Investors may be underestimating the risk stocks face from the midterm elections

A divided government could raise the prospect of impeachment, more government shutdowns.

  • By Ryan Vlastelica,
  • MarketWatch
  • Market Analysis
  • Market Volatility
  • Market Analysis
  • Market Volatility
  • Market Analysis
  • Market Volatility
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Political issues have been among the biggest drivers of trading in the U.S. stock market in 2018, as investors grapple with the uncertainty of trade policy and the economic effect of the tax bill passed late last year. However, another D.C.-related issue may not be getting the attention it deserves on Wall Street.

The U.S. is fewer than 80 days until the midterm elections, an event that could represent a turning point for both the government and the market should the Democratic Party regain a majority in the House of Representatives, the Senate, or both. Current polls indicate strong odds of the former, though flipping the Senate is seen as a longer shot.

Nevertheless, a divided government could be a risk to markets if it results in an increase in political instability and uncertainty. Analysts at Société Générale said that a change in the ruling party of either house "could have serious market and economic consequences, such as potentially more frequent government shutdowns, impeachment considerations and general uncertainty."

Historically speaking, such issues tend to have limited direct impact on economic conditions. The stock market, for example, generally shrugs off government shutdowns, and the unrest that could arise from the prospect of impeachment proceedings against President Donald Trump becoming more likely wouldn't translate to changes in demand or corporate profits. Nevertheless, a more uncertain political environment could amplify volatility if it clouds the outlook for trade policy and other legislative issues.

"We do not foresee material changes to our economic calls, but there are important issues to consider," wrote Stephen Gallagher, a managing director and head of Americas research at the investment bank. "All this uncertainty could affect decision making. For an aged business expansion, uncertainty might be more damaging."

SocGen wrote that changes in legislative leadership wouldn't make a difference for the two biggest policy-related factors that have underpinned equity markets since the 2016 election: the tax-cut bill and deregulatory efforts.

"Bigger concerns lie in the normal functioning of government," the report read. "Trump is already threatening government shutdowns, and this strategic tool could be used more frequently."

Democratic majorities, in either chamber, could also increase the likelihood of investigations into the Trump administration, or impeachment proceedings. SocGen analysts, using the Clinton impeachment as a historical guide, suggested little evidence that such actions affected the economy or equities, "at least for any sustained time-frame."

"Impeachment would primarily run parallel to economic/financial developments, providing a sustained threat but not necessarily being disruptive," the report read. It noted that were Trump removed from office — something it didn't speculate on the likelihood of — Vice President Mike Pence would succeed him in office, and likely maintain similar economic policies.

"Eventually, that may be a favorable circumstance, but for some time, uncertainty and any serious impeachment discussion would be more likely to weigh on confidence. With the economy now in the later stages of a business cycle and the positive effects of fiscal stimulus ebbing, we do not take comfort in a beneficial succession."

While such events would likely result in a resurgence of market volatility — something that has been lacking of late, with the Cboe Volatility Index trading below 13, well under its long-term average between 19 and 20 — a so-called "blue wave," where Democrats make steep gains, could be a positive catalyst for some sectors of the market. SocGen suggested that a Democratic majority could result in better odds of a large-scale infrastructure program, one of Trump's primary campaign issues, an initiative that has stalled during his time in office.

"There is a plausible scenario in which Trump could achieve far more on infrastructure spending with a Democratic Congress than he could with the Republicans," Gallagher wrote.

Beyond the prospects of shutdowns or impeachment, a divided government has historically not been a good environment for equities. According to the Goldman Sachs's Investment Strategy Group, stocks — particularly small-capitalization stocks — tend to bigger annualized gains in periods of united governments, where one party controls the White House and the two branches of the legislature.

According to the firm's data, small stocks see gains of 9.5% in periods of divided government, less than half the 21.8% annualized gain it sees in periods of united government. For large-cap equities, as measured by the S&P 500 (.SPX), stocks see annualized gains of 10.8% in periods of a divided government, compared with gains of 16.4% during united governments.

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