Gaming out market reactions to the US midterm elections
Split control in Washington usually keeps the status quo intact, and reduces the volatility brought by political uncertainty
Election Day
It's the day Americans (and people in much of the rest of the world) have been waiting for. The US midterm elections wrap up today. At this late stage there's little point in speculating on the outcome. It's possible that we might have a cliffhanger that drags on for days or months before it's clear who has control of the House of Representatives and the Senate. That said, if the result is the widely anticipated "red wave" victory for the Republicans, Americans should know the outcome before going to bed on Tuesday. There is no telling when we'll get the final results, but hopefully investors will get a fairly accurate picture on who their leaders will be by the end of Tuesday as they try to make sense of their portfolios.
The early polls showed Republicans leading by a strong margin in both chambers of Congress. That narrowed during the summer, as President Joe Biden's approval ratings recovered. But the poll of polls produced by RealClearPolitics suggests that Biden's recovery stalled about six weeks ago. This is how they've moved this year:
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Polls Suggest Biden's Recovery Will Fall Short
Biden's approval rate has plateau-ed, while voters are opting for Republicans
How does this translate into probabilities for the final outcome? The PredictIt.com betting site is as good a measure as any. Following the polls, the bettors shifted their view during the summer, and for a while thought that a Democratic victory in the Senate election was in the cards. Now, anything but clear Republican victory in the House would be a major surprise, while the Senate is thought to more likely go to the GOP:
Bettors Think Republicans Have Survived a Difficult Summer
Predictit odds suggest the House is safe for the GOP; less so the Senate
What are the stakes for voters? Whatever happens, a Democrat in the White House will hold the power of veto for another two years, so full-scale passing of a Republican agenda if that party gains control of Congress isn't going to happen. On the other hand, the US would see a split government that will hinder Democratic Biden's agenda, and thwart smooth passage for any ambitious policies. In other words, gridlock will ensue, which may or may not be bad depending on which party you support. Split control in Washington usually keeps the status quo intact, and reduces the volatility brought by political uncertainty. However, a Republican-controlled Congress has traditionally prompted equities and risk assets to rally more as Points of Return discussed here.
Past Cycles
Regardless of the outcome, midterm cycles have been a boom for US equities in general. This is what typically happens during midterm years, as seen in a chart produced by Strategas Research Partners. Note that this year's performance is on a different scale, because it has effectively been an exaggerated version of the usual midterm cycle:
Resolution of uncertainty should then be great for stocks, and many strategists have been showing off charts like this one as a reason for bullishness. It needs to be tempered by one problem, which is that counting of ballots takes place more slowly now, and is likely to be marked this year by increasing political clashes over the vote-tabulating process itself. If the election proves closer than currently appears likely, then Pennsylvania — which could be crucial to the outcome in the Senate — might keep us waiting a week. And if neither candidate wins 50% in Georgia, that state's Senate race could go to a run-off in January. If, as was the case two years ago, a Democratic victory in Georgia would be enough to give them effective Senate control, then we might have to wait a couple of months longer than usual for the rally that comes with the resolution of uncertainty.
Inflation
At a top-down level, what matters most is the effect on inflation and macroeconomic policy. If Democrats win, they have full control and will likely push the remaining parts of their spending agenda, a move markets will likely view as inflationary (although it might be good for the stocks of any beneficiaries of government largesse). As the House currently looks close to certain to move to the Republicans, any surprise here could have a big effect. If Republicans win the House, Senate, or both, gridlock will likely limit significant increases in federal spending, a less inflationary outcome for markets.
This is the point of Morgan Stanley strategist Mike Wilson who appeared on Bloomberg TV Monday:
The midterms could have lasting implications if it's a decisive victory for the Republicans because as I have said before we think that majority of the inflation spike was a result of the excessive fiscal spending and that of course will be curtailed even if the Republicans just win one chamber ... Ultimately this should be good for bonds.
Research over the years has shown that bond markets like mixed government. It tends to mean that excessive borrowing cannot happen, which suits bond investors. In a less clear way, the same is true for stocks, according to LPL Financial's Barry Gilbert and Jeffrey Buchbinder. Data going back to 1951 reveal that a Democratic president with a Republican or split congress (the likely outcome as of now) posted an average S&P 500 return of over 17%, versus an overall average of just over 12%. A split congress and a Republican president saw returns just as strong.
Going Through the Ceiling
There is one wild card in all of this, and that is how exactly a Republican majority would behave. One of the few post-midterm years in which stocks suffered came in 2011, after the "Tea Party" wave swept the GOP into control of both the House and Senate. That was followed by brinkmanship over whether to raise the federal debt limit, which effectively meant threatening to force the US to default on some of its Treasury debt. Standard & Poor's famously stripped the US of its AAA credit rating over the issue, and the market sold off sharply before staging a dramatic rebound once the standoff had been resolved and the debt ceiling raised in August 2011.
