The influence of politics on investing

How did the market react ahead of the US elections in 2016?

Let’s analyse how the market behaved ahead of the US elections in 2016. The consensus was that Hillary Clinton would be the next President of the United States. The large majority of reputable polls gave Clinton a lead over Donald Trump, so the market was relatively calm as Trump was seen as the more ‘unpredictable’ candidate. However, his win was a big surprise, which led to some significant moves, as traders had to price in what his presidency may entail.

UK’s referendum on EU membership

A similar situation occurred in the UK’s referendum on EU membership, where a largely unexpected ‘Leave’ vote caused a severe drop in the British pound and led to speculation that the European Union may disintegrate. Uncertainty and disbelief can lead to more rapid movements in the market.

A change in government often means a change in ideology, which could mean a different approach to monetary or fiscal policy, both of which, especially the latter, can be big drivers for financial markets. The dollar surged after Trump won the election, as the market expected a looser fiscal policy to force the Federal Reserve to raise interest rates. 

What else gets impacted during political instability? 

Taxes

Changes in tax policies, such as income taxes or capital gains taxes, can directly affect investment returns. Higher taxes reduce overall returns for investors, as a larger portion of their earnings goes towards taxes rather than reinvestment or savings. For example, a significant increase in capital gains taxes could lead to a decrease in the value of stocks, as investors may be less likely to hold onto them for long periods to avoid the higher tax burden. 

In this case Labour’s shadow Chancellor, Rachel Reeves, explained how she did not come into politics to raise taxes on working people as she does not believe you can “tax and spend your way to growth”. 

On the other hand, we do not expect the Tories to announce any reforms to income tax but are instead favouring a reduction to National Insurance which was announced in their 2024 Spring Budget. 

Regulations and Policies

New government regulations and policies can positively or negatively affect specific industries or the entire economy. More rigid regulations tend to have a negative impact on stock investments, as they increase costs and reduce profitability for companies. Conversely, deregulation can boost the bottom line of certain industries and make their stocks more attractive to investors. For instance, the Trump administration's deregulation of banks led to increased profitability and higher stock prices for financial institutions.

In this instance, Labour Party leader Rachel Reeves has announced that, if elected, she will eliminate the tax exemption for private schools, which currently avoids Value Added Tax (VAT) and business rates. This policy is expected to generate an additional £1.7 billion annually. The Conservative Party is reportedly against this proposal. 

Interest Rates

The government influences interest rates on loans, which affects the cost of credit for companies. High interest rates make it costlier for companies to obtain credit, which can hurt profitability. This can lead to a decrease in stock prices, as investors may become less optimistic about a company's ability to generate earnings in a high-interest-rate environment.

One of the main policies from the Labour Party's manifesto is that it will implement strict fiscal rules focused on economic stability. The party will introduce a new fiscal lock to restore economic security to family finances by strengthening the powers of the Office of Budget Responsibility. Keir Starmer has vowed to prevent a repeat of the economic turmoil caused by the Conservative government's mini-budget under Liz Truss, which crashed the economy and left working people worse off.

The Tories have pledged to halve inflation to ease the cost of living and give people financial security whilst growing the economy to better-paid jobs and opportunities across the country. 

Michael Saunders, a former external member of the Bank of England's Monetary Policy Committee (MPC) from 2016 to 2022, criticised Prime Minister Rishi Sunak's comments about interest rates as "basically nonsense." He stated that all major political parties have committed to the same 2% inflation target, and the recent drop in inflation is due to global factors and the Bank of England's decision to raise interest rates, not government action. 

Saunders suggested that instead of discussing interest rates, which the government does not control, Sunak should focus on issues the government can influence, such as addressing the UK's worsening economic potential growth rate and proposing serious ideas to improve it.

The current interest rate set by the Bank of England stands at 5.25%, which is the highest level in 16 years. However, it is anticipated that interest rates will start to decline later in the summer.

The Bank of England typically lowers interest rates as inflation falls, which significantly impacts mortgage costs. While political policies that reduce inflation, like keeping fuel duty low, can indirectly influence interest rate decisions, there are also many factors beyond the government's control, such as geopolitical events. 

Economic Outlook

Political decisions and policy changes impact the overall economic environment, which is a key factor in stock market performance. Uncertainty around political decisions can cause markets to trade sideways until the uncertainty is resolved. For example, the 2016 US presidential election led to significant market volatility due to the uncertainty surrounding the outcome and potential policy changes.

Specific Industries

Some political actions can have targeted impacts on specific industries. For instance, the Trump administration's trade policies, such as tariffs on imported goods, can negatively affect companies that rely heavily on international trade. Conversely, policies that support domestic manufacturing, such as tax incentives or subsidies, can boost the competitiveness of companies in these sectors.

A Labour victory could have significant implications for the oil and gas industry. Labour leader Sir Keir Starmer has pledged to set up a publicly-owned clean power company, Great British Energy, to "cut bills for good and boost energy security." This initiative will be funded through a windfall tax on oil and gas companies, which could potentially increase from 35% to 38%. In contrast, the Conservative Party, has historically been more supportive of the oil and gas industries and has emphasised the importance of using the UK's fossil fuel resources to ensure energy security. A Labour victory could be detrimental to the oil and gas sector, while potentially benefiting the renewable energy sector and utilities companies with the necessary infrastructure to support the transition.

During the first election debate, the high cost of buying a home was a significant topic. Sir Keir Starmer emphasised his plans to increase housebuilding, which could positively impact the housing sector. Market analysts believe that under a Labour government, housebuilders and related industries such as brickmaking and builders' merchants could benefit. This is because Labour intends to reintroduce mandatory targets for local areas, which would likely increase demand for building products. Additionally, the cyclical nature of housebuilding and stabilising interest rates could also contribute to the sector's growth.

The Tories have been relatively quiet about their housing plans if they win another term, but there are some indications of their potential direction:

• In late 2023, the government announced leasehold reform measures as part of the King's Speech. These reforms aim to address issues in the leasehold system, making it easier for leaseholders to buy a freehold property and reducing the ground rent they have to pay.
• The future of the Renter's Reform Bill, designed to end controversial Section 21 "no-fault" evictions, has been called into question after the election announcement delayed its passing. The bill has also been subject to a series of amendments, which campaigners believe have watered down its effectiveness.

Conclusion

While politics can influence investing, it is essential to remember that business fundamentals and profitability are stronger long-term drivers of stock performance. Diversification and staying focused on your financial goals are key to weathering political uncertainty. By understanding the potential impacts of political decisions on your investments, you can make more informed decisions and achieve your long-term financial objectives.

Generally speaking, many believe that the more a government spends, the more the economy might grow, which could lead to a rise in inflation. In such a situation, the country’s central bank might decide to act by raising interest rates, which could support the currency. Additionally, many believe that political parties or individuals who are seen as more fiscally responsible or more concerned with promoting economic growth could boost both the stock market and the currency. So in the case where a government that is seen as economy-friendly is in danger of losing its position of power, traders may react nervously and may sell the currency or stocks.