Politics and stocks, an uneasy relationship

Global stock markets have had one key driver over the last 7-months: politics. The election of Donald Trump last November led to one of the quickest thousand point rallies in a US stock index for 80 years. The political effect has spread to Europe, with the election of Emmanuel Macron in France and Mark Rutte in Holland helping European stocks to play catch up. But, are we seeing the downside of political drivers, and could risk assets be in for a rough time in the future?

Price action on Wednesday has been decidedly risk off in tone as political scandals continue to engulf Donald Trump’s Presidency. The US indices are down some 1% so far as the market wonders how Congress will react to reports that the President tried to pressure the head of the FBI to drop an investigation into his National Security Advisor, as well as passing official secrets to the Russian Foreign Minister. The current situation is reminding some of the Watergate scandal that brought down the Nixon Presidency, and investors are in cautious mode.

But what does this incident tell us about how markets react when politics becomes a key driver of risky assets? Below we take a look at the key points worth considering if you are trading financial markets in this political climate.

Volatility: before this scandal broke, the Vix index was at its lowest ever level. On Wednesday it jumped by the most in a month, highlighting the level of nervousness felt by the market to events in Washington. When politics turn juicy, financial markets are not immune, and the Vix may have made a bottom, at least in the short term, which could limit upside for stock prices.

All that glitters is gold: Stocks have sold off heavily on Wednesday, while safe havens have surged. The gold price has jumped more than $20 so far today, and the spot gold price is now above its 200-day moving average, a key resistance level. When the political situation turns sour this is gold’s chance to shine. If we do see tensions in Capitol Hill escalate further then we would expect gold to march higher, and a move back towards $1,300, the high from mid-April, could be on the cards.

Economic policy: the rally that started in November was partly driven by Trump’s promises on economic legislation including health care reform, infrastructure spending and tax changes. The Trump scandal could delay economic legislation being put into action, and this is a big concern for traders right now. If Trump doesn’t deliver on his economic promises then the rally since November will lose one of its major pillars, which could lead to some unwinding of the risk trade, and further downside for US stocks, in particular tech stocks and financial stocks that were driven higher by expectations of Trump’s economic policies regarding financial regulation and proposed changes to the tax code.

Impeachment: some people are throwing around the possibility of a President Trump impeachment. If this were to happen then we would expect a hefty sell off, at least initially, in US and global stocks along with the dollar, while we would expect safe havens like US Treasuries, gold and the yen to rally. However, two things to consider include: 1, we are a long way off impeachment. The Republicans control both the House of Representatives and the Senate; they need to agree to an impeachment of President Trump, which they may not do to one of their own party. 2, Even if President Trump were impeached, it would actually remove the biggest political risk from office. We would assume that Veep Mike Pence would take over as POTUS, he is considered a more reliable pair of hands, which could restore calm to financial markets relatively quickly if an impeachment was to occur.

A word on safe havens: Last month we noticed that the Swiss franc had been outperforming the Japanese yen, which may have suggested that the Swissie had become the world’s safe haven currency of choice. However, as volatility has spiked on Wednesday, the yen has outperformed the Swissie, suggesting that when risk appetite really turns sour, investors still switch to the yen, as you can see in chart 2. If we continue to see events in Washington turn against President Trump then we could see USDJPY, which fell below its 50-day sma on Wednesday, head back towards 110.00.

Overall, events in Capitol Hill this week highlight the tricky relationship between politics and financial markets. When politics turn sour Washington does not offer financial markets a lifeline, which can lead to a spike in volatility and a sell off in risky asset prices. If the Trump scandal continues to unfold, then it could be good news for the yen and gold, but bad news for investors looking for higher stock prices.
 

Figure 1:

Source: City Index and Bloomberg