If the stock market could speak to our politicians, it would probably tell them to keep agreeing to disagree! There is an old Wall Street adage that “gridlock in D.C. is good” for stocks. In response, the Philadelphia Federal Reserve Bank has quantified partisan conflict, with results that confirm the folklore. The Philly Fed Partisan Conflict Index tracks the degree of political disagreement among U.S. politicians at the federal level by measuring the frequency of newspaper articles reporting disagreement monthly. Higher index levels indicate greater conflict among political parties, Congress and the President. To construct the index, researchers perform keyword searches of major U.S. news outlets including The Washington Post, The New York Times, Los Angeles Times, Chicago Tribune and The Wall Street Journal.
Over the past 36 years, stocks have risen at a faster rate when the index value has been high. This interaction between the Partisan Conflict Index and the stock market may seem counterintuitive, but it tracks other gauges of economic and political uncertainty – i.e. the stock market climbs a wall of worry. When the Partisan Conflict Index has been above 100, the S&P 500® Index has risen at a 12% annual rate versus a 6% annualized return when the index has been below 100 (going back to 1984). We see two possible explanations for this high-anxiety, high-performance correlation. First, a high degree of partisanship prevents the government from passing major legislation that could be counterproductive for the economy. Markets tend to function better when the government gets out of the way and lets the laws of supply and demand dictate winners and losers. Second, the Partisan Conflict Index acts like a sentiment index. High levels of uncertainty create pessimism, which allows stock markets to rally when the fears prove to be unfounded.
From an economic perspective, political polarization tends to imply a slower pace of economic growth. The slower growth could be due to the uncertainty it creates with respect to the timing and type of government policy. Capital expenditures slow during elevated levels of partisan conflict and accelerate when the index is low. Our analysts see this relationship playing out today with subdued investment in property, plant and equipment by major corporations. At this stage of the economic cycle, we would normally expect faster capital expenditure compared to the current sluggish pace.
As the Partisan Conflict Index is hitting record levels, it appears the politicians are listening to the stock market. With little hope for bipartisanship, this gauge would indicate that we should expect economic growth to remain low—close to its post-recession trend, and stocks could continue to grind higher.