Washington has helped shape global markets over the past 12 months, whether it is the US corporate tax cut or Donald Trump’s trade war against China. So investors who ignore Tuesday’s midterm elections do so at their potential peril.
Historically, the midterms have ushered in a buoyant period for equities even in the event the balance of power in Congress changes. Americans head to the polls at a delicate juncture for markets, with October’s sharp declines prompting many investors to conclude that gains for equities will be harder from here.
“The typical pattern is a sell-off in advance of midterms, then regardless of the election outcome, a rally afterwards,” said David Donabedian, chief investment officer at CIBC Private Wealth Management. “It seems the most important fact that comes out is that the elections are over.”
Given the wild swings in markets over the past month and a sharply divided electorate, pricing in an outcome is more fraught than usual. However, investors and strategists are largely agreed that the consensus currently discounted is that the Democrats retake control of the House of Representatives and the Republicans keep the Senate.
A Congress split between Republicans and Democrats is typically associated with legislative gridlock, which is not necessarily a bearish signal for the stock market. In fact, it can be considered bullish since the status quo is a more predictable outcome for investors and analysts to model against.
“The mostly likely outcome is probably the most boring because it keeps fiscal policy, regulation and trade policy constant” Michael Zezas, chief US public policy strategist at Morgan Stanley, said of a result in which the Republicans retain the Senate but lose control of the House.
In the scenario of a split Congress, any push by Republicans for further tax cuts is likely to prove tough, said Mr. Zezas. There is bipartisan support for an infrastructure spending plan, but bipartisan agreement on how to make it happen may prove more elusive.
There is little common ground among investors on what a politically divided Congress means for trade policy, where hopes for a thawing in US-China tensions buoyed global markets on Friday. Some investors have suggested that if Democrats retake the House, they would try to limit the Trump administration’s more forceful policies. Others argue that the executive branch holds considerable power over trade policy and, what is more, any attempt to check the president could result in an even more aggressive stance.
If the consensus expectation for the election result unfolds, the market reaction is likely to be neutral to mildly positive, investors say. But, as Mr. Zezas said, “the most likely outcome is not a very high probability outcome. “If you look at betting models, there is a 60-65 per cent chance that Democrats take the House and Republicans keep the Senate. That means there is 35-40 per cent chance that something totally different happens.”
Therein lies the chance for heightened volatility for a market already grappling with the threat of higher interest rates, the prospect of weaker earnings growth and an economy, which outside the US, is slowing.
Should Democrats outperform expectations and take both houses, some investors worry that the risk of impeachment rises. It is also likely to eliminate the possibility of further tax cuts and may embolden efforts to roll back some reductions already made.
With the effects of the current fiscal stimulus beginning to roll off next year and Wall Street forecasts for earnings growth sliding to roughly half this year’s 20 per cent, whether or not there is political impetus for further stimulus matters for stocks.
“The market will decline at least temporarily,” said Phil Orlando of Federated Investors. “The kneejerk reaction of the market will be initial concern about the impeachment issue and a change in the fiscal policy approach.”
Conversely, if Republicans keep both Houses, many investors predict a jump in stocks, helped by hopes of an easier path to further stimulus.
“A surprise hold of the House [by the Republicans] will cause a major bounce in the stock market,” said Dave Lafferty, chief market Strategist at Natixis Investment Managers.
But he added that “at some point in the future, the market will realize there is no way to pay for this. Eventually that scares the market, but it won’t be the market’s initial reaction People will wake up six months to a year from now and realize all we are doing is spending money we don’t have and that will drive up interest rates”.
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