Beyond the ballot: How US elections impact the markets

History tells us that when politics collides with global markets, uncertainty leads to volatility.

Trading stocks, indices or global currencies always entails some element of risk. But politics, for example a major event like the US Presidential election, can add another level of complexity. That will often spark volatility which means unpredictable price action.

The outcome of the US election may be tougher to forecast than economic data as more often than not, the stock and forex markets are heavily influenced by interest rates and inflation. But politics can have a big or even bigger impact. Of course, that does make for potentially more opportunities for traders.

Understanding how politics functions can be beneficial as it encompasses a wide macro area including elections, government fiscal and monetary policy. However, there can be times when even the most seasoned trader can be caught out.

 

Key takeaways

• Political events, particularly US elections, can cause volatility in global markets, creating opportunities for traders
• US indices like the S&P 500 tend to gain during election years
• Historical data indicates a consistent relationship between US presidential cycles and the US dollar
• During election cycles, traders should focus on solid strategies, stay informed about news and polls, and implement effective risk management techniques

 

How US elections impact the markets

Every four years, the US presidential election will majorly influence the country’s policies, laws, and foreign relations.

Politics is often unpredictable, drawn out and might involve several other countries too. A prime example was the trade war started by President Trump in 2018 which initially targeted China, but then spread to other major trading partners, friend and foe alike.

However, history tells us that certain market patterns often repeat themselves during election cycles. That means the stock market and global currencies can equally exhibit similar price moves to previous US elections.

For example, since 1980, both the S&P 500 and the Nasdaq 100 US stock indices have always posted an annual gain during a US presidential election year. The only exceptions are down to a major market crisis (the dot com bubble in 2000 and the global financial crisis in 2007/08).

Stock indices annual % change during election years

While these are only based on historical data, it does show how they can affect markets and how to potentially profit from the US election cycle volatility as a trader. Just remember, past performance is not a guarantee of future results.

 

Analysis of historical data on forex markets during US elections

There does appear to be a close relationship with the US dollar and US presidential elections. Research shows that Republican presidencies tend to start with a strong dollar, which then depreciates over the course of the presidency.

In contrast, Democratic presidencies tend to begin with a weak dollar that then appreciates. These patterns result in an apparent presidential effect in US foreign exchange rates, the direction of which depends on whether exchange rates are measured by levels or by returns.

How the US dollar changes during presidency

The reason for this tends to do with economic policies. A Republican administration is often fiscally conservative and business-friendly which sees lower taxes and a tightening of government spending. This can result in a softer greenback that makes US exports more attractive and competitive.

On the flip side, a Democrat administration will usually wish to increase government spending and promote public sector job creation. This can cause the dollar to rise as big government and higher corporation taxes are expected.

Of course, this doesn’t always mean volatility across all currencies. In fact, the JPMorgan Global FX Volatility index indicates that (outside of the shock Trump win in 2016) wider forex markets do not experience significantly higher volatility during the US election cycle.

How politics affects markets

Perhaps a greater factor on market volatility than an election is perceived political instability.

Political instability can have a major impact on markets as it can cause currency volatility which results in investors buying safe haven currencies.

For example, a contested result in a US presidential election would drag out the process of declaring the next White House incumbent long after election night. That would be a concern for markets with an uncertain period ahead seeing the Yen, Swiss franc and potentially the US dollar being bought, depending on the consensus view of how long the political turmoil might last.

But if the uncertainty was not resolved relatively quickly, markets may start questioning the nature of US political institutions which would be a dollar negative. In turn, investors would sell higher risk assets and cyclical global currencies which are risk-sensitive, like the Australian dollar and New Zealand dollar.

Political events can directly impact forex markets due to their influence on numerous different areas of the economy including GDP, capital inflows and trade relations. Typically, it is negative political events which cause major volatility in trading.

A recent example is the Brexit vote in the UK in June 2016. The UK electorate decided to leave the EU in a shock referendum result which had been expected to keep the country in the economic region. This caused the value of sterling to plunge to a 31-year low from above 1.50 to below 1.1650 in just five months.

The chart below highlights this, showing GBP dropping against the dollar, and the Euro rising against GBP.

 

Tips for traders during political uncertainty

Volatility can be extremely high during times of political turmoil and elections. That means traders need to ensure their strategies and processes are solid and back-tested against unpredictable price action.

The chart below shows the Volatility Index (VIX) around the US presidential election. This index is known as Wall Street’s “fear gauge” and reflects predicted volatility of the S&P 500 over the next 30 days.

Beyond a few outliers, the October lead-up to a presidential election sees a double-digit % rise in market volatility. Once the results are in, markets tend to calm down a little – with a double-digit % drop in November.

VIX relative % change during US election years

Keeping up with the latest news, polls and exit polls can make traders more knowledgeable about what to expect and plan accordingly about the potential market impact of one leader being elected over another. Traders could also set alerts to notify them of fast-moving prices and potential trading opportunities in global currencies.

By using derivatives like CFDs, traders can go both long and short benefitting from two-way price moves, as the news changes and as politics ebbs and flows.

Managing risk during political uncertainty

Risk management and mitigation is probably one of the most important skills that new traders often overlook. While many might focus on different timeframes and products to trade, ultimately a successful trader is one who is able to prevent losses and keep hold of their trading capital, whilst at the same time becoming more profitable.

This should involve simple processes like:

• determining the risk per trade
• establish your risk/reward ratios
• keep an eye on forex correlations and cumulative exposure

Using different orders to enter and exit positions is also crucial, and these might include stop loss limit and take profit orders.

The bottom line

While the impact of US elections on global markets is significant in many ways, perhaps the greater catalyst for volatility is uncertainty.

Presidents from different sides of the House will enact their own policies which will have a marked impact on fiscal and monetary policy. Over the medium term, potentially more significant will simply be how the economy is performing and what stance the Federal Reserve takes to further its dual mandate of price stability and maximum employment.

USD