Why Politics Shouldn't Drive Investment : Focus on Market Fundamentals

Why Politics Shouldn't Drive Investment: Focus on Market Fundamentals 

Every new presidential term arrives with speculation over which market sectors might emerge as winners or losers. Yet, while it can be tempting to see political shifts as harbingers for market trends, the reality is more complex. Historical data shows that established economic, liquidity, and price trends often play a more decisive role in determining market outcomes than political shifts. Relying on these trends as indicators is far more effective than reacting to the unpredictable tides of political change.

The present environment illustrates this well. While inflationary pressures in the United States are likely to support higher yields over time, many market trends predicted to flourish after Donald Trump's victory are unlikely to reach their expected heights. Political developments and financial markets simply do not align in a straightforward manner. Despite recent years' intense focus on the intersection of politics and finance, the enduring effect of political decisions on markets tends to be limited.

Political uncertainty related to economic policy has relatively little influence on stock market volatility. There are exceptions, as in the aftermath of Lehman Brothers' collapse in 2008 and Donald Trump's 2016 election, where political and market uncertainty fueled one another in a reinforcing cycle. However, this sensitivity is generally kept in check when the Federal Reserve intervenes to stabilize the markets. For instance, during quantitative easing (QE1) in 2009 and the initial pandemic response in 2020, the Fed acted as a stabilizing force, reducing the chance of prolonged market disruption due to political events.

So far, market shifts expected from Trump's policies are largely playing out. Yet, it would be imprudent to anticipate their endurance. While yields currently lean higher, bonds have become oversold, suggesting a likely tactical reversal in the near future. Treasury Inflation-Protected Securities (TIPS) and gold have been on the rise, though gold, now considered overbought, is showing signs of a corrective phase. Stocks are poised to continue benefiting from steady growth and liquidity, so long as yields don't rise too swiftly. Meanwhile, the dollar has strengthened but will likely decline over time as inflation erodes real yields.

In the longer term, it is the overarching trends in economics, liquidity, and price that will decide which sectors thrive under the new president's second term, not political maneuvering. Although political news may often create short-term excitement, it has limited medium-term influence on the markets.

History shows that even when markets are sensitive to political changes, as in 2016, the effects are often brief. Many expected Trump's presidency to fuel growth, reduce regulatory red tape, bring about tax cuts, and lead to greater infrastructure investment. These policies were supposed to boost yields, the dollar, and benefit sectors such as banking, energy, industrials, and materials, while hurting emerging market equities. However, reality had other plans. While industrials and materials performed relatively well, the tech sector ultimately outshined all others, boosted by the pandemic-driven shift to remote work. This unforeseen event underscores the unpredictable nature of market responses to political changes.

Contrary to expectations, financials and energy lagged behind other sectors, even before the pandemic hit at the end of Trump's term. Small and mid-sized stocks outperformed large caps during Trump's first year in office but were eventually overtaken over his entire term. The dollar initially rose after Trump took office, only to relinquish those gains and ultimately end lower. Emerging market equities, which were expected to suffer, nearly matched the performance of small caps.

The "America First" agenda, which aimed to favor smaller and more value-oriented companies, was also turned on its head. Growth stocks became the top performers of Trump's presidency, while value stocks fell to the bottom. This was notable because, under every other president since 2000, value stocks had outperformed growth. In 2020, following Joe Biden's election, it was widely assumed that energy stocks would suffer, given the administration's commitment to renewable energy and its opposition to fracking. However, Russia's invasion of Ukraine drove oil prices higher, resulting in energy becoming the best-performing sector under Biden. Despite predictions, healthcare lagged, ending up as the second-worst performer.

This pattern isn't unique to recent administrations. When George W. Bush took office in 2000, the energy sector was expected to prosper due to his background in oil and his commitment to energy independence. Financials were also projected to gain from deregulation. Although oil prices rose, the energy sector underperformed both in Bush's first year and throughout his first term. Financials fared no better, eventually suffering greatly as the financial crisis unfolded in 2007-08.

Barack Obama's presidency was anticipated to benefit healthcare due to the Affordable Care Act, utilities due to a focus on renewables, and technology due to a focus on digital infrastructure. However, all three sectors underperformed in his first year and throughout his term, with tech being the only one to achieve a slight gain.

The central issue with investing based on political expectations is the high noise-to-signal ratio. Much is said, yet little is accomplished in ways that align with initial promises. Even when political agendas are pursued, they often fall short of initial expectations or take far longer than anticipated to implement. More targeted approaches, such as investing in specific themes, might offer some advantage, but investors are still left with the fundamental question: will these policies actually materialize as anticipated?

Investing based on political shifts can be a dangerous path. This has always been true but is especially so with a president as unpredictable as Trump. The safest approach for portfolio management remains an emphasis on liquidity, price, and economic data rather than reactionary shifts based on political news.