Political Gridlock ...Is Impasse Good for Capital Market Returns?

Some years ago, I was a partner in a firm where one of my other partners did political analysis. Though he had impeccable credentials and a strong and vital interest in the area, I always questioned the validity and the utility of this kind of analysis in making judgments about capital markets. I may have short-shrifted my former partner Bill.

Political economy, a rather old and somewhat antiquated term was superseded by economics. Yet, the interdisciplinary study of both subjects helps garner understanding of the political institutions, the political environment, and capitalism and how these influence one another.

As November mid-term elections approach in the States, there appears to be some concern developing that political gridlock could develop in Washington. Far be it for me to attempt to make any political forecast or show favoritism...at heart, I am libertarian and prefer as little government as possible. Yet gridlock, the condition of the U.S. House of Representatives, the Senate and the Presidency NOT being controlled by the same political party, seems to be a possibility that one should consider.

What influence does political gridlock have on capital market returns?

There is a widespread belief that gridlock is positive for the stock market. The most recent Financial Analysts Journal (Sept/Oct 2006) (sub required) addresses this fallacy. The origin of this belief is that gridlock reduces economic uncertainty because it lessens the chances for significant legislative changes.Rebecca Byrne in "Fear of a United Government" in theStreet.com published this article in November of 2004. She suggested, "investors ...like a government where power is more evenly split, because the chances of a legislative curveball are vastly reduced."

Kevin Hassett at The American Enterprise, back in March of 2000 wrote about the Clinton years:

" Back in 1992 when Clinton took office, visions of economic catastrophe danced in the heads of Republicans. The Democrats controlled the House, and liberals' cleverest schemes were about to become the law of the land. It was a critical break when Hillary's grandiose health care plan failed. But tax rates were raised significantly. Other interventionist policies--such as higher minimum wages--were introduced. Yet fast-forward seven years, and we find ourselves amidst one of the economic golden ages of U.S. history. What gives?"

He adds:

"There is some truth to all of these arguments, but they neglect an important fact. If liberal Democrats had been able to have their way with the economy over the past seven years, they surely would have contrived horrific enough policies to overpower even these potent economic positives. So we are left with just one conclusion: The '90s have not been an era of economic foolishness in Washington. Whether he intended it or not, the Clinton presidency has been a fairly good time for government-keep-your-hands-off economics."

He concludes:

"We will be studying that question for years, but my hunch is that the golden key was precisely what media pundits complained most bitterly about over the last few years: The national government's inability to do anything significant since the Contract with America. Precisely because government was so paralyzed by gridlock that it could not possibly impose its will on our fast-moving, radically changing economy, unprecedented innovation and economic growth became possible."

The FAJ study, written by Scott Beyer, Gerald Jensen, and Robert Johnson investigated the relationship between political gridlock and investment returns from 1949 to 2004...a divided government, representing gridlock occurred froughly two thirds of the time. The findings are quite interesting and in stark contrast to what is generally believed.

During gridlock periods, the small-company premium (outperformance) is absent. Returns achieved by the largest cap companies exceeded the return to the smallest companies by more than 3 percentage points.

Here by decile, are the annual equity returns under gridlock:

Decile I (largest)...8.27%
2.............................8.30%
3.............................8.65%
4.............................8.76%
5.............................7.66%
6.............................7.74%
7.............................7.12%
8.............................7.04%
9.............................6.72%
10...........................4.65%

During periods of political gridlock, returns were fairly consistent across the range of market caps (essentially market cap agnostic) with a range of 4.65%-8.76%.

Political harmony produced returns that were quite different:

Decile I (largest).....8.78%

2.............................12.65%

3.............................13.76%

4.............................14.87%

5.............................15.38%

6.............................18.07%

7.............................18.83%

8.............................20.32%

9.............................20.42%

10...........................27.03%

It appears that most of the small-cap effect must have occurred during times of political harmony. For the bottom half of market caps, the return differences between gridlock and harmony exceeded 10 percentage points, very statistically significant.

It was also found that equity returns were more volatile in gridlock periods than in harmony periods.

As the article concludes (my emphasis):

"The results reported for equities... run strongly counter to the view that equity markets prosper during periods of political gridlock. Instead, we found that equities performed better during periods of harmony; more specifically, small-capitalization equities thrived during periods of political harmony. This evidence contradicts the commonly advanced view that equity investors benefit from the lack of legislation enacted during periods of political gridlock. The findings are consistent with the view that the increased incidence of legislative action during periods of political harmony is advantageous to equities—particularly small-cap stocks."

The impact of political gridlock on bonds appears to be quite different, more like the result one would expect. Bond markets prosper during times of legislative gridlock. The lack of legislative action dampens government spending, inflation, and deficits. Investors' inflationary concerns tend to increase during periods of political harmony.

So there you go...a few very surprising conclusions.

1. "Gridlock is good" appears to be a myth. Equity returns are higher and less volatile during political harmony.
2. Large companies produced higher returns than small companies during gridlock periods..the small cap effect occurs only during political harmony.
3. Bond investors develop inflationary fears during periods of political harmony.
4. Finally, political conditions may be an important consideration for both equity and fixed-income investors. Sorry Libertarians and especially sorry to you, Bill!