The Election and the Markets

November 2016 MARKET UPDATE The Election and the Markets "The basis of our political system is the right of the people to make and to alter their constitutions of government." George Washington George Washington (1732-99) was a U.S. founding father, the commander in chief of the army in the American Revolution, and later the first president of the United States. Born and raised in Virginia, Washington spent his early career as a surveyor, later enjoying a long and storied military career. Following the Revolutionary War, Washington presided over the Constitutional Convention in 1787. He was unanimously elected president by the Electoral College in both 1789 and 1792, the only president to have won all electoral votes in a U.S. election. Washington served as president from 1789 to 1797; he was the only nonpartisan president of the United States. The 2016 election will be held November 8, not news to anyone at this point. This election year has been filled with media attention and public scrutiny. From a market perspective, financial markets typically do not favor uncertainty, and some volatility entered the arena due to the fast-paced developments of the 2016 U.S. presidential campaign. Polling has shown to be volatile throughout this election cycle, and many have even come to question the polling processes themselves different polls have shown dramatically different results. Not surprisingly, markets have responded to this election cycle in kind, with confusion and sometimes volatile trading. In our conversation about the election, it is not by any means our intent to predict the outcome. For that there has been much coverage by political analysts, media, and other sources. But the question we hear from investors is, "What happens to the markets based on the outcome of the election?" Election Market Implications The media, polls, and political analysts have covered this election with great interest and Table 1 Gains under Various Configurations of Party of President and Majority Party in Congress March 4, 1901-August 7, 2012 Stocks Industrial Inflation Real Stock Long-Term Fed (DJIA) Production (CPI) Returns Gov t Bonds* Dollar** Democrat President 7.73% 5.26% 4.44% 3.14% 3.84% 0.11% Republican President 2.95 1.80 1.80 1.13 7.75-1.42 Democrat Congress 6.01 4.48 4.36 1.59 5.54-1.11 Republican Congress 3.57 1.45 0.65 2.89 6.39-0.23 Democrat President and Congress 7.26 6.29 4.60 2.54 2.89-2.24 Democrat President, Republican Congress 9.63 1.11 3.79 5.63 8.14 4.00 Republican President and Congress 1.62 1.56-0.37 2.00 5.48-4.24 Republican President, Democrat Congress 4.32 2.04 4.01 0.30 8.99-0.56 All Periods Buy/Hold 5.13 3.38 3.01 2.06 5.77-0.91 *Data since 1925 **Data since 1971 Note: Majority Party = Party with average control in House and in Senate greater than 50% Source: PNC

Chart 1 Third-Party Votes E=estimate attention. This election cycle is certainly one most Americans would soon like to put in the rear view mirror, in our view. A question we often hear from clients is: "How does the stock market perform in an election year?" A second question is typically: "Does it matter to financial markets who wins?" In looking at past election data, there are many factors that help determine how markets react to which candidate or party wins an election. Interestingly, looking at data since 1901 shows that the market tends to prefer a mixed Congress, with majorities in the two chambers held by different political parties (Table 1, page 1). One positive data point of note: election years tend to be favorably correlated with market returns. Since 1928 the median return of the S&P 500 in an election year has been 9.0% and the return has been positive 15 out of 21 times. All election years have experienced a rally of at least 10% at some point during the calendar year. The median election-year rally has been 17.2%. Corrections occurring during election years tend to be of the magnitude of about -10.3%. Volatility data are slightly different, particularly for an incumbent party, which in this case is seeking reelection in a slow recovery period. We would expect market volatility could rise as the election date draws closer, especially given the particularly polarizing election 2016 is turning out to be. The Election The faceoff between the two major party nominees in the presidential debates seemed to be a turning point in this election. After the first presidential debate, former Secretary of State Hillary Clinton was able to recover ground lost following the muchtelevised fainting episode of September 11. Heading into the final month of the race she had a slight lead over Donald Trump. We would be cautious when looking at who won or lost any of the debates as being a sure predictor of the outcome of this election. In addition, polling has been shown to be volatile through this election cycle, and many have even come to question the polling processes themselves; different polls have shown dramatically different results. It is not Table 2 S&P 500 Performance 3 Months Prior to Presidential Election Price Incumbent Correlation Year Return Party to Result 1928 14.91% Won Y 1932-2.56 Lost Y 1936 7.92 Won Y 1940 8.56 Won Y 1944 2.29 Won Y 1948 5.36 Won Y 1952-3.26 Lost Y 1956-2.58 Won N 1960-0.74 Lost Y 1964 2.63 Won Y 1968 6.45 Lost N 1972 6.91 Won Y 1976-0.09 Lost Y 1980 6.73 Lost N 1984 4.80 Won Y 1988 1.91 Won Y 1992-1.22 Lost Y 1996 8.17 Won Y 2000-3.21 Lost Y 2004 2.16 Won Y 2008-19.48 Lost Y 2012 2.45 Won Y 2

