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The market wants Turnbull: why close election races increase volatility for investors

Traders prefer Coalition wins, but it’s the not knowing that matters the most. Lukas Coch/AAP

The market wants Turnbull: why close election races increase volatility for investors

The July 2nd federal election will be the third in a row called by a prime minister who took office mid-term. Polling currently suggests it will be another close race, with a hung parliament possible.

Amid the debates about how the two major parties would manage the economy if elected, it’s interesting to consider the interplay between political uncertainty and the economy.

Uncertainty about the election outcome (a measure of political uncertainty) creates ambiguity, making it difficult for both investors and corporate managers to make decisions. The possibility of a change in government expands the range of possible economic policies that must be considered by firms and investors.

There is uncertainty not just on whether a policy will change, but also about the size of the economic impact relating to the policy change. This is particularly so when there is a significant difference in policy between the major parties.

The dispute on carbon and resource taxes in previous Australian elections is an example of this policy uncertainty. The doubt about the outcome of this debate explains why stocks for the “base-materials” sector (mining/resources) have proven most sensitive to changes in opinion polling. With negative gearing hogging the limelight at the start of this election campaign, perhaps stocks related to the housing market will prove more sensitive this time around.

Political uncertainty impacts the real economy through the investment and hiring decisions of firms and can result in falling consumer confidence and slowing retail sales. This relationship is two-way as changes in economic fundamentals may lead to changes in the likelihood of the election outcome. An observation not lost upon Bill Clinton’s advisers who famously coined the phrase “It’s the economy stupid”.

Political uncertainty impacts financial markets

Political uncertainty also leads to uncertainty in financial markets, and this tends to manifest in higher levels of volatility. The chart depicts the relationship between “two-party preferred” polling results and the level of financial market uncertainty (measured using implied volatility from short-term options).

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Political uncertainty also impacts the bond and currency markets. For instance, a change in fiscal policy may result in changes to the supply of government bonds (or credit rating) and influence bond yields. Similarly, a new trade policy may impact the value of the dollar. The connection between election uncertainty and financial markets also differs according to the level of political, economic, and press freedom.

Financial markets might welcome a Turnbull victory

Financial markets tend to respond more favourably to the prospect of a victory by the Liberal-National Party Coalition. Stock market prices increase, bond yields rise by smaller amounts, and volatility declines, following a Coalition victory. This could be because Coalition policies are viewed by the market as more “business friendly” or “fiscally responsible”. The jury may still be out on this latter claim, while Labor struggles to prove its economic credentials.

My research suggests there tends to be some financial market preference (shown as lower market volatility) for the incumbent party to win the election. This is particularly true when the Coalition forms the incumbent government. Investors tend to be more aware of the policies of the incumbent party and less uncertain about how those policies would affect the macro-economy.

As polling day approaches, changes in the likelihood of the election outcome have a larger effect on market volatility. This is because the level of media scrutiny increases and investor attention becomes more focused.

My research also shows this relationship is stronger when the economy is struggling. Political parties are likely to invoke a wider range of economic policies in order to repair a struggling economy. And the type of policy favoured by the respective parties for fighting recession may also be very different.

What does this mean for investors?

Several factors suggest that investors should be cautious in the coming weeks.

First, recent signs of a slowing housing market and deflationary pressures culminating in historically low interest rates suggest the economy is struggling. Together with the tight opinion polls, this creates perfect conditions for financial market volatility in response to changes in the odds of the election outcome.

Second, there appears to be a clear difference in the economic policies of the two parties. Particularly regarding changes to the tax system.

Third, research shows that investors around the world are not particularly good at calling the correct result. They are often surprised by the election outcome – both the winner and the victory margin. So, it is likely there will be a jump in market uncertainty.

Investors should expect higher levels of volatility and allocate their assets accordingly; choosing less volatile assets that are not heavily influenced by government policy.