The Election Effect on Markets

RCM Managed Asset Portfolio 

By Christopher Chiu, CFA

June 1, 2024

The Election Effect on Markets

With the Presidential election coming this November there is a chance control of the Presidency and Congress will change once again.  These changes have been meaningful to equity performance. Since 1933, the average annual return for the S&P 500 index has been 12.9% when Republicans had both Congress and the Presidency and 9% when Democrats had total control. Average returns were 15.7% when a Democratic president had a split Congress and 13.7% when a Republican president did. 

What people will take from this is that the market likes their party. There is evidence to suggest either party is better for the market. But what these data tell me is that what the stock market likes is a divided government. A divided government does much better than either a totally Democrat or Republican-controlled government. And I suspect this is because with a divided government there is less chance of government spending. The best example of this was 1994 when Clinton lost the Congress in the midterm elections, while New Gingrich rose to become Speaker of the House with his Contract with America. This change from a Democrat-led government in 1992 to a divided government in 1994 resulted in a series of compromises that led to tort reform, welfare reform, and general government spending cuts.

These reforms in turn led to an era of great period of prosperity in the second half of the 1990s as the budget became balanced and actually grew into a surplus.  Without the government’s need to borrow heavily, interest rates were allowed to go lower. The valuations for public companies rose and with the accompanying wealth effect, unemployment fell to a then record low.

Where Government Spending is Bad

Some government spending is necessary, but I want to show you when it is bad, specifically when it prioritizes consumption over investment spending. As the typical Keynesian argument goes, government induced hiring immediately puts money in peoples’ pockets and then people can go out and spend, which then creates jobs. This is most noticeable in the April job numbers which are downstream from Biden’s Infrastructure plan. More than half of the new jobs were in government, healthcare, or social assistance. As this money is spent, it multiplies the money in circulation, as it trickles down to restaurants, to hotels, to retail, who then must hire more people to keep up with this demand. 

However, since much of the latest infrastructure bill is directed to consumption rather than

infrastructure, this money eventually gets used up and is no more. Government-induced consumption

spending does conjure growth but mostly in the short term. Then what becomes necessary is more

government spending to sustain that growth.

This is where Keynesian economics diverges from its intellectual alternative, the Austrian school of economics. The Keynesians would say that any spending is good. Unlike the Austrian economists, the Keynesians don’t distinguish between good spending and bad spending. However, consumption spending, which is for immediate use, has much lower enduring benefits for the economy. Sure, travel spending puts money in the pockets of the hotelier and hospitality workers and funnels out further but eventually this gets dissipated much faster than people realize because it doesn’t have a renewing mechanism. 

Better Kinds of Spending

The form of spending that has the best long-term effect is one that will not be consumed away. It will be the kind of spending on capital goods which allows other goods and services to be produced from it. This is investment spending and is a hallmark of classical economics because it assumes that when people make this kind of spending, it is necessary and choice worthy. It isn’t the kind of money that is forced into people’s hands to spend right away but often comes from people’s accumulated savings. And more than likely, it has been fully deliberated upon before it is spent. 

A good example of investment spending in a free-market economy is one that allows an entrepreneur to more easily borrow money to build a store in a location that sorely needs it, which can be used again and again to provide a service to a community. In this case, you get the same stimulative benefits of paying the construction workers and construction company and having that money trickle down to the broader economy, but now you also have a store present to serve the community for years to come. The result is likely a better allocation of resources because the project has been deliberated upon by both its lender and entrepreneur who had to determine and bear the risk of its viability.

More Negatives of Government Spending

A lack of permanence and profligacy are some of the negatives to consumption spending. But I will end by discussing a largely unseen and often unmentioned negative. And this is the opportunity cost that comes from government spending. That is, when government projects are begun, something else positive in the free market is prevented from happening. Government borrowing that is used to stimulate consumption crowds out private investment. When companies need to borrow money, they must compete with the government that also needs to borrow. All things being equal, investors will choose to lend to a less risky U.S government than a riskier company venture. Companies competing with the government to borrow money therefore have to offer higher interest rates, which hurts their new projects on the margin and the long-term feasibility of the ventures.

One can object, What does it matter if a few projects are crowded out? What is meant to get made will get made. After all, it’s only at the margins that government spending crowds out marginal projects. But this is where differences are made, at the margins. I will illustrate this point with this last example.

As of April 2024, SpaceX has launched almost 5900 Starlink satellites into orbit, thereby providing to large populations throughout the world much easier access to broadband. This achievement has never been realized through NASA because though their government-mandated responsibilities, they would never have seen it as being possible or even necessary. This was left up to individual entrepreneurs and investors at the margin who (1) were able to envision a large enough need for this service (a large enough market), and then (2) bear the risk that they could justify the upfront cost before realizing the cost advantages later, after learning from successful and failed launches. Is it little wonder that SpaceX has ascended where NASA has receded?