Government Gridlock Is More Bullish For Markets Than Blue Or Red Waves

The reality is that it is businesses that create jobs, not politicians. Businesses tend to do a better job of creating jobs when they aren’t burdened by Washington’s meddling in their affairs. Since Washington almost always meddles to varying degrees with the economy, it’s amazing how so many businesses in so many industries continue to be profitable and to expand their capacity and payrolls, with only recessions briefly tripping them up.

This line of thinking leads to the widely held notion that the economy and the stock market do best when Washington’s politicians are stymied from meddling as much as they would like by political gridlock, i.e., when the party of the president doesn’t have majorities in the House and/or the Senate. Divided government is bullish, while unified government is bearish, or less bullish.

Our governing system of “checks and balances” is the core principle that guided the nation’s founders when they wrote the US Constitution. In addition, many of them signed the Declaration of Independence, which declared: “Governments are instituted among Men, deriving their just powers from the consent of the governed." They were mostly lawyers, and they designed a system that worked best when it didn’t allow any majority party to have too much power for too long.

By the way, Abraham Lincoln, who was a lawyer as well as a president, famously restated the founding principle in his Gettysburg Address: “that these dead shall not have died in vain—that this nation, under God, shall have a new birth of freedom—and that government of the people, by the people, for the people, shall not perish from the Earth.”

Today, many investors fear that a Blue Wave on Election Day could happen, giving the Democrats’ unfettered power to implement their expansive and expensive agenda, including increasing federal spending, raising federal taxes, imposing more regulations, packing the Supreme Court, and so on. Wall Street strategists, including yours truly, countered that the bearish impact of higher taxes and more regulations should be offset by more spending in the Blue Wave scenario.

At my firm, we recently analyze the performance of the S&P 500 under unified and divided government since FDR took office (Fig. 1). We calculated the percentage increases in the index from January-through-December periods during the two alternative regimes. We found that during the previous six Blue Waves, the S&P 500 increased 56% on average. During the previous three Red Waves, the index rose 35% on average. During the seven periods of divided government, the S&P 500 rose 60% on average.

This suggests that gridlock is more bullish than the two unified alternatives, which are also bullish, but less so, with Blue Waves more bullish than Red Waves. Perhaps the market figures that government is less likely to grow much bigger when the government is divided rather than unified. In any event, the government has been getting bigger and more meddlesome for years, as evidenced by ever-widening federal budget deficits and mounting federal government debt (Fig. 2). (The founders generally disapproved of debt and believed that the amount the country owed should be limited.)

Alternatively, could it be that the White House and the Congress don’t matter as much to the stock market as does the Fed? I think so, and so does Barron’s, which chose to run a cover story on Fed Chair Jerome Powell with the title “This Is Jerome Powell’s Moment, No Matter Who Wins” this week. The article, written by Nick Jasinski, observed:

I was quoted in the piece as follows: “He’s a pragmatic pivoter. He’s done what he set out to do, and [shown a willingness to] change his mind depending on what the situation demands, but not be totally inconsistent.” Chapter 8 of my book Fed Watching for Fun & Profit is titled “Jerome Powell: The Pragmatic Pivoter.”

I previously have observed that no matter who wins the White House on Tuesday (or before Inauguration Day), he won’t be as important as Powell, whose first term doesn’t end until early 2022. Powell has made it very clear that he intends to keep the yield curve close to zero. The federal funds rate was lowered to zero on March 15 (Fig. 3).

The 10-year US Treasury bond yield has been below 1.00% since March 20 (Fig. 4). From February through September, the Treasury issued $670 billion in notes and $259 billion in bonds (Fig. 5 and Fig. 6). Over the same period, the Fed purchased $1,223 billion in notes and $338 billion in bonds. Previously, I’ve argued that if the bond yield rises above 1.00%, the Fed will most likely announce an official target range below 1.00%, a.k.a. “yield-curve targeting.”

Finally, since Halloween coincided with a full moon this weekend, all the more reason to fear the front cover curse. What could possibly go wrong for Powell?