surprising, therefore, that markets have responded to this election cycle in kind, with confusion and sometimes volatile trading. Many view Ms. Clinton s campaign as reminiscent of George H.W. Bush, whose run in 1988 was seen as a symbolic third Ronald Reagan term. Ms. Clinton s numbers have been following Mr. Bush s trajectory from the convention forward, according to Strategas Research Partners. Strategas also believes this election will be a battle for the vote of the college-educated white demographic, and more specifically, the women within that group. This group has overwhelmingly favored Republicans in past elections. When it comes time to vote on November 8, many political strategists cite voter turnout and thirdparty candidates as possible game changers (Chart 1, page 2). In this election, polls show that third-party candidates could receive the fifth-largest share of support in 100 years. If support for them were to drop off, it could consolidate support for either of the two major party nominees. The Markets and the Election Looking at the markets, history has shown that stocks have exhibited some relative correlation with the winner of an election. The directional return of the S&P 500 has correctly predicted the outcome of 19 of the past 22 elections. For the three months preceding the election, if stocks were positive the incumbent party typically won the election (Table 2, page 2). If returns were negative, the incumbent party usually lost. Uncertainty in the short run tends to affect sentiment and seems to indicate that change could be warranted. Conversely, if things are positive, it seems to presage more of the same. In the current election cycle, the three-month period for returns preceding the election began on August 8, 2016. In a shorter timeframe, this correlation has shown to be more pronounced. If you look at the one month preceding the election, if returns have been positive, the incumbent typically won (Chart 2), while if negative the opposition won. Further, in the Chart 2 S&P 500: Percentage Change 1-Month Prior, Incumbent versus Nonincumbent 1933-2012 Chart 3 S&P 500: Percentage Change 1-Month Prior, Open Election Incumbent versus Nonincumbent 1948-2008 one-month period preceding an open election (with no candidate up for re-election), the returns data are even more pronounced. In five of the seven open elections since 1948, there were negative returns and the opposition party won (Chart 3). Congress Matters More This presidential election has caused much media attention, public scrutiny, and market reaction. But what is more important to markets is what happens within Congress in terms of party control. Polls this 3

past summer were showing the probability that Republicans would retain control of the House; control of the Senate looked to be up in the air. As the election approaches, the down-ballot races, including congressional races, are gaining more attention. The Republicans currently control the Senate; a net gain of five seats would be required for the Democrats to take control. If the Democrats were to gain four seats, then the Senate would be divided 50/50 between parties, with the vicepresident s party being the tie-breaker for control. At the start of October, however, Cornerstone Macro published a report indicating that investors were beginning to question what would happen if the Republicans lost control of both houses of Congress. A shakeup in the control dynamics could indeed send stocks selling off, at least initially. The big question as it pertains to Congress is whether the Republicans can retain their majority in the Senate or House of Representatives. According to Evercore ISI, there is a small but rising risk of a Democratic sweep of both houses. However, a Democratic clean sweep is not the most probable outcome heading into the last weeks before the election. Some current polling suggests Congressional races favor a split House and Senate which, when combined with either party in the presidency, leads to an outcome that, as we have outlined, is more conducive to the markets' appetite for a balance of power. On the other hand, if the Democrats were to take complete control, one would not expect certain sectors to do well, namely, Energy and Financials, which are outperforming since the first debate in September (Table 3). To Brexit, or Not to Brexit? Some analogies can be drawn between the tone in the United Kingdom preceding the Brexit referendum and that in the United States prior to the presidential election. The most certain conclusion, in our opinion, is that there is no certain conclusion. No polling can predict with absolute certainty the outcome of an election. The day before the vote, the polls for Brexit showed a 76% chance that the outcome would be to stay in the European Union. Some comparison between this and Ms. Clinton s lead in the polls can be drawn. As we noted earlier, the polling processes have been challenged throughout this election cycle. Also, as we think about the comparisons between the Brexit vote and the outcome of the U.S. election, there is one huge difference. The Brexit vote was majority rules, whereas the U.S. presidential election is based on the Electoral College. Looking Beyond As the November 8 election day approaches, we begin to look beyond it to what are some possible scenarios for the economy and the markets following the election. From an economic perspective, the uncertainty of this election and the Table 3 Sectors Selected Industries and the Presidential Election Cycle Democrat Republican Sectors Consumer Discretionary - + Consumer Staples + Energy + + Financials - - Health Care - - Industrials + + Information Technology Materials + Telecomm Services - + Utilities Select Industries Alternative Energy + - Aerospace/Defense + + For-Profit Education - + Housing - Insurance + Master Limited Partnerships - Municipal Bonds + Natural Resources - + Real Estate Investment Trusts + Source: Cornerstone Macro, Strategas Research Partners, PNC 4

