Politics has a long history of influence on financial markets and real economic decisions. Its impact is most pronounced around changes of leadership at the national or state levels or both as market participants are faced with uncertainty associated with government policy changes. The 2020 U.S. presidential election bears some distinct differences with historical economic reactions, however.
This year’s U.S. general elections are characterized by the COVID-19 pandemic and tight outcomes even as vote counting enters the fourth day with a barrage of election-related lawsuits filed by the sitting president’s lawyers. At the time of writing, the reported number of new cases has risen from 92,660 on Election Day to a record level of 121,504 on November 5. The situation is further clouded by a weak economy that has been struggling to emerge from country-wide shutdowns in March 2020, with a national unemployment rate still hovering around 6.9% (according to a November 6, 2020 news release by the U.S. Bureau of Labor Statistics). Changes in government policy are also imminent; the news is trickling by the hour in favor of the Democratic Party, which is expected to flip the control of the White House and possibly the Senate. The Democratic Party’s policies regarding health care, education, renewable energies, immigration, and the environment can be expected to be markedly different from those of the incumbent Republican Party.
Financial markets tend to become jittery with such policy uncertainty. As of Wednesday, November 4, the S&P 500 is up 2.3% and 6.7% from the previous close and last Friday’s lows, respectively. In the same timeframe, the NASDAQ Composite is up 3.8% and 7%, respectively. The S&P 500 index has experienced a year-to-date rise of 8.72%, while the Dow Jones Industrial Average is in the red, around negative 0.52%, over the same period. However, while these values align with historical averages, the volatility is notably higher this election year. The Chicago Board Options Exchange VIX index, which measures the market expectations of near-term volatility conveyed by stock index option prices, has changed from 12.47 on the first day of trading in 2020 to 61.59 at the start of the pandemic-induced lock-downs. It has subsequently dropped to 35.55 on Election Day and 27.58 as of November 5, compared to a 15-year average of 17.49.
Some investors see market volatility as “fishing in troubled waters” because they might have more confidence in their forecast of how the markets could behave in post-trouble times. The majority of market participants, individual or institutional alike, however, prefer a calmer environment. They need stability in cash flows. Examples include retirees whose income depends on their retirement accounts’ short-term performance or insurance firms whose cash outflows covering claims need stable cash inflows from investments. If and when political uncertainty intensifies, investors require a higher return on their investment to compensate for bearing additional risks. Indeed, Bialkowski, Gottschalk, and Wisniewski (2008) and Boutchkova et al. (2011) find that the stock market volatility around national elections is significantly higher than normal time periods. Pastor and Veronesi (2013) and Baker, Bloom, and Davis (2016) show that political uncertainty leads to an increase in the equity risk premium. Additionally, stock returns become more volatile and correlated when the economy is weak.
Market jitters translate into a real impact on corporate financing decisions. Jens (2017) finds that political uncertainty-induced volatile financial markets cause firms to delay issuing more debt or equity as all sources of external financing become costly. However, a new trend is observed this year. Acharya and Steffen (2020) document that U.S. firms rush for cash amid the 2020 pandemic. That is, firms have been drawing down bank credit lines and raising cash levels during the first phase of the outbreak, and only the highest-rated firms tapped capital markets for cash during the second phase. This is especially true for firms facing the risk of becoming a fallen angel, i.e., downgraded from an investment grade to a speculative grade. The explanation for such behavior is the fear of an impending pandemic-induced liquidity crisis when demand for products and services suddenly stops.
Hinh D. Khieu is an associate professor of finance in the College of Business at Prairie View A&M University.
Real economic decisions are subject to no less pressure from political uncertainty. Julio and Yook (2012) examine 248 national elections in 48 countries held between 1980 and 2005 and document that during election years, firms reduce investment expenditures by an average of 4.8% compared to those in non-election years. Jens (2017) study U.S. gubernatorial elections from 1984 to 2008 and find that firms headquartered in states with a gubernatorial election reduce investments by 4.9% in the following quarter relative to those in other states. Moody’s Analytics chief economist, Mark Zandi, is quoted as saying that political uncertainty weighs on “our willingness and ability to take risk,”[1] and Vanguard group chief economist, Joseph Davis, calls such situations an “uncertainty tax” on the U.S. economy.[2] Such impact is greater for firms more susceptible to state-level policy changes. They include small firms, firms with more potential investments, firms in politically sensitive industries, and firms that make costly-to-reverse investments. The explanation could be what Bernanke (1983) terms the “bad news” principle: the value of waiting during periods of heightened uncertainty is significant.
That value should also be significant for those of us with weak nerves waiting for the actual statistics, several quarters later, on how firms adjust their policies or consumers go about their holiday shopping. The hope is that the election outcome will not come later than January 20, 2021, and the COVID-19 pandemic will be over quickly after vaccines become available. We will all breathe the fresh air of relief before we know it, just as the uncertainty has come down from nowhere. Until then, hang tight.
References
Acharya, Viral, and Sascha Steffen, 2020. “The risk of being a fallen angel and the corporate dash for cash in the midst of COVID.” Review of Corporate Finance Studies, forthcoming.
Baker, Scott R., Nicholas Bloom, and Steven J. Davis, 2016. “Measuring economic policy uncertainty.” Quarterly Journal of Economics 131, 1593–1636.
Bernanke, Ben S., 1983. “Irreversibility, uncertainty, and cyclical investment.” Quarterly Journal of Economics 98, 85–106.
Boutchkova, Maria, Hitesh Doshi, Art Durnev, and Alexander Molchanov, 2012. “Precarious politics and return volatility.” Review of Financial Studies 25, 1111-1154.
Jens, Candace, 2017. “Political uncertainty and investment: Causal evidence from U.S. gubernatorial elections.” Journal of Corporate Finance 124, 563-579
Julio, Brandon, and Youngsuk Sook, 2012. “Political Uncertainty and Corporate Investment Cycles.” Journal of Finance 57, 45-83.
Pastor, Lubos, and Pietro Veronesi, 2013. “Political uncertainty and risk premia.” Journal of Financial Economics 110, 520-545.
[1] “Political uncertainty will continue to stunt economic growth,” Forbes, Janet Novack, October 16, 2013.
[2] “Federal government begins first shutdown in 17 years,” Forbes, Janet Novack, September 30, 2013.