After the 2010 Midterms, Gridlock Wasn't Good...
Brinkmanship over the federal debt ceiling drove a tumultuous year
Perversely, note that Treasuries actually gained once they were downgraded, as international investors still saw them as the best haven in a time of crisis. But overall, it was one of the weirdest and most dangerous years in market history, and nobody wants to see a repeat. Even more importantly, nobody wants to find out what happens if Congress were really to go through with forcing a sovereign default, but it certainly wouldn't be pleasant. Former President Donald Trump has said that Mitch McConnell, the Republican leader of the Senate, should be impeached if he refuses to go along with a standoff over the debt ceiling, so the issue won't go away easily. For Ian Lyngen of BMO Capital Markets, his main concern is what happens after the elections:
The wildcard is the extent to which the midterm results indirectly endorse Trump's potential candidacy in 2024 – a reality that could ultimately trigger a more sizeable response in risk assets.
As Bipan Rai of Canadian Imperial Bank of Commerce wrote:
The real drama will be next Spring/Summer when debt ceiling concerns flare up again, and extraordinary measures are expected to run out.
Gridlock normally means inactivity. In 2011, it meant anything but. That episode didn't work out well for Republicans, as the Democratic president Barack Obama was re-elected the following year. Would they really be so reckless as to try it again, only this time with high inflation and falling bond markets?
Who Cares? It's All About the Fed
One of Wilson's key points is that the spike in inflation has been driven primarily by excessive spending, both in 2020 and 2021. That is, of course, contentious. Others argue that this inflation is a monetary phenomenon driven by the massive increase in the money supply to deal with the pandemic. On this view, it was the Fed who got us into the mess, and it's now up to the Fed to get us out of it.
If anything, Christopher Smart of the Barings Investment Institute does not think this midterm cycle is consequential at all because in the end it all boils down to the Fed:
Frankly, it's hard to imagine much new direction on economic policy even when the presidential 2024 vote rolls around given how divided the electorate remains... Ultimate political power may remain in the hands of voters, but for the next few years the course of the economy is almost entirely in the hands of the Fed and its blunt tools to tame inflation and support employment.
This was also the conclusion of an influential study called What to Expect When You're Electing, published in 2012, which showed
Security returns are significantly related to shifts in Fed monetary policy, political gridlock and the year of the presidential term; however, returns are generally invariant to the president's political party affiliation. Overall, our findings suggest that investors should focus less attention on the party of the president and instead more closely monitor Fed actions. Furthermore, it appears that political harmony should be welcomed by equity investors, but not debt investors.
In an increasingly embittered nation, it's unlikely that anyone is going to be very enthusiastic about the results. But provided Republicans don't overplay their hand again, a Republican sweep will help bonds a little at the margin, and therefore also help stocks, while the Fed's governors, who will remain in their posts until after the next presidential election, remain far more important.
Picking Winning Stocks
Even amid all the debates over top-down macro outcomes, the precise election results could have a profound impact on individual stocks. Looking at possible outcomes, Dan Clifton of Strategas offered two stock portfolios, one for a Republican sweep and one for a Democratic sweep. One of the few common themes the two portfolios have is inflation. Beyond that, sectors as varied as defense, energy and cannabis stand to be affected. Take a look at the following table, which summarizes Clifton's suggested portfolios, to get a clearer idea of the differences.
Strategas' 2022 Stock Porfolios
Republicans are poised to win US midterm elections
A Republican portfolio favors defense stocks as the war in Ukraine rages, police and immigration enforcement as making the border more secure would likely rise as a priority, and the companies that would benefit the most from the cancelation of corporate tax increases, which would likely remain off the table until the next elections in 2024. The Democratic portfolio, meanwhile, comprises clean energy stocks, companies that would be unscathed by Democratic proposals for a "share buyback tax," and beneficiaries of state budgets.
Defense is one sector that has benefited greatly from the Ukrainian conflict:
It's An Ill Wind from Ukraine....
Defense stocks have prospered mightily since Putin's invasion
Republicans are traditionally much more enthusiastic about defense spending than Democrats, so it should be a good bet for this to continue. But as an increasingly vocal faction within the Republican party opposes any more escalation in Ukraine, that maybe should not be taken as a given. Might the election result lead the US to put pressure on Ukraine to negotiate for a peace settlement? It's just possible. That might well be good for the global economy, but it would likely be very unpleasant for defense stocks.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of "The Fearful Rise of Markets." @johnauthers
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.
