Economic Policy Risk and Financial Markets

Economic Policy Risk and Financial Markets

Much is being said about the potential effects of the U.S. Presidential election this fall. Concerns abound about the potentially devastating effects of “higher taxes and bigger government” if Clinton wins or “trade wars” if Trump wins. I think we have little to worry about. I believe that our only election concern is that the elections will lead to a strongly unified government – and polls indicate that outcome is unlikely.
My concern with a unified Federal government is that a strong government can make big changes – and it is the potential for big changes that causes uncertainty. Markets tend to falter much more when persistent economic uncertainty rises than when quick negative outcomes occur.
The major Federal economic policy changes of the past almost always occur when a single party is in firm control. The Federal government can be firmly controlled when one party wins the presidency and both chambers of congress, or perhaps when a particular branch of the Federal government (especially the presidency) garners a high level of public support and trust.
Many people lament the near paralysis of our Federal government since the 2010 congressional elections. However, I believe the paralysis bodes well for our financial markets. The so-called paralysis means fewer massive tax changes, fewer massive spending initiatives and a relatively stable regulatory environment. Our financial markets have soared in the last six years of so-called government paralysis.
A recent example of the market-jarring effects of major changes in economic policy is the vote for the UK to exit the EU. It took a week or two for the markets to calm down after the uncertainty caused by that vote.  But after the uncertainty generated by the vote eased, equity markets reached new highs.
Ongoing uncertainty with regard to a pending issue causes volatility and bear markets. For years the world’s equity markets shook from the fear that Greece, Portugal, Italy or Spain would default on their debt and/or leave the EU. The long-term uncertainty tortured investors.
Sometimes it seems as though financial markets react much more favorably to bad news than to increased uncertainty. This should not be surprising since most of us react this way in our personal lives. How often have you heard someone receiving bad news such as an unfavorable medical diagnosis commenting that “Even though the news is bad, I feel better knowing what is wrong”.
In a similar vein, we should expect some market volatility during the uncertainty leading up to the election results. However, I believe that the only outcome that will have a serious negative short-term effect on the market is one in which the election generates a widespread, unified mandate. I do not believe that outcome will occur and therefore I view pre-election jitters in the financial markets to be modest and short-lived.

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