Opinion

James Saft

Gridlock holds perils for stocks

October 2, 2013

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) – Don’t kid yourself: if you hold equities you ought not to welcome political gridlock.

If you hold stocks, history shows you’ll do worse. If you are strictly a bond investor, or fear inflation above all else, perhaps you’ll be happier with finger pointing and inactivity in Washington.

Markets have been mildly spooked by the government shutdown and budget impasse, though not nearly as much as they would be if they came to believe that a debt default was on tap for later this month.

It is impossible to predict how long the shutdown will last, or whether the debt ceiling will be lifted and default averted, but what we can be sure of is that we will be living with gridlock, defined here as a time when the House, Senate and White House are not under unified party control, for at least the next year.

And, given the hardening of views on both sides, and an electoral reality which leaves incumbents feeling more vulnerable to attacks from their own party rather than from the center, we can expect a particularly locked-down political grid.

You can think what you like about this politically, but on the evidence it will not be a good thing for stock market investors, especially those who invest in the smaller companies which are the principal generators of job growth.

Between 1965 and 2008 there have been 354 months of gridlock and 174 months of harmony, or one-party control of the executive and legislative branches. During that time large-cap stocks have performed just a smidge better during periods of harmony, returning 10.33 percent annually against 10.12 percent. In small caps, however, there has been a huge disparity, with returns of nearly 30 percent annually under periods of political harmony and just 8.67 percent during gridlock, according to a paper slated to be published in Managerial Finance, an academic journal.

Interestingly, the paper, by Scott Beyer of the University of Wisconsin Oshkosh, Luis Garcia-Feijoo of Florida Atlantic University, Gerald Jensen of Northern Illinois University and Robert Johnson of Creighton University, found that bonds, specifically corporate bonds and T-bills, do better under gridlock. Corporate bonds return almost 11 percent under gridlock, as against 2.38 percent during political harmony, while T-bills show 6.18 percent annual returns under gridlock and 4.87 percent under harmony.

Inflation too is lower during periods of gridlock, with just 4.17 percent then compared to 5.01 percent the rest of the time.

WHO BENEFITS?

The idea that gridlock might be good for investors is often bruited about the market, and usually on some kind of theory that the less ability the SOBs have to do anything the less they will be able to harm us.

I suppose if you are massively rich and only concerned with not seeing your purchasing power eroded by inflation, that might well be true. If you are a typical investor trying to make a portfolio grow for future use, you might opt for harmony, or single-party domination, if you prefer.

Presuming a portfolio with 60/40 equity to debt portfolio, with 50 percent in large caps, 10 percent in small caps, 30 percent in T-bills and 10 percent in corporate bonds, you would considerably outperform based on the numbers in the study, principally because of the huge small-cap returns.

Why exactly that would be is unclear, but we can hazard some guesses. Periods of political gridlock tend to be periods of uncertainty, which in turn sometimes leads to changes in the pace of government spending but always to households and businesses having less confidence in the outlook.

Smaller companies are both more levered to growth and less able to withstand temporary slowdowns than their larger peers. There is also the possibility that smaller companies are more likely to be the beneficiaries of government support for research, be they defense technology companies or biotech firms.

“The findings are consistent with the view that the increased incidence of legislative action during periods of political harmony is advantageous to equities – particularly small-cap stocks,” Robert Johnson said via email.

“Bond markets may prosper during gridlock because the lack of legislative action dampens government spending, inflation, and deficits. According to this view, bonds thrive because interest rates are constrained by the reduced demand for funds by the government (less competition for funds) and because concern about future inflationary pressures is less during gridlock.”

Considering that we have a government shutdown, the risk of a very damaging default, and at least a year of gridlock in Washington, now might not be the time to expect to bank big returns.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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