RQA Economic Insights: October 2024 — Richmond Quantitative Advisors

RQA Indicator Spotlight: Election 2024: What’s at Stake for Equity Markets?

As the 2024 presidential election draws nearer, traditional polls indicate a tight race, while betting markets are slightly favoring a Republican victory. With this uncertainty, discussions about the potential impact on risk assets are heating up. But how much do elections really matter to equity markets?

Historical Perspective: Pre-Election Market Trends

To understand the potential market impact, we analyzed the last eight presidential election cycles, focusing on the 60-day period leading up to the event. When comparing election years to non-election years, we observe that the S&P 500 tends to soften slightly before the election. However, this dip is not drastic and is mainly influenced by outliers like the 2008 election, which coincided with the Global Financial Crisis (GFC). Excluding 2008, the differences in pre-election performance become even smaller, suggesting that market participants tend to approach elections cautiously but not overwhelmingly negatively.

The chart below illustrates the S&P 500’s performance leading up to recent elections, highlighting the relative softness compared to non-election years:

Post-Election: The Market Rebound

Interestingly, both election and non-election years generally see positive returns from early November through mid-January. Removing the 2008 financial crisis, election years actually edge out non-election years in terms of returns during this post-election window. What’s notable is that the outcome—whether a Republican or Democrat victory—doesn't appear to have a distinct impact on post-election performance. It suggests that markets are more relieved by the end of uncertainty than driven by a specific candidate’s win.

Here's a look at how the S&P 500 has fared in the months following past elections:

This end-of-year performance also aligns with the so-called "Santa Claus Rally," a phenomenon where equities often see gains during the final trading days of December and early January. We’ll dive deeper into this concept in next month’s update.

Election Volatility: VIX Dynamics

To further gauge market sentiment, we turn to the CBOE Volatility Index (VIX), which measures the market's expected volatility over the next 30 days. Simply put, it’s a gauge of the "market's fear." The VIX often rises leading up to the election, as traders hedge their bets or reduce exposure amid heightened uncertainty. This pattern is consistent across election years, demonstrating a noticeable uptick in implied volatility compared to non-election periods.

However, once the election results are in and the immediate uncertainty dissipates, the VIX tends to decline. This reduction in volatility can even act as a catalyst for market rallies, as the hedges put in place lose value and are unwound. Importantly, the volatility spike also represents a "risk premium," reflecting the small probability of contested results or delayed clarity—an outcome that markets generally dislike.

The following chart highlights the typical pre- and post-election volatility trends:

A Note on the Bond Market: Interest Rate Trends and Volatility

While equity markets often get the most attention during elections, it’s also worth examining bond market dynamics. Leading into the 2024 election, we’ve seen a notable shift in interest rates, driven by various economic factors and shifting Fed policy expectations along with what may unfold in a Republican victory. The rise in rates has been accompanied by an increase in interest rate volatility, as measured by the MOVE Index (the bond market’s equivalent of the VIX).

Higher rate volatility typically signals uncertainty about future monetary policy and potential shifts in inflation expectations—both of which can be influenced by the election’s outcome and its anticipated impact on fiscal policy. This backdrop of rising bond yields and volatility could create additional risks for fixed-income investors but might also present opportunities for those seeking to position for potential shifts post-election.

Key Takeaways for Investors

Historical data suggests that the U.S. presidential election has a limited immediate impact on equity markets, provided the outcome is clear. While we observe some increased volatility and minor softening in prices leading up to the event, markets generally stabilize and rally once uncertainty subsides, regardless of which party wins.

In summary:

Pre-election periods often see mild downward pressure but nothing dramatic unless accompanied by broader economic issues.
Post-election periods tend to perform well, with both election and non-election years enjoying positive returns.
Volatility typically spikes before the election but subsides afterward, adding to potential upside as the event risk fades.
Bond markets are experiencing rising rates and interest rate volatility, underscoring the broader uncertainties around policy and inflation as we head toward the election.

Investors should remain aware of election-related volatility but focus more on the macroeconomic landscape and policy shifts that will unfold over the longer term. And don’t forget: the last few months of the year often coincide with the "Santa Claus Rally," which we’ll explore in more detail in our next update.

