General elections affect stock markets. The uncertainty around their outcome typically increases market volatility before votes are cast. Markets also continue to adjust after an election takes place as the policy priorities of the newly installed government become apparent.
A clear margin of victory and a returning incumbent tend to reduce uncertainty and minimise the volatility observed in stock markets.
Successfully predicting election outcomes is difficult. Over the last decade, pollsters, political analysts and reporters have made some notable forecasting errors. One clear example is the 2016 US presidential election, when estimates put the likelihood of Hilary Clinton winning at between 71% and 99% (Kennedy et al, 2018).
Financial markets reflect this challenge. In the absence of a clear consensus about the outcome, we see larger daily price changes that tend to offset each other. While these leave prices unchanged overall, they create amplified market fluctuations over the election period.
The size of the fluctuations depends, in part, on the electoral system. Majority systems – such as the UK’s ‘first-past-the-post’ and the electoral college in the United States – where losing by 0.5% has the same outcome as losing by 95%, are less predictable than proportional representation systems. This can affect stock market returns significantly (Lausegger, 2021).
This difficulty is evident in the heightened volatility of share prices during elections. One study finds that within the 51 days surrounding elections, stock market returns exhibit more than 20% higher volatility than anticipated. What’s more, the compensation for bearing this risk proves relatively modest (Bialkowski et al, 2008).
Why do stock markets care?
The link between elections and the economy has been known for a long time. Work from the 1970s pointed out that politicians often boost the economy before elections to gain favour, only to follow up with tough measures like inflation control via higher interest rates afterwards (Nordhaus, 1975).
This may explain some long-term predictability in US stock markets. A study of how stock markets process information during electoral cycles suggests that the market is somewhat inefficient because some long-term trends were predictable (Allvine and O’Neill, 1980).
This work proposed a trading strategy of buying shares two years before US presidential elections and selling shortly before the election. The strategy outperformed a ‘buy-and-hold’ strategy by 3.4% per year for the period 1961-78. A subsequent study found similar results when data were updated to include the early 1990s (Gärtner and Wellershoff, 1995).
There is some evidence to suggest that it is not just the timing of elections that affect stock markets but that the outcomes matter too. Contrary to the assumption that Wall Street prefers Republican presidencies, evidence suggests that stock markets historically perform better during Democratic presidencies (Santa-Clara and Valkanov, 2003).
Other work highlights that the reaction of any particular share to election outcomes will depend on the tax policies that may affect that company and the industry of which it is a part (Wagner et al, 2018).
What about the UK?
From 1945 to 1994, only one out of six Labour victories led to a positive change in the FT30 index of the largest UK companies the next day, while seven out of eight Conservative wins did (Hudson et al, 1998). This supports the anecdotal evidence that the City prefers Conservative governments.
But in the longer term, the analysis finds no difference in UK stock market returns under Labour or Conservative governments. It also shows that trading strategies trying to exploit predictable returns in the two years prior to elections are ineffective in the UK. This suggests that the outcome of the general election may matter less for longer-term market returns in the UK than in the United States.
Figure 1: UK stock market performance by government, 1923 to 2017
Source: Bank of England millennium of economic data, author’s calculations
Figure 1 seems to support the belief that the markets perform better under Conservative governments. Using the Bank of England’s millennium of economic data to extend analysis back to when the first Labour governments were formed in the 1920s and up to 2017 when the database ends, we see that the Conservative governments of 1979-97 and 1951-64 coincided with periods of strong stock market growth of over 36% and 22%. During most Labour governments, there appears to be little stock market growth.
But the Conservative (or Conservative-dominated) governments of the 1920s, 1930s, 1970s and 2010s only saw the stock market index grow between 1% and 5% over the parliament. Comparably, the Labour government of 1974-79 saw stock market growth of over 28%. This suggests that any long-term correlation may be more coincidental than causal.
A contributing factor to the perception that markets prefer Conservative governments may be due to their greater success in general elections, and their ability to remain in power for longer than Labour.
Figure 1 shows stronger support for the saying ‘time in the market beats timing the market’, with the Conservatives in power for 679 months versus 398 months for Labour governments. This equates to an average duration of 84 months, and a maximum duration of 216 months, for the Conservatives compared with 66 months and 156 months, respectively, for Labour.
Is there no effect?
While the evidence may not support election outcomes having a long-term impact on the stock market, the same is not true for the short term. The short-term effects of national elections have been found across several studies.
One cross-country analysis finds that stock market volatility can double during election weeks. Compounding factors include a closely contested election, a narrow margin of victory (with coalition governments seeing further increased volatility) and a change of government (Bialkowski et al, 2008).
Another cross-country study, looking at the period 1974-95, shows positive abnormal returns in the two weeks leading up to an election week. This is particularly strong when the election is called early and lost by the incumbent government (Pantzalis et al, 2000).
The short-term effects are more acute for uncertain and delayed outcomes, such as the 2000 US presidential election. These cases are typically associated with a negative stock market reaction (Nippani and Medlin, 2002). The short-term effects are also more likely to be pronounced for surprise election results, as was the case with the US election result of 2016 (Wagner et al, 2018).
This year, the impact of the UK general election may be compounded by the effect of the US presidential election in November. Evidence suggests that US political cycles may be a proxy for global political uncertainty (Brogaard et al, 2020). US election periods tend to suppress equity returns and increase volatility outside the United States, as investors become more risk-averse and invest in less volatile assets.
Do policies affect share prices?
Before an election, we have political uncertainty. This uncertainty is likely to have direct effects on the real economy, which is then reflected in stock market valuations. Evidence from the United States indicates that firms reduce investment expenditures during election years by nearly 5% (Julio and Yook, 2012). In addition, political risk affect the value of international investment in a country (Bekaert et al, 2014).
After an election, political uncertainty is likely to be replaced with policy uncertainty as the priorities of the newly installed government become apparent. Distinct from the intended effect of any economic policy, stock markets react negatively to economic policy uncertainty.
Research using over 100 years of data finds that greater economic policy uncertainty increases risk and suppresses the returns on shares in companies and industries that are particularly sensitive to government spending or regulation. This includes sectors such as defence, healthcare and finance (Baker et al, 2016).
The negative stock market effects are most likely to be attributable to economic policy uncertainty affecting the real economy, with investment, industrial production and unemployment all reacting negatively.
Changing governments are often associated with pivots in foreign policy and international relations. Shocks to geopolitical risk are associated with lower share prices too (Caldara and Iacoviello, 2022).
With the UK election in July and the US election in November, investors should anticipate fluctuating markets.
Where can I find out more?
Who are the experts on this question?
- John Turner
- Gareth Campbell
- Elroy Dimson
Author: Clive Walker
Image: Elenathewise on iStock
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