CIO Insights: June 2017

Freddy Lim

Co-founder and CIO

07 June 2017

Executive Summary

  • Trump came into office with a slew of promises on tax reforms and other business-friendly policies. Since his election victory, the S&P 500 has rallied roughly 16.3%, and effectively front-loaded a lot of the potential upside associated with Trump’s promises. As a result, the market could be vulnerable in the near term if Trump is engulfed by any political predicament.
  • Our study of past notable presidential impeachments reveals that political events rarely alter the course of financial markets with long-term effects unless the economic environment was already in a weakened state. In other words, political events don’t impact the market as much as commentators may suggest.
  • Macro-economic factors, not periodic political events, dominantly drive asset returns over the medium and long term. The Oil Embargo of 1973, cultivated by a series of events that came before it (i.e. the breakdown of the Bretton Woods currency accord and the prior fall in US oil production that began in 1970), exemplifies how a major event can have a significant and lasting impact on global inflation.
  • The current investing environment is rife with political and geo-political uncertainties that necessitate taking measures to enhance the “staying power” of an investor’s portfolios. Thus, we recommend minimizing, or avoiding, the use of leverage, and strictly adhere to pre-specified risk limits, rather than try to outperform the impending short-term market volatility that we can expect in the coming months with the trials in the US. In addition, we think investors can better understand and manage risks by stress-testing their portfolios against major historical scenarios. We encourage investors to adopt a long-term view, and base asset allocation decisions on sound economic principles.

Heightening Geo-political Uncertainty

Trump came into office with a slew of promises on tax reforms and other business-friendly policies. Since his election victory, the S&P 500 has rallied about 16.3%, and effectively front-loaded a lot of the potential upside associated with Trump’s promises. As a result, the market could be vulnerable in the short term if Trump is engulfed by any political predicament.

As Trump is mired in the controversy around Comey’s memo and the probe into Russia’s possible meddling of the US election, we’re bracing ourselves for a potential Trump impeachment. Meanwhile, in Brazil, President Michel Temer is engulfed in bribery allegations, and the Supreme Court has approved an official investigation. 

In 2016, Dilma Rousseff of Brazil and Park Geun-Hye of South Korea were both removed from office. In 2016, we experienced quick market recoveries after political event shocks, such as the British Referendum, Trump’s election victory, and the Italian Referendum. These political events certainly heightened market volatility briefly, but they did not alter the course of financial markets in the medium and long term.

With the Comey hearings coming up, it’s good to know what we should be preparing for.

Haven’t We Seen This Before?

The short answer is, yes, we have most definitely seen political uncertainty before.

Studies of past notable presidential impeachments reveal that political events rarely alter the course of financial markets with long-term effects, and that macro-economic environments hold much more long-term weight in the markets. History teaches us that for a single event to alter the long-term trajectory of asset prices, it would have to exert significant and lasting influence on growth and inflation. When it comes to political events involving presidential questioning, we fail to find significant and lasting impact in any of the notable presidential impeachments we have studied.

When we analysed the Clinton and Nixon impeachments for insight into how the global markets will likely react in the face of a potential Trump impeachment, we found that the political uncertainty did not drive market changes, but rather the macro-economic factors did.

For a single event to alter the trajectory of asset prices, it would have to exert significant and lasting influence on growth and inflation. One such rare occurrence was the Oil Embargo in 1973 which exerted a significant medium-term impact on global inflation. Even so, the oil shock was cultivated by a series of events that came before it (namely the breakdown of the Bretton Woods currency accord and the decline in US oil production that began in 1970). Elsewhere, we have failed to find significant and lasting impact in each of the notable presidential impeachments we have studied in Table I.

 

Sources: Data for stocks, growth and inflation from Bloomberg. The respective indices for “Stocks” are S&P 500 (US), Bovespa (Brazil) and Kospi 200 (S.Korea). For each country, growth is proxied by year-over-year percentage change in industrial production and inflation by the headline CPI.

Bill Clinton (United States)

The most recent US political scandal being taken to court was when Bill Clinton was impeached by the House of Representatives on December 19, 1998 for allegedly having misled a grand jury about his extramarital affair with Monica Lewinsky in the White House, and then persuading others to lie about it [5]. After a trial, the Senate acquitted Clinton of both charges on February, 12 1999. He went on to apologise for the affair, and then completed his second term in office.

As colorful as the Bill Clinton affair was, the real culprit behind the sell-off in global equities was the Russian Crisis of August 1998 [6] [7]. It was then that the US Federal Reserve had responded swiftly and enacted three 25bps rate cuts between September and November of 1998. This provided “cushioning” for the stock market, and the S&P 500 then rebounded quickly, as seen in Figure I.

By mid-1999, it became apparent that US growth had rebounded from the lows seen in late-1998, which enabled the US Federal Reserve to raise interest rates again. This makes it evident that the Clinton impeachment had little to no effect on the global financial markets, as they were already rebounding due to strong economic activity.

