Making money on the election trade is harder than ever

Investors in India and Mexico, and to an extent Monday in France and the U.S., have seen big swings as a result of such bets—and some big losses when they went wrong.

This week first. French assets party recovered on Monday from their steep election-campaign selloff thanks to hopes that, while the far-right National Rally will win the most seats in Sunday’s second-round vote, a (shaky) tactical agreement by other parties will prevent it from having a majority in Parliament.

The spread of French 10-year bond yields over Germany’s—a gauge of French sovereign risk that had risen sharply after the election was called three weeks ago—dropped by the most in a day since 2022. Hard-hit bank stocks rallied.

In the U.S., the bet was the other way around. Investors became even more convinced that Donald Trump would win not just the presidency but also Congress following last week’s dismal debate performance by President Biden.

With a clean sweep, Trump would have few constraints on his agenda—which markets take to mean even bigger deficits and higher interest rates. The 10-year Treasury yield jumped 0.2 percentage point from Friday’s low to Monday’s high, before pulling back a bit. The move might have been bigger still if it hadn’t been for some disappointing manufacturing data indicating possible economic weakness.

The moves after the Indian and Mexican elections were even larger. The emerging markets showed the power of elections to shock, even when the expected winner does win.

In India, exit polls pointed to a Narendra Modi landslide, but when it turned out he needed to form a coalition to govern, stocks plunged almost 6%, the biggest one-day fall since the onset of the pandemic in 2020.

In Mexico, the exact opposite result led to a similar market response. Claudia Sheinbaum won the presidency with a surprise landslide, and stocks plunged 6%, also the most since 2020. The peso tanked too.

All these results are easy for politically savvy investors to explain. A clear win by Marine Le Pen’s party in France or by Donald Trump in the U.S. will, they think, mean more unproductive giveaways by a government that already has huge debts. Higher bond yields will follow.

A landslide by Modi in India would have given him a mandate for land and other reforms that investors like, as well as productivity-boosting infrastructure spending. In anticipation, stock prices had already risen, so they fell sharply on the result.

In Mexico voters gave Sheinbaum, a former Mexico City mayor, an overwhelming majority, meaning she will be able to push through constitutional changes she promised. Investors took fright, fearing more welfare handouts will hurt growth and the economy. Both stocks and the currency were hit.

So far investors don’t care about the election in the U.K., where the first-past-the-post voting system has left one big uncertainty. Will the Labour leader, Keir Starmer, have merely a decent majority, or an enormous one? Voting is on Thursday, and markets seem confident that even if he wins a crushing majority, he won’t go on a spending spree—despite a campaign by the governing Conservative party focused on warning of the dangers of a “supermajority” for Labour.

The obvious lesson ought to have been learned long ago: Trades based on election results are a gamble on unreliable polls.

The less-obvious lesson is that such trades aren’t investments, and the two need to be distinguished. After Modi formed a coalition in India, stock prices recovered, and the benchmark Sensex index closed at a new high on Monday. The same goes for the U.S. the last time Trump governed: Stock futures overnight were limit-down, off 5%, after his 2016 win, but hit record highs later that month.

Sometimes the knee-jerk reaction is correct. After the U.K.’s vote to leave the European Union in June 2016, the pound crashed from a high of $1.50 to $1.28 within two weeks. It has never again reached $1.50 and currently stands at $1.26.

Mexico has only had a month to consider, but so far the peso has sold off even more and stocks remain well below their pre-election levels. Investors need to pay attention to the bets on Trump vs. Biden, on France and perhaps even on Britain.

What they should expect in a year of political uncertainty: Surprises and big market swings. The skill comes not only in correctly anticipating when the polls are wrong, but in identifying when the market has overreacted to the result, too.

Write to James Mackintosh at james.mackintosh@wsj.com