Chart 4 Equity Markets Reward Gridlock 1933-2015, Excluding 2001-02 Chart 5 Average Change in Senate Seats Chart 6 Change in GDP 1949-2015 Source: Bloomberg L.P., PNC probable implications in the outcome scenarios could be leading some businesses to hold back on investing. The top takeaway, from Evercore ISI s perspective, is that across the variety of scenarios, fiscal policy for next year could include the Fed raising interest rates at a faster pace than the market currently is predicting. As we stated earlier, markets typically trade higher if the incumbent party is viewed as the likely winner. This makes sense. Markets don t like change, equating it to risk and unknowns. A change in party could also upset the outlook for a Fed rate hike in December, given some amount of uncertainty. A so-called gridlock, where one party has majority control of the Senate and the other has control of the House, is typically rewarded by markets. (Chart 4). Historically speaking this seems to be in line with recent data, which show that the highest rate of turnover of seats in Congress in the past 70 years has been since 2006. Senate seats have been turning over since 2006 at an average of six seats per two-year election cycle, levels not seen since the post-great Depression and post-world War II years (Chart 5). Coinciding data would show that the United States has been experiencing the slowest economic growth period since those same decades following the Depression and the two World Wars. This can also be described as politically volatile (Chart 6). Following any election, regardless of the outcome, there is usually a relief rally. According to Strategas Research, the fourth quarter of the fourth year of a presidential election cycle shows the highest quarterly performance versus any other quarter. What normally follows in the first quarter of a presidential term is often, not surprisingly, market lows as markets try to assess the new political landscape and its impact on Washington. 5

Chart 7 S&P Total Return by Presidential Cycle 1928-2014 Chart 8 Fiscal Policy of New President E=estimate In addition, by looking strictly at performance of the stock market, there is some correlation to the year of the presidential term. The first two years tend to have the lowest absolute performance. The best year for markets tends to be the third year, which is a pre-election year (Chart 7). This also tends to be the year when presidential candidates begin to focus on approval ratings ahead of campaigning. History has shown that bonds tend to perform better in the first half of an election term than the second half. But we have seen this shift with the best being the first quarter, and the worst the third quarter. Conclusion Regardless of which candidate wins the election, the new president of the United States will be faced with some large tasks. From a fiscal perspective, the next president is facing a fiscal drag of 0.5% in 2017 (Chart 8). Congress will be faced with the task of addressing fiscal policy next year, as the new fiscal policy enacted in 2016 largely borrowed against next year; it is not surprising in a fourthyear presidential term that Congress kicked the can down the road. Government spending has been a positive for GDP growth in the past seven quarters, and whether this continues will be an issue for the new government. Tax revenues this year from corporations have been lower, given lower corporate profits. Government spending has increased at the same time. As a result the federal budget deficit has increased by 28%, or $115 billion, in the past five months according to Strategas. Other places the market is hoping the government will contribute to the economy is in infrastructure spending and tax reform. But even if a plan was enacted next year, funds would not enter the economy until 2018, and most estimates show this adding to GDP only modestly. On the tax reform front, we believe most would argue that a solid reformation is much overdue and very necessary. The last effective fiscal policy was probably that of 2003, in our view. In addition, we think a repatriation holiday is seen as possibly in play for a new president, particularly at a time in history when corporations have record amounts of cash on balance sheets. Health care is another mammoth topic under debate. With so many unknowns, we are certain to revisit these topics when we at the very least have clarity as to the makeup of the Oval Office and new Congress of 2017. Our research has shown that economic expansions typically cease from an atypical overheating, or an external shock versus old age. At just over seven years, or 84 months, the current recovery is longer 6

than the average historical recovery but not by much. And if you consider the more recent recoveries, there have been more than a few that have gone on much longer: 1970 at 106 months, 1991 at 92 months, and 2001 at 120 months. It is our conclusion that while there is often a discussion as to where we are in this recovery cycle, we believe the most important thing to note is that expansions do not end naturally. There is typically an event that brings the cycle to an end, for example, tighter monetary policy or some other exogenous shock, such as oil. In the last recession it was the massive leveraging and deleveraging of the housing market as the causal factor; in the prior it was the technology bubble build and bust. The outcome of this election is not likely to be a shock to the system by this definition; however, we do expect the election and its outcome to bring great amounts of uncertainty, which in turn tends to bring market volatility. We will be closely following the election outcomes and the possible implications. We invite you to join us for our post-election Webinar on November 9 toll free at 800-832-0736, international toll at 303-330-0440, room number *3333584#. Bill Stone, CFA, CMT Managing Director, Investment and Portfolio Strategy Chief Investment Strategist Amanda E. Agati, CFA Institutional Investment Strategist and Senior Investment Advisor Chen He, CFA Senior Portfolio Strategist Marsella Martino Senior Investment Strategist Rebekah M. McCahan Investment Strategist Katie S. Sheehan, CFA Fixed Income Strategist Paul J. White, PhD, CAIA Director of Portfolio Strategy Michael Zoller Investment Strategist 7

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