ELECTIONS & ECONOMY : ITS IMPACT ON THE MARKETS

"The issue is that the markets right now are anticipating a stable government and rapid policy actions. To the extent markets are disappointed, it will reflect on stock markets, perhaps on bond markets, perhaps on exchange markets. We have to be prepared for some turmoil." 

– Raguram Rajan, Governor, RBI

Does elections affect the economy or is the vice versa? Is there a relationship between the elections and the economy of a Nation and if so, which is the cause and which is the effect, will be an interesting question to ponder over! Let us accept the fact that, there is a general perception that, people vote based on the economic performance of the incumbent government and hence, both are interlinked. Therefore, the broader assumption seems to be that, better the economic performance of the incumbent government, higher the chances of it winning an election. Now, let us examine whether this is true in case of U.S.A., to start with.

In his study “Does the Economy Determine the President? - A Regression Model for Predicting US Presidential Elections”, Roy K. Roth of Brigham Young University – Utah makes the following statement prior to 2012 American Presidential Elections: “There is still almost a year until the 2012 election. Currently, it is not even clear who the Republican nominee for the presidency will be. Using data from Fair’s website my prediction is the same for all models. I predict a victory for President Obama.” And we all know what followed.

On the contrary, take a look at the following analysis:

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      When there was a situation where the economic growth was lower than the previous administration, the incumbent Government won twice during Eisenhower & Ronald Reagan regime and the incumbent government lost twice during Ford and Sr. Bush regime.

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         Similarly, when there was a situation in which higher unemployment rate prevailed than the previous administration, the incumbent Presidents Ronald Reagan & Clinton won twice and the incumbent President Ford lost the elections.    

Franklin D. Roosevelt was re-elected when the unemployment rate was well into the double digits !

The most significant contribution of this paper is that perhaps economic indicators are not as significant as they have been portrayed. Of course, they seem to have significant effects on the share of the popular vote. However, this research indicates that their effects are less significant in actually determining the winner of an election.

In Indian scenario, the paper titled “Political Cycles in a Developing Economy: effect of elections in the Indian States” by Stuti Khemani, Development Research Group of the World Bank, studied the effect of state elections on the policies of state governments in 14 major states over the period 1960-1994.

The empirical results for fiscal policy show that election year have a negative effect on some commodity taxes, a positive effect on investment spending, but no effect on deficits primarily because consumption spending is reduced. With regard to public service delivery, elections have a positive and large effect on road construction by state public works departments!

In recent past, post LPG – Liberalisation, Privatisation & Globalisation era starting 1991, the trend is fairly clear. The Narasimha Rao Government which introduced the sweeping reforms, lost power in the 1996 general elections. In the year 2004, BJP went to election with the “India Shining” slogan and they were again voted out! In 2009, despite the global recession and its impact on Indian economy, the incumbent Government came back to power as a coalition. In 2014, the way markets are moving up, it looks like markets are aiming at a stable government to push forward the limping reforms.

Sensex which was hovering around 17,500 in August, 2013 is now in the range of 22,500; this movement of 5,000 plus points has happened in a matter of 8 months which translates into an appreciation of about 26 %. In the month of March alone after the announcement of the general elections, the markets have gone up by 8 %. FIIs have invested $ 6 billion in December, 2013 quarter and more than $ 3.7 billion into equities in March quarter. FIIs holding in Sensex companies are at an all-time high of 8 %.

Markets generally discount the future in advance and hence, the current upward movement may be attributed to various factors – both political and economic – which might happen at a future date.

The CPI based inflation which was hovering around two digits for most part of the last two years has come down closer to 8 % range. Though IIP numbers are not very encouraging, the Trade Deficit is under control, thanks to lower imports of gold on account of increased import duty and consequently, the Current Account Deficit which was looming large on us last June came down substantially. Rupee has started stabilising and dollar is hovering around Rs. 60/-, adding some optimism into the markets.

Therefore, the current upward momentum in the markets can be attributed to a combination of expectations for policy reforms as well as election spending, apart from above mentioned factors. Moreover, in a bullish market, economic or corporate fundamentals do not matter anymore. Markets will create events to sustain the momentum.

