Measuring The Relationship Between U.S. Political Risk And The S&P 500

A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Monday, Dec. 31, 2018. U.S. stocks erased gains in thin trading on the final day of what is shaping up to be the worst year since the financial crisis. Photographer: Michael Nagle/Bloomberg© 2018 Bloomberg Finance LP

As U.S. markets open (briefly) again tomorrow, this analysis addresses a key question for most global investors: What is the relationship between U.S. political risk and the recent volatility in equity markets? A quick scan of financial headlines could lead one to conclude that U.S. politics — the ongoing government shutdown, the president’s attacks on the Fed, developments in the U.S.-China trade dispute, the Mueller investigation and more broadly, the chaotic governance style of the Trump administration — are core drivers of stock market gyrations. At the same time, equities have boomed during (very) recent periods of political volatility and US markets — large, deep and diverse — are historically quite resilient to geopolitical shocks. A lack of data measuring (or even defining) political risks adds to the confusion, with investors relying on “breaking news” headlines, ad hoc punditry and their own implicit (or sometimes explicit) bias to try unwind the politics-markets connection.

GeoQuant fills this void with our daily, systematic and AI-driven political risk data streams, allowing investors to ‘connect the dots’ between politics and markets. To wit, here we examine the relationship between key U.S. political risks and the S&P 500. The analysis echoes the three core points we have made over the past two years of U.S. political volatility:

  1. There has been a major buildup of U.S. political and geopolitical risk which — at least until recently — has not been reflected in U.S. equity markets, in large part due to strong economic fundamentals and equity “positive” risks like pro-cyclical, expansionary fiscal policy. The country’s negative ‘political fundamentals’, as we argued, would bite once economic fundamentals began to fall off.

  2. That said, larger draw downs in the S&P 500 over the past 6 years are clearly associated with periods of increasing top-line Political Risk, while Policy Risk and Regulatory Risk are both negatively correlated with the S&P 500 in the same period.

  3. Higher U.S. political risks — especially Policy Uncertainty Risk and Geopolitical Risk — have hit the market more severely since the 2018 midterm elections, as predicted at the time.

The graph below tracks our top-line U.S. Political Risk score against the S&P 500 close over the past six years. Recall that for each country in our dataset the top-line Political Risk score is composed of 22 fundamental political sub-indicators, ultimately grouped into Governance Risk, Social Risk and Security Risk — more holistic, theory-driven measurements of political risk than suggested by sensationalistic headlines.

United States Political Risk vs. S&P 500 Daily Closing PriceGeoQuant 2018

The correlation between the two indicators is weakly positive (r=0.19), suggesting no (intuitively negative) relationship in aggregate. Nonetheless, by overlaying the largest single day drawdowns in the S&P 500, as indicated by the red vertical lines in the figure above, it is clear that all but one (the March 2018 drawdown) came amid increasing U.S. Political Risk. This echoes our broader findings that although the relationships between political risk and market outcomes are often too complex to be captured by  bivariate correlations, even these simple analyses reveal compelling, highly relevant patterns that only become apparent by measuring political risk at high frequency. [NB: nearly all of the largest single day increases in the S&P 500 come after big drops — i.e. “buying the dip” — making that analysis less compelling].        

The complexity of political risk notwithstanding, per the table below, two of the most equity-relevant sub-indicators of U.S. Political Risk – Regulatory Risk and Policy Risk – do show relatively strong, negative correlations with the S&P 500 over the past six years, at -.52 and -.61, respectively.Moreover, the correlation for Policy Risk — which aggregates macro-policy risks, micro-policy risks and investment/trade policy risks — has strengthened  to -0.80 since the 2016 presidential election, while the correlation for Regulatory Risk (which is effectively a sub-indicator of Policy Risk) has strengthened to -0.81.

The strengthening of these relationships post-2016 election reflects the equity-positive decline in business regulations under the Trump administration, along with the more idiosyncratic, negative effects of  nationalist /unpredictable trade policies. Note further that higher Macro-economic Policy Risk under Trump — i.e. pro-cyclical tax cuts and higher spending — have generally been good for equities (i.e. a positive correlation), weakening the broader negativity of the Policy Risk relationship.

Correlation Between Risk Indicator And S&P 500GeoQuant 2018

A much broader set of U.S. political risks have negative relationships with the S&P 500 since the even more recent U.S. midterms, reflecting trends which we warned about before and after the polls.

We specifically predicted an increase in Policy Uncertainty Risk, which has since materialized with the government shutdown, Trump’s accelerated attacks on the Fed and mixed signals on the U.S.-China trade dispute (NB: unlike Policy Risk, Policy Uncertainty Risk includes the potential for rapid policy change and/or instability, regardless of the direction of such change).  

Higher Policy Uncertainty Risk is set to continue in 2019 with a new Democratic House, at least in part due to developments in the Mueller probe and the related set of Institutional/Regime risks associated with a potential impeachment drive and the Trump administration’s more aggressive posture toward state institutions.

United State: Policy Uncertainty RiskGeoQuant 2018

Note as well that a new Democratic House is also driving a projected spike in previously declining Regulatory Risk — albeit from a low base.

United States: Regulatory RiskGeoQuant 2018

Finally, note the strong negative post-midterm correlation between the S&P 500 close and U.S. Geopolitical Risk, as latter has been exacerbated by recent developments like the Syria troop withdrawal, the Mattis resignation and escalating “cold tech war” tensions with China.

United States: Geopolitical RiskGeoQuant 2018