Did you ever play the game “what if” as a child? What if I won a million dollars? What if Joey (Sally) likes me? What if the Giants (Jets) win the Super Bowl? While we’re being a little sophomoric with these examples, in investing, we also consider the what ifs. While our base case—the most likely outcome—is not part of our “what if” scenario, it’s important to consider the range of possible situations that could play out. In our new blog series, we address the “what ifs” we are talking about the most, and how they could change the trajectory of the economy and markets.

What If [Insert Name] Wins the Election?

Our first “what if” looks at the upcoming presidential election. Knowing that this is a polarizing discussion, we are intentionally prioritizing our discussion around how markets typically react to elections, regardless of which political party or candidate wins. As the field of candidates thins out, we will then publish our perspective on comparing policy priorities and the potential impact on industries and the markets.

Investors often fear a sell-off if their candidate loses. Yet, based on our research, the policy agenda and equity market response may not always be tied together. For instance, in 2016, several well-known market participants predicted that the equity market would fall between 4% and 30% should President Trump win. In reality, the markets rose one day after the election and continued to rise in the year following—by over 20% (Display).

How Markets React to an Election Outcome

Our research concludes that there are two reasons why investors’ fears that markets will fall as a result of an election outcome may be misplaced.

First, there is a powerful pattern of markets ignoring presidential contests for most of the year, then playing catch up in the last six weeks or so before the election. This pattern means that irrespective of anyone’s policy agenda, the market fails to react. This is not to say that markets don’t react to changes in policy during a presidential term. Agendas that are transformed into actual legal or regulatory policy do trigger market reactions as the financial impact is digested, and ultimately manifested.

Second, recessions are more predictive of sell-offs in election years than who wins. Negative equity returns in non-recessionary election years are extremely unusual. In fact, there have been only two election years where markets fell that could not be tied to a recession—in 1940 during the fall of Western Europe and in 2000 as the dot-com bubble burst (Display). So, forecasting a recession is far more important than predicting who wins a presidential election when projecting market performance.

Together, these point to an expectation that the markets could shrug off the outcome of the election, both early in the year, and after the polls close on November 3. But what if the fears become self-fulfilling?

Perception Becomes Reality

The behavior of investors is an important component of how well a market performs. Sentiment can often overrule fundamentals, especially in the short run. If the market becomes fearful of the leading candidate, or the winner’s policy agenda, then markets can move lower. And if the market moves down on that worry, it can cause a snowball cycle of more fear, which would push returns even further down, and on and on. So, while empirical evidence points toward markets staying positive unless a recession hits, market perception could short-circuit that expectation.

Our Base Case

Our outlook for this year is one of slowing US economic growth with elevated uncertainty. Softness in manufacturing and trade—even if the trade war is resolved—may spill over into labor and while we’re not forecasting a sharp deceleration, we wouldn’t be surprised by some weakening in the labor markets. Importantly, we are not forecasting a recession. In this environment, we would anticipate a return to more normal equity markets, but with heightened volatility. The election news cycle could certainly add to the ups and downs.

Our asset allocation team is focused on mitigating volatility by diversifying among asset classes, geographies, and market factors, and continuing to focus on company and economic fundamentals. This is where we’ve added value in the past, and where we’re likelier to have higher predictive success than attempting to forecast election results or likely policy changes. While history tells us that “what if [fill in the blank] gets elected” probably won’t cause the markets to substantially sell off, we do think the markets will react if there is a meaningful deterioration in fundamentals.

Our next installment in our series, “What if the Markets Party Like It’s 1990?”, will be available later this month.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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