In March, Goldman Sachs gave a more upbeat view of Indian stocks, changing them to “overweight” from “market weight” on the potential outcome for the elections and improved economic fundamentals. The same international investors who were expressing concerns about Indian economy and mentioned the possible downgrading of India hardly about a year back have now started talking about India as an investment destination.

If one looks back in time, In 2004, the Sensex was down 1 % , two months prior to elections & fell 11 % after the election verdict, underperforming Asian indices because the BJP, which had been expected to come to power with “India Shining” slogan, did not win. The Left support for the Congress government pulled down markets. The PSU stocks, banks, oil companies & capital goods makers were the top losers.

In 2009, Sensex rose 18 % in the 2 months before elections, amidst range of gains in Asian indices. It rallied 24 % , one month after the election results, outperforming the Asian markets. But that was also due to the economy coming out of a downturn on the back of a massive stimulus programme world over. The top sectorial gainers were metals, capital goods and real estate.

It is tough to say that economy is the only factor or even the predominant factor in elections. There are many factors that influence voting. By giving too much weight to economic outcomes, we may run the risk of oversimplifying matters.

Since there isn’t strong empirical evidence to suggest that economic growth & reforms-oriented policies lead to favourable electoral outcomes, the government would always lack the incentive to push policies that are perceived to be politically sensitive, such as reducing subsidies or introducing market-oriented policies.

The BJP-led NDA, which the market probably is expecting will come to power, also lost an election under the India Shining slogan. Therefore, BJP may also probably be reluctant to pursue market-orientated policies in an aggressive manner. So, it is important that investors anchor expectations to realistic levels.

Further, opposition did not make much effort to resist populist policies of the Government. On the contrary, they have supported costly entitlement programs. In the recent past, both the ruling party as well as the opposition has supported welfare schemes & subsidies to the same degree. These programs have led to increased subsidies, price guarantees & central provisioning.

These policies constitute a substantial shift from the far more pro-market policies that the BJP pursued when it led the NDA government from 1999 to 2004. For example, the BJP’s opposition to greater FDI in retail. BJP government in Rajasthan banned FDI in retail. Does that indicate that the party does not want India to open up further to foreign investment, or is it merely political posturing?

Whoever was in power, last 30 years, India’s average growth rate has been about 6 % irrespective of reforms. Today, India is on the downside of the cycle, with growth below 5 %. Some rebound is likely as the U.S. economy is in the upswing. But it is important for us to undertake legal & regulatory reform and build capacity if growth is going to be sustained. Therefore, a lot of effort will be required on the part of the government to bring back investments and growth on track.

Economic environment may not change immediately after the formation of a new government, though sentiments will turn positive, at least in the short run.  

Corporate India believes that the country's economy could resurge to grow 6.5% this year if a strong reform-minded stable government comes to power. But a 'business as usual' approach by a coalition could mean growth lingering at current levels or improving moderately, while, a fractured mandate could trigger panic in an already subdued economy.

If the market is expecting a change of government at the centre, it probably needs to contain its excitement & expectations. Looks like even if NDA comes to power, as is widely expected, it may not lead to a major shift in the policy framework.  New Government may not be looking at a major overhaul of economic policy, but might look for minor modifications that would lead to better outcomes.

Of course, with a stable government at the Centre, investment sentiment will certainly improve,  GDP may grow at least 1 % higher than average and inflation may shoot up again closer to double digits. Rupee might appreciate a bit or stabilize around current levels as FDI & FII money flow in.

Moot question now is, do you invest in the markets now? We have to look at markets beyond elections. The new Government have to address structural flaws in the current system. Fixing these problems requires creating new policy frameworks, writing new laws and then implementing them. These things can’t be done in a day. Hence, wait and watch; Caution needed!

Please remember, a strong pre-election correction has led to a stronger upward movement, post elections! Similarly, a strong pre-election rally rarely sustained post-election! But, “Is it different this time? Only time can tell ! 

- Presented at CFA Institute Chennai Chapter and published in the Hindustan Chamber of Commerce Monthly.