This paper investigates the impact of political cycles through the government spending channel on the cross section of U.S. stock returns. According to a partisan view of political cycles as in Alesina (1987), Republicans and Democrats differ in policies related to taxes, government spending and social benefits. We focus on government spending, which represents on average about 20% of annual U.S. gross domestic product. Most financial economists would agree that government spending has an impact on expected firm cash flows. In addition, the uncertainty about the impact of government policies may affect the rate at which future cash flows are discounted. We investigate empirically the importance of these channels.
To identify the impact of presidential partisan cycles on asset prices through the government spending channel, we compare the stock market performance of firms in industries with ex-ante different exposure to government spending and investigate their relative performance over presidential partisan cycles.
If government spending has a significant impact on asset prices, it can be identified by the differential performance of firms with heterogeneous government exposure, ceteris paribus. Furthermore, if the presidential partisan cycle affects stock returns through the government spending channel, it should be reflected in the differential performance of these firms across the presidential cycle.
We construct a novel measure of industry exposure to government spending using detailed industry level data from the NIPA input-output accounts. This measure is defined as the proportion of each industry’s total output that is purchased directly by the government sector, as well as indirectly through the chain of economic links across industries. We then investigate the link between stock returns, fundamentals and government spending over the presidential partisan cycle.
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Government Spending, Political Cycles and the Cross-Section of Stock Returns