Economic Forecast Model

As of the end of September, the growth metric in RQA’s Economic Forecast Model increased to 0.27, up from August's 0.24 and July’s 0.20. This marks a few consecutive months of steady growth, signaling stabilization and avoiding a dip into negative territory below the zero bound. The current trend suggests a measured pace of improvement, with positive expectations that reflect resilience rather than robust acceleration.

*Source: Analysis by RQA. Data from U.S. Federal Reserve; Bureau of Labor Statistics; Norgate Premium Data; Institute for Supply Management.*

The RQA Economic Forecast Model represents a consolidated composite of key economic leading indicators and market-based explanatory variables. The goal of this composite model is to present a holistic measure of primary U.S. economic growth drivers and their trends over time. (Additional detail on the model’s construction is provided here.)

Values above the zero-line are indicative of positive U.S. economic growth expectations in the near-term, and therefore, indicate economic strength and lesser chance of recessionary pressure. On the other hand, values below the zero-line represent the opposite - a more negative outlook and more elevated probabilities of the U.S. experiencing an economic contraction.

TAKING A CLOSER LOOK AT THE ECONOMIC DRIVERS

The RQA heat map of economic drivers provides additional insight into the U.S. growth outlook. By examining trends across sectors—such as labor, industrial activity, and financial conditions—we gain a more detailed understanding of the economy's health and trajectory. This breakdown helps us anticipate potential shifts in growth expectations and inflation trends.

Recent economic data, while showing some ebb and flow, suggests a steady environment with no major red flags or signs of overheating. Employment data remains stable to moderately weak, with a slight decline in the RQA Labor Composite and an increase in initial unemployment claims. Core employment indicators, such as the employment-to-population ratio and average weekly hours, remain relatively consistent.

The persistent contrast between strong services and weak manufacturing continues, reflecting the economy’s shift toward the service sector. While the ISM Manufacturing PMI dipped further, the services sector showed modest improvement. Industrial activity has experienced minor declines, indicating headwinds for production, but no alarming signals.

Income and consumption trends softened, with real personal income growth moderating. However, retail sales saw slight improvement, and overall consumer spending maintains a cautious yet resilient tone.

Financial indicators continue to reflect shifting investor expectations. The treasury yield curve shows early signs of steepening, indicating potential changes in economic outlook. Corporate bond spreads narrowed modestly, suggesting easing credit conditions. Equity markets performed well, with the S&P 500 posting strong gains.

Inflation remains stable, as CPI eased further and core PCE showed a slight increase. The M2 money supply grew modestly, suggesting gradual shifts in monetary conditions. Overall, inflationary pressures appear contained, with no major concerns on the horizon.

MARKET REGIME DISCUSSION

As we close out the quarter, the market has largely digested the Federal Reserve's interest rate policy and is now positioning itself for the upcoming election in the near term and potential positive seasonality as year-end approaches. Equities have risen to levels near all-time highs, reflecting optimism about the election’s implications and seasonal trends in the months ahead. However, despite the momentum, equities remain somewhat stretched from both a total return and risk-adjusted return perspective. We will continue to monitor these developments in the coming weeks.

Yield Curve Steepening

Medium- to longer-term rates have continued to rise since the Fed's recent policy announcement, suggesting normalization across the yield curve. While questions remain about how high long-term rates could go and what factors are driving them, a positive sloping curve could simply indicate a return to a more standard structure after years of inversion. Monitoring the long bond will be crucial to managing potential shock risks that could drive yields higher from current levels.

Economic Growth

The forecast growth model has shown gradual improvement over the past few months, alleviating near-term concerns of a negative reading. This upward trend suggests stabilization, with the outlook moving from contraction risk to a more optimistic, albeit modest, growth trajectory.

Economic Quadrant Update: Inflationary Boom

Our economic quadrant model remains largely unchanged, still positioning the economy within an "inflationary boom." Both growth and inflation metrics remain close to the zero bound, indicating a fragile regime that could shift with future data releases.