Gridlock’s Gone, Now What?

This article examines the relationship between security returns and “political gridlock,” which occurs when the U.S. House of Representatives, Senate, and presidency are not controlled by the same political party. The findings support the following conclusions: First, the common view that equities prosper during political gridlock is a myth. Second, fixed-income securities do prosper during gridlock. Third, large companies exhibit higher returns than small companies during gridlock. Finally, the relationship between gridlock and security returns is independent of monetary conditions; this finding supports the existence of a unique “gridlock effect. ” Overall, political conditions are relevant for investors, but previous views about their influence are misguided. With the 2006 elections approaching and the possibility of a change in control of the U.S. Congress, the effect on the markets of “political gridlock”—when the party controlling Congress differs from the party of the U.S. president—is on investors’ minds. The press, political analysts, and financial analysts consistently contend that gridlock is good for the equity markets. The rationale for this theory is that equity investors prefer gridlock because it reduces the chances for significant legislative changes. To date, however, this topic has come under little academic scrutiny. In the study reported, we evaluated returns from 1949 through 2004 for 10 equity indices, 4 fixed-income indices, and an inflation index. Two broad types of statistical analysis were applied: First, we focused exclusively on political conditions by examining security performance during periods of political gridlock versus periods of political “harmony” (the same party controlling Congress and the presidency). Second, we estimated regressions with monthly return as the dependent variable and two independent dummy variables representing (1) political harmony versus gridlock and (2) expansive versus restrictive monetary conditions. Contrary to the popular contention, our results show that political gridlock is associated with lower equity returns than the returns associated with political harmony. Furthermore, the superior performance during periods of political harmony was especially prominent for small companies. No small-company premium is available during gridlock periods; we found that, on average, large companies’ returns exceeded the returns of small companies by 3.22 percentage points during gridlock in the sample period. In contrast, the performance difference between small and large companies is immense during periods of political harmony, with small companies returning 27.03 percent versus 8.78 percent for large companies. This evidence indicates that the well-documented small-company premium has prevailed primarily during periods of political harmony. In contrast to equity returns, we found bond returns to be significantly higher during periods of political gridlock. We observed return differences (of “gridlock” returns minus “harmony” returns) of 7.17 percentage points for long-term government bonds and 6.28 percentage points for corporate bonds. This finding suggests that the return difference can be attributed primarily to changes in the general level of interest rates rather than changes in credit spreads. Given the potential interaction between political conditions and monetary conditions, we reexamined the relationship between gridlock and security returns while controlling for changes in monetary conditions. Our regression results confirm that political harmony is associated with superior performance for small-company equities but political gridlock is associated with stellar performance of fixed-income securities. This article makes several key contributions. First, we present evidence indicating that the “gridlock is good” tenet is a myth for equities; equity returns actually tend to be lower during periods of political gridlock. Second, we show that the small-company premium has existed only during periods of political harmony. Third, we show that fixed-income returns are significantly higher during periods of gridlock. Finally, we note that even after control for monetary conditions, equities performed poorly during periods of gridlock whereas fixed-income securities prospered. Overall, our evidence suggests that political conditions are an important consideration for both equity and fixed-income investors. Thus, our findings support the considerable attention that financial market participants and the media pay to political conditions. Editor’s Note: This article was submitted for publication prior to the decision in January 2006 that the FAJ would no longer publish articles written by CFA Institute staff.