How has the US stock market performed around midterm elections?

After a torrid October for stock markets, there is concern among investors that the US equity market could yet have further to fall, with a combination of macroeconomic factors and political tensions clouding the outlook.

The latest political event on the agenda is the US mid term elections, which could define the remainder of Donald Trump's presidency.

History tells us that markets have historically struggled to price in political risk at times like this, exemplified by the market’s response to Brexit  and the election of Trump.

The mid terms may pose a challenge for investor confidence at a time when US stocks have been on their longest ever bull run – a period of rising prices unbroken by falls of more than 20% from the peak - that is well into its 10^th year.

Here, we look at why the elections are so important for markets.

What are the US midterm elections?