• What overreacting to volatility can do

As Election Day in the U.S. nears, don’t let short-term noise distract you from wise, long-term investing. Election volatility can mislead investors. Being aware of typical market behavior during election cycles can help you prepare for volatility over the coming months.

1. The U.S. Presidential Election is a Poor Predictor of Stock Market Returns 

Even though the U.S. Congress has the constitutional power to control federal spending and taxation, the president has significant influence over policy-setting. The president’s administration can impact business and markets through executive orders, regulatory changes, and overall economic policy. 

Presidential elections are therefore of high interest to businesses and investors. For investors, the hypothesis of a presidential-cycle effect or the assumption that a president's political party is correlated to stock market returns is alluring. Still, it probably is not a sound investment strategy. 

Frequently cited data indicates that U.S. stock markets since 1927 have performed better under Democratic presidents. However, when looking at data on a longer horizon, since 1828, there is no statistically significant correlation between stock market performance and the U.S. president’s political party.¹ This doesn’t mean that the stocks of individual companies or sectors are immune to election results. However, the U.S. president's political party likely does not have a meaningful impact on the overall stock market's performance. 

Midterms may have a greater market impact than presidential elections

When predicting stock market returns during political cycles, one study showed that midterm cycles have a greater effect on market performance than the presidential election, underscoring the unreliability of a presidential election’s impact on market returns.²

The election cycle tends to cause black-and-white thinking, and we can become overly confident or overly fearful of the economic consequences of an election. How do we separate the election cycle noise from the more pertinent economic currents? By keeping focused on our long-term goals. 

2. A Country's Election Process Increases Its Stock Market Volatility 

While we can’t predict the future direction of the market based on the presidential election results, we can assume U.S. stock market volatility will pick up as the U.S. election nears. National elections in industrialized countries tend to increase the country’s stock market volatility during the election window due to the uncertainty of macroeconomic policy.³

Short-term market swings can cause concern for investors, and significant dips in the market can often cause investors to panic and alter, or completely abandon, long-term investment plans. 

Understanding that volatility is a natural part of the election cycle while being mindful of your risk tolerance can help ease fears when stock prices move more than normal. One study of 27 industrialized countries showed market volatility was 23% higher than expected within 51 days of an election.⁴ 
 

3. International Exposure Can Mitigate Volatility in Equities

While U.S. policy and business cycles play a significant role in shaping global economic conditions, a country's local business environment and economic factors are the primary drivers of its stock market returns. During politically charged periods like election seasons, investing in international equities may help temper volatility.

The global election cycle is perpetually in motion, with major elections regularly occurring across the world. For example, Germany, France, the U.K., India, and Brazil each have critical elections on the horizon. These elections can significantly impact their respective markets and, in turn, global market dynamics.

Diversifying globally may offer an effective way to mitigate the risks associated with U.S. election-related volatility. By spreading investments across various international markets, investors may reduce their exposure to the uncertainties of any single political event. This approach not only helps in managing risk but also may provide opportunities to capitalize on positive developments in other regions, potentially enhancing overall portfolio performance. 

4. Elections Impact Bonds, But Not as Much as Federal Reserve Policy

Flight to Quality During Elections

In times of political uncertainty, particularly around elections, investors often seek safety by moving their assets into more stable investments. The tendency of bond investors to move toward higher-quality, lower-risk assets during politically charged times is well-documented. 

During U.S. presidential election years, this "flight to quality" can be observed in spreads that tend to decline steadily as elections approach, while short- and intermediate-term bonds typically see increased demand.⁵ This demand often makes these bonds relatively more attractive compared to longer-duration or riskier bonds. However, evidence shows that Federal Reserve policy has a greater impact than elections on bond returns.⁶

Historically, short- and intermediate-term bonds have served as a reliable haven in uncertain environments relative to longer-duration bonds. Amid higher interest rates and tightening spreads, though, investors may seek a safe haven in cash. But it is important to be mindful of the Fed. The potential of interest rate cuts will likely have a significant impact on bond markets and make cash yields less attractive. 

Given the increased political uncertainty coupled with the likelihood of more accommodative monetary policy, the sweet spot for investors seeking a haven in fixed income may be short- to intermediate-term bonds.