"Real" Politics

On October 4th, Flávio Bolsonaro edged President Lula in the first round of Brazil’s presidential election. Markets reacted favorably to the news as Brazil’s primary stock market index, the Ibovespa, jumped 7.7% to a record high the next morning, while the Brazilian real currency gained roughly 4.7% against the dollar over the ensuing week. Polymarket, an online prediction market, gave Bolsonaro an 86% chance of winning the October 25th runoff as of the 13th, and still had him near 77% the Friday before the vote.

Then Brazil voted the incumbent Lula back into office to the surprise of many… including investors in the Brazilian stock market.

On Monday, October 26th, the Ibovespa index fell nearly 14%, its worst single-day return since March 2020 during the depths of the COVID pandemic. Trading was halted at one point after the decline triggered a circuit breaker.

This is both a breaking story as well as a tale as old as time in investing, because as soon as that initial spike higher occurred investors came flooding in chasing that initial performance, and perhaps believing it would continue under a political order that wasn’t even voted in yet (and now won’t be):

Between the close on October 5th and the trading day before the election on the 23rd, the iShares MSCI Brazil ETF (EWZ) went pretty much sideways heading into the official election (technically falling by just under 1%). However, assets under management in the fund grew by over $3.7 billion, a 37% increase in a matter of weeks; this represents investor inflows, and based on data from YCharts, it was one of the largest periods of inflows in the history of the 26-year-old fund.

And on Monday it dropped by a magnitude similar to that of our own Black Monday of 1987 (which ironically also occurred in October) when the S&P 500 dropped by just over 20% in a single day. EWZ fell 19.8%, the 2nd worst day in the history of the ETF based on YCharts data. It was a double whammy for US investors buying EWZ because both the index and the currency fell sharply as the real lost more than 8% against the US dollar that day. That drop reduced investor assets by approximately $2.7 billion in a single day, and roughly a quarter of the funds assets going into Monday had been invested in just the three weeks prior.

But there’s another story underpinning some of those EWZ allocations earlier this month, and that is investors continuing to use politics as a key driver of their investment decisions. And wouldn’t you know it, we have a pivotal midterm election ourselves right around the corner.

Investors may be worried and asking the question: could a Brazil situation happen in the U.S.?

Let’s look at this from two different angles, the first being how the US market (as proxied by the S&P 500) has performed following midterm elections:

In each of the 19 midterm elections since 1950, the S&P 500’s price return over the following year was positive (1986 was close, but remember that included Black Monday and we were still positive during that period). Furthermore, the average across these 19 periods has been just over 15%. This is decades of returns but still a small sample size, plus it does not imply that the next midterm will follow suit. The starting point also matters here, as further back in history there have been significant drawdowns following midterms - it just hasn’t occurred in the last 75 years.

The other angle would be from how we expect this midterm election to shake out (though remember Brazil as a cautionary tale on the accuracy of polls and prediction markets), and that is that we will have two years of “political gridlock” in which no party controls all three chambers (as of October 28th, prediction markets favored Democrats to win both the House and Senate¹).

A popular belief is that markets favor gridlock over a unified government, though that may be confusing causation with correlation: just because two things happen around the same time, does not mean they are related and/or feed off of each other.

It could just be a coincidence. As the tables below from Hartford Funds illustrate, there have been periods where both split and unified governments have corresponded with both strong and weak equity returns. But in our view, on average and over the long-term the political backdrop has had minimal, if any, real impact on the stock market:

The top table shows each “unified” political environment over the last 90 years, when one party controlled the White House and both chambers of Congress. I’d like you to pay particular attention to those annualized 3-year return figures, a time horizon in each of these periods where the majority party was subject to midterm elections part of the way through but retained control of the Presidency.

In theory, that should give that administration ample time and minimal hurdles to act on their legislative agenda. Of those twenty observations, the range of return outcomes was just above 34% (-7.4% to 27.0%) with a median return of 12.8%. The overall average? 12.0%.

Now what about divided governments? Of those twenty-four observations, the range was only 2.5% wider (-5.6% to +31.2%) while the median return was 13.9%. Technically better, though not significantly. And the average return? 12.6%. Note that these figures are measured from January 1 after each election, unlike the J.P. Morgan data above, so the two data sets are not directly comparable.

The key takeaway is that the “middle ground” figures, the average and the median, are not that different across the potential political environments. But within those environments, the range of outcomes in the short-term can be all over the map, both deeply negative and strongly positive. What does that say about the influence politics has on the equity markets?

In our view, very little.

We believe Democrats flipping both the House and Senate in the 2006 midterms twenty years ago was not the reason 3-year returns dropped to -5.6%, the Global Financial Crisis was the catalyst there. Likewise, the bursting of the Tech bubble had little to do with politics.

But both are why we have had any negative 3-year returns post-election over the last 50 years.

Brent Coggins, Chief Investment Officer

Triad Wealth Partners