Swedroe: Politics, Policy Affect Returns

November 26, 2018

Politics and economic policy impact stock returns as they influence expected cash flows. In addition, the uncertainty about the impact of both politics and policy can affect the rate at which future cash flows are discounted. Vito Gala, Giovanni Pagliardi and Stavros Zenios contribute to the literature on their impact with their August 2018 study “Politics, Policy, and International Stock Returns.”

World Economic Survey Data

The authors identify the impact of politics and policy on asset prices by comparing the stock market performance of countries with ex-ante different politics and policy ratings. To measure and disentangle politics and policy, they use the database of experts’ surveys—Ifo World Economic Survey (WES) conducted by the Ifo Institute Center for Economic Studies. They used experts’ surveys on government stability as the politics variable, and confidence on government economic policy as the policy variable. Their database consisted of 22 developed markets and 20 emerging markets during the period January 1992 to December 2016.

The WES surveys national experts in economics (54%), business (19%) and natural sciences (10%), with the remaining 17% from professional and applied sciences, other social sciences, law or humanities. The panelists are in leading positions or engaged in economic research, and over 40% have a Ph.D.

Following is a summary of their findings:

  • Ranking by political stability is not indicative of ranking by economic policy.
  • The most stable developed countries were Scandinavia, Switzerland and the U.S., whereas low scores were associated with Spain, Greece and Belgium. For emerging markets, low stability is associated with Israel, Turkey and Egypt, whereas Chile is among the most stable.
  • Improvements in politics and policy lead to positive stock market returns for developed markets, but negative returns for emerging markets.
  • In developed markets, countries with high political stability (economic policy) outperform countries with low political stability (economic policy) by a statistically significant 4.2% (4.8%) per annum.
  • Political stability and confidence in economic policy predict positive future economic growth in developed and emerging economies—suggesting a direct economic link among politics, policy and returns through expected cash-flow effects.
  • Developing countries with both high political stability and economic policy outperform countries with low political stability and economic policy by about 5.9% per annum. For emerging markets, the pattern in average returns is reversed. Specifically, countries with high political stability (economic policy) underperform countries with low political stability (economic policy) by about 10.5% per annum. Countries with both high political stability and economic policy underperform countries with low political stability and economic policy by about 13.9% per annum.
  • Exploiting the politics and/or policy predictability in cross-countries’ returns shows that these strategies yield abnormal returns as large as 8.8% per annum for developed markets, and 25.5% per annum for emerging markets. These findings are robust to different specifications of asset pricing models (exposure to factors that explain returns).
  • While developed countries with high political stability and confidence in economic policy have high future economic growth and stock market returns, emerging countries with high political stability and confidence in economic policy have high future economic growth but low stock market returns.
  • A developed economy improving its economic policies will have an average increase in future annualized stock market returns of 2.5%. Similarly, if a developed country improves its political stability up to the next quartile, its future annualized stock market returns will increase on average by 3.5%. The economic significance is even larger for emerging markets. Future stock market returns for an emerging economy deteriorate on average by 5.5% per annum following an improvement in its economic policy ratings. Similarly, an improvement in political stability for an emerging economy yields on average a decrease of 6.0% per annum in future stock market returns.

The authors concluded: “These empirical findings suggest that politics and policy have first-order impacts on stock market returns, and that such impacts are substantially different for developed and emerging markets. Average returns are positively related to both political stability and economic policy for developed markets, but they are negatively related for emerging markets.”

They add: “These results suggest that most of the differences in returns across politics, policy and politics-policy portfolios are due to abnormal returns rather than risk premia. Consistently with the large mispricings across all international asset pricing models, financial markets seem to under-react to the predictable effects of political stability and economic policies.”

Risk Premia Or Abnormal Returns?

Developed-market countries with high political stability (economic policy) outperforming countries with low political stability (economic policy) is inconsistent with a risk-based explanation, as more stable countries are less risky and thus should have lower (not higher) returns.

Thus, it appears the markets are mispricing assets. This might be another example of investor preferences for “lottery tickets”—investments with a high likelihood of underperforming but with the possibility of lotterylike winnings—or it could be mispricing, or another unidentified risk factor.

However, emerging market outcomes are entirely consistent with a risk-based explanation—countries with high political stability (economic policy) underperform countries with low political stability (economic policy) by about 10.5% per annum. And countries with both high political stability and economic policy underperform countries with low political stability and economic policy by about 13.9% per annum. Greater uncertainty leads to higher discount rates applied to expected cash flows and thus higher expected returns. Given that limits to arbitrage are greater in emerging markets, we would expect that, if there were an anomaly, it would be in the emerging markets, not the developed ones.

There’s one other interesting point. Despite the large differences in returns from the long-short portfolios and the wide availability of the data, there’s no evidence that actively managed funds have been able to exploit the information available. That’s certainly true in the supposedly inefficient asset class of emerging markets, as I discussed last month. The latest SPIVA results show the same thing in both developed and emerging markets.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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