US election: will diversification benefit portfolios?

With an intriguing US presidential race underway, risk-based investors are asking questions that typically fall into three categories. First, which political issues are likely to capture the market's attention? Second, what investor behaviour is usually observed as the campaigns evolve? Third, does enhanced diversification provide measurable benefits during such periods? 

This week, Simply put delves into historical data to seek a better understanding of how our All Roads multi-asset strategy may behave during this critical periods.  

US elections under a spotlight of debt-building

Volatility surrounding the odds of a Democratic victory has been notably high recently. At the end of April, the probability assigned to a Democrat win was almost on par with that for the Republicans. But after this balance shifted dramatically to favour the GOP after the first presidential debate, a key observation has been the recent synchronisation between these odds and the movement in 10-year US Treasury yields. 

As Figure 1 shows, from February to July, the likelihood of a Democratic win fluctuated in tandem with 10-year yields, with the correlation between the increments of both series peaking at close to 50% in April. The tentative message from markets here is that if the Democrats continue to lead the White House, public spending is expected to remain robust, possibly leading to a necessary rise in yields. This could be due to the inflationary pressures such spending might ignite, or an increase in the fiscal premium. 

To date, markets’ primary concern has been inflation. This, along with the Fed's policies, continues to be a principal driver of US yields, overshadowing concerns about the fiscal premium. If public spending becomes a central issue for markets in this electoral cycle, and potentially leads to significant market fluctuations, it begs the question: what other insights into market and portfolio trends can be gleaned from past presidential elections? 

This analysis not only helps to understand current dynamics but also to anticipate future market movements in an increasingly complex investment landscape.

FIG 1. Odds of a Democrat win relative to 10-year Treasury yields 
 
Source: Bloomberg, LOIM, as of 11 July 2024. Past performance is not a guarantee of future results. For illustrative purposes only.

Dissecting Republican and Democrat wins 

US elections represent a distinct form of political risk. Unlike unforeseen events, such as a snap election, they are organised around predetermined dates and allow markets to make informed projections about potential outcomes. This predictability enables analysts to historically assess the performance of various asset classes both before and after these elections and elucidate any trends associated with either Democratic or Republican victories. 

Using weekly data on equity, bond and commodity performance in the US since 1960, Figure 2 illustrates the performance of a 50/50 equity/bond portfolio for the three months before and after the last 15 US elections¹. Note that Democrats have prevailed seven times (1964, 1976, 1992, 1996, 2008, 2012) and Republicans eight (1968, 1972, 1980, 1984, 1988, 2000, 2004, 2016). 

The chart reveals consistent patterns. Democratic wins generally see a dip in performance preceding the election, followed by a recovery. This ‘average’ trend is significantly influenced by the Barack Obama victory, which was followed by the recovery from the Great Financial Crisis. However, similar trends are observed with other Democratic wins, such as those of Jimmy Carter in 1976 and Joe Biden in 2020, as well as Bill Clinton's first victory in 1992. Republican victories generally lead to positive market performances before the election, followed by a brief retreat after the results are confirmed. 

Ultimately, both Democratic and Republican wins tend to result in a positive performance for balanced portfolios, with the exception of the initial Richard Nixon victory and the elections won by George Bush Jr, when there was negative performance for the three months after the elections. However, the extent of this negative impact was relatively limited.

In essence, US elections typically induce market fluctuations before leading to an average market uptrend in the six months over the voting period. This raises an intriguing question: does enhanced diversification reward investors in such circumstances? This analysis not only sheds light on past trends but also helps investors plan strategies for future electoral cycles.


FIG 2. Performance of a sample 50/50 equity/bond portfolio before and after US elections, 1964-2024¹
 
Source: Bloomberg, LOIM. As of 11 July 2024. 50/50 stands for a weekly-rebalanced 50% S&P 500 and 50% US aggregate bonds portfolio. Past performance is not a guarantee of future returns. For illustrative purposes only.

A diversification premium during US elections?

This time around, the question for risk-based investors, like ourselves, is straightforward: does valuing diversification impact performance during US election cycles? Observations suggest that while markets generally experience fluctuations around election events, they tend to end in positive territory. A pertinent question then arises regarding the relative performance of risk-based investing with or without inflation hedges, proxied by commodities. 

Figure 3 offers some insights, showing the performance of three distinct portfolios during the six months surrounding US elections from 1964 to 2020¹. These portfolios include the standard capital-allocation 50/50 US portfolio used previously, a risk-based portfolio based on the same bonds and equities as the 50/50 and a third risk-based portfolio that incorporates commodities. Both risk-based portfolios are leveraged to match the volatility of the first 50/50 strategy. The three key findings can be summarised as follows:

1. Risk-based solutions generally outperform the 50/50 portfolio before an election
2. Risk-based solutions with commodities outperform the 50/50 portfolio on average after the vote 
3. In scenarios where Democrats win, both risk-based portfolios tend to outperform the 50/50. However, when Republicans win, the advantage of enhanced diversification appears to be diminished, as the risk-based portfolios would not have added significant value over the 50/50 portfolio, or even detracted value when commodities are ignored

Overall, risk-based solutions have consistently outperformed the 50/50 portfolio during Democratic victories, whereas this outperformance tends to disappear in the event of a Republican win.

FIG 3. Risk-based and standard 50/50 portfolio performance before and after US elections, 1964-2020¹
  
Source: Bloomberg, LOIM. As of 11 July 2024. Subject to change. 50/50 stands for a weekly-rebalanced 50% S&P500 and 50% US aggregate bonds portfolio. Risk-based stands for a weekly rebalanced risk-based portfolio based on S&P500, US aggregate bonds and commodities (BCOM index). Past performance is not a guarantee of future returns. For illustrative purposes only.

What this means for All Roads

Given these trends, we believe that our All Roads solution could provide a form of financial shelter for investors leading up to the election, especially with the current focus on Treasury budget issues, which reduces exposure to bonds. Following the election, our strategies should be well-positioned to capitalise on a market rally, assuming historical patterns hold true. Diversification embeds an option-style pattern that tends to be activated when Democrats win – but that has little cost when Republicans win.

Simply put, the US election is likely to trigger sharp market fluctuations. Risk-based strategies have historically been well-positioned during such periods.
 

sources:

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• An improved growth outlook worldwide, with Europe at the forefront in this recovery period. The upcoming earnings season should provide further insights into this trend
• Inflation pressures are mounting in the global economy, but there are growing signs that this trend may be losing momentum, which is welcome news for central bankers
• The chance of monetary policy surprises has risen somewhat, primarily due to European data suggesting a slower-than-anticipated rate-cutting programme

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcaster gathers economic indicators in a point-in-time manner to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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