U.S. politics and markets: time will tell

by Mark Y. Rosenberg PhD, CEO @GeoQuant

Do politics matter to U.S. markets? The question is being asked with increasing frequency since President Trump’s election, after which U.S. equity markets have reached record highs despite a dramatic mix of government dysfunction, policy uncertainty, and an unorthodox (to say the least) array of foreign and domestic provocations by the country’s chief executive.

For those skeptical of any real link between U.S. politics and financial markets, the question’s very persistence suggests a simple answer: No, and stop looking for one. Indeed, even those investors/analysts/commentators who grasp the obvious importance of political risks more globally can point to the strength and size of America’s markets to shrug off the relevance of rising political risks here at home. Meanwhile, others — especially those schooled in the dark arts of political science and political economy — continue to warn of impending doom.

Linking the idea of “political risk” in the United States to market performance is a tricky subject. Part of the problem is that a country’s political risk is not directly measured or systematically defined, leaving analysts and their ilk to cherry-pick events and subsequent market responses in order to make a case. Fortunately, GeoQuant’s proprietary technology solves this problem by defining, systematizing and quantifying political risk with unprecedented speed and accuracy, for the first time enabling direct comparisons to everyday market outcomes and proxies.

The graph below plots GeoQuant’s daily Political Risk score for the U.S. against S&P 500 closes from August 1st, 2016 (shortly after the GeoQuant system went ‘live’) through July 15th, 2017. This Political Risk score is modeled off more than two dozen daily sub-indicators, which are themselves derived from hundreds of traditional country risk data points and large quantities of text scrapped from formal and social media. GeoQuant’s U.S. Political Risk score is a dynamic measure of the likelihood that a political event will have an adverse impact on an economic or investment outcome in the country. And, as you can see, it is (almost literally) rising every day.

Just as clearly, the S&P has been climbing along with it, suggesting not only that rising U.S. political risk doesn’t matter, but that if anything it may even be propelling (?!) the S&P to new heights. There may have been a (quasi-) case for this argument when markets expected the Trump administration to make good on promises regarding tax reform, a healthcare overhaul and a massive infrastructure build-out. In this scenario, wider political risks from deteriorating international/trade relations, growing social polarization, highly-stressed state institutions (including the nation’s law enforcement and security agencies) and historically-low approval ratings were outstripped by the gleam of tax cuts being pushed through a GOP-controlled Congress. Now, however, with Trump clearly bogged down in “this Russia thing” and unable to deliver on many of his promises, the S&P continues to soar. I wonder whether a graph has ever made a political analyst feel less relevant.

But — not so fast. As pointed out by The Economist last week, forward-looking market indicators now appear to be deteriorating due to what appears to be long-term and systemic dysfunction in Washington, suggesting storm clouds ahead. And adding our U.S. Political Risk score to the mix, as we do below, strengthens that analysis. The first graph shows U.S. Political Risk versus 5-year inflation expectations, with higher expectations for inflation (broadly) mirroring expectations for stronger economic growth in a developed economy like the U.S. Starting in early April, however, rising political risk is clearly associated with lower inflation expectations. This indicates that markets are losing faith in the potential for growth-enhancing reductions in taxes and regulations and/or increases in infrastructure spending — and paying more attention to the Trump-related political morass blocking their advance. In other words: not good!

We see a similar dynamic if we look at US Political Risk vs. yields on the 10-year T-bill. In this setting, lower yields reflect weaker growth expectations as political risk continues to rise. Sad!

Will the S&P 500 be bothered? Time will tell. GeoQuant would argue that it is worth looking more closely at U.S. Political Risk since last August to get additional clues as to how the future may play out. Our technology allows us to identify times when the pace of U.S. political risk accelerated — i.e. when tough political times got tougher — alongside those where it decelerated, when we all caught a (temporary) breather. We can then look at how the S&P 500 moved around these points.

To do so, we replicate the first figure tracking U.S. Political Risk vs. the S&P 500. But this time we look at the extent of daily increases in Political Risk rather than the Political Risk score itself. We mark the most prominent points of accelerating and decelerating risk — along with associated events — and observe corresponding shifts in the S&P.

Broadly speaking, larger spikes in daily Political Risk correspond to subsequent drops in the S&P, while smaller upticks track subsequent rallies. This relationship is not strong, to be sure — but it has strengthened over the past two months. Moreover, in those same two months, the magnitude of daily risk increases is clearly on the rise, following a declining trend post-election. Note that this is the same period in which greater U.S. Political Risk began tracking reduced 5-year inflation expectations, as well as lower yields on the 10-year T-bill.

Will U.S. political risk finally weigh on equity markets? While only time will tell, GeoQuant’s revolutionary technology works in step with time to help forecast the outcome.