Richard Nixon (United States)

Although Nixon was not impeached, he faced highly a highly probable impeachment in 1974, similar to what we might see in the coming months with Trump. Nixon’s resignation was a pivotal moment in US politics, but its impact on financial markets was overshadowed by the aforementioned Oil Shock of 1973. In October 1973, members of OPEC (Organisation of Petroleum Exporting Countries) announced an oil embargo in response to the US’s support for Israel during the Yom Kippur War [3].  By the end of the oil embargo in March 1974, oil price had risen from $3 USD per barrel to nearly $12 globally [4].

Aside from spurring inflation, the oil embargo had a severe impact on costs, creating a subsequent stagnation of global economic activity. In a little more than a year from the oil embargo, between November 1973 and September 1974, the S&P 500 had responded with a decline of about 41.3%.

It was the oil embargo of 1973-- not Nixon’s resignation-- that drove the global economy to stagflation, and in turn stock prices lower. The subsequent recovery of financial markets was also dependent on normalisation of economic conditions.

Nixon’s resignation on August 9, 1974 was approximately 6 weeks before the US stock market found its bottom after months of decline. The US stock market started to stabilise 5 months later, around January 1975. By March 1975, three consecutive declines in CPI inflation were observed, providing greater evidence that inflationary pressures have abated. This planted the seeds for the S&P 500’s sustainable recovery.

 

Dilma Rousseff (Brazil)

More recently, on August 31, 2016, the Brazilian Senate removed Dilma Rousseff from office with a 61–20 vote, finding her guilty of breaking Brazil's budget laws [8]. Then-Vice President Michel Temer replaced Rousseff as the new President of Brazil.

As illustrated in Figure III, the impeachment of Dilma Rousseff had little effect on the Brazilian stock market (proxy by the Bovespa index). Although industrial output was contracting, the decline was already rapidly decelerating since January 2016 (i.e. year-over-year percentage change in Brazilian industrial production was reversing its course). At the same time, inflationary pressure was easing off the highs observed in December 2015. In other words, Brazil’s “real” growth rate was improving from around late 2015, and was the primary reason that drove the outperformance in Brazilian equities. Credit can also be given to the quick recoveries of global stocks after “Brexit,” which relieved prior stress in investor sentiment over the outlook for emerging markets.

Park Geun-Hye (South Korea)

Closer to home, South Korean President Park Geun-Hye was charged with harbouring interventions to the presidency from her aide, and was impeached on December 9, 2016 when 234 of the 300 National Assembly members voted in favor of impeachment. On March 10, 2017, the court upheld the impeachment in a unanimous 8–0 decision resulting in the removal of Park from office.

Throughout the fiasco, economic factors in South Korea provided little guidance. As shown in Figure IV, South Korean CPI inflation was hovering in a tight range while there were large swings in industrial production (year-on-year percentage change). These provided little insight about South Korea’s economic trends. Instead, due to south Korea’s export dependency, international forces were the dominant driver. With the global economy was already on the mends, Park’s impeachment was not able to exert much influence on the proxy Kospi 200 index.

Enhance the “Staying Power” of Your Portfolio

At the time of writing, we continue to observe an environment with disinflationary growth. This environment tends to be supportive of risky assets, and it will take a lot more than a presidential impeachment to change the course of markets, as demonstrated in the examples above.

The current investing climate is rife with geo-political uncertainties, and investors need to take measures to enhance the “staying power” of their portfolios. We recommend minimising (or avoiding) the use of leverage, and to strictly adhere to an investor’s pre-specified risk limits. In addition, investors can better understand risks by stress testing their portfolios against major historical scenarios. 

At StashAway, asset allocation decisions are based on economic regimes, as economic factors are dominant drivers of asset returns over the medium and long term. StashAway’s financial advisory platform builds customised portfolios that take into consideration the appropriate risk level that each unique customer should take, and the automatic rebalancing feature ensures that each customer’s portfolio does not deviate from the determined strategy. To learn more about StashAway’s investment framework, visit https://www.stashaway.sg/r/stashaways-asset-allocation-framework.

 

References

[1] Agiesta, Jennifer. Approval Highs and Lows. The Washington Post. 2007-07-24.

[2] https://www.thoughtco.com/presidents-who-were-impeached-3368130

[3] https://www.history.com/topics/yom-kippur-war

[4] https://www.theguardian.com/environment/2011/mar03/1970s-oil-price-shock

[5] https://www.history.com/this-day-in-history/president-clinton-impeached

[6] https://news.bbc.co.uk/2/hi/special_report/1998/08/98/russia_crisis/165646.stm

[7] https://openknowledge.worldbank.org/bitstream/handle/10986/3797/WPS5312.pdf

[8] https://www.nytimes.com/2016/09/01/world/americas/brazil-dilma-rousseff-impeached-removed-president.html?_r=0