A Divided Government Could Spell Trouble for the Markets

New research shows that when the same party controls Congress and the presidency, the stock market significantly outperforms.

Illustration by II

Illustration by II

Following an already gloomy year in the stock market, investors are staring down a recession — and a change in the party that controls the U.S. government could exacerbate it.

New research from the University of Oxford, published in late November, shows that the U.S. stock market tends to perform better when the country’s government is unified — that is, when the same party controls both Congress and the presidency.

As new leaders prepare to take their oaths in January, Republicans are set to gain control of the House of Representatives, while Democrats will remain in the majority in the Senate.

The research doesn’t bode well for the market under these conditions. Between 1927 and 2017, annual excess stock market returns averaged 10.7 percent under unified governments but only 0.8 percent when the government was divided.

For a value-weighted portfolio, the difference between a unified government and a divided one is 9.95 percent over a period of 91 years. In an equal-weighted portfolio, it’s even higher, with a difference of 18.73 percent.

The researchers — Mungo Ivor Wilson and Theofanis Papamichalis, both scholars at the University of Oxford — used data from the Center for Research in Security Prices on monthly stock returns between January 1927 and December 2017. They constructed logarithms of the returns of value-weighted and equal-weighted portfolios over that period, then subtracted the value of the three-month Treasury bill to find excess returns.

The data, in the end, included 1,092 monthly observations, 24 elections, 12 Democratic and Republican presidencies, and 23 unified and 24 divided governments.

Wilson and Papamichalis wanted to build on past research on U.S. stock returns during Democratic and Republican presidencies, studies that have been collectively referred to as the “Presidential Puzzle.” That research initially found that under Democratic presidents, U.S. stock market excess returns are on average “far higher” than under presidents from the Republican party.

And their research does indeed build on that information. The two men found that it doesn’t statistically matter whether a Democrat or a Republican president is leading a divided government — it just matters that it’s divided. Under a Republican presidency, the average annual excess return of a value-weighted portfolio was 9.81 percent. Under a Democrat? It was 9.86 percent.

The researchers also showed that unified governments tend to have higher average growth rates — 4.75 percent under unified governments, as opposed to 2.09 percent when the government is divided. Although outside research has previously shown that Democrat-controlled governments are associated with higher GDP growth, the researchers say that their findings show that unified governments are a better predictor of higher growth.

“One might think that a very plausible explanation for the differences in excess returns would be compensation for risk,” the paper said. “We show that this is not the case.” In fact, they found that risk and volatility are lower when the government is unified than when it’s divided.

It remains to be seen whether these findings will hold true in the latest iteration of the U.S. government, although many investors are already predicting a recession in 2023. If nothing else, governmental division could end up being just one more factor on which poor market performance can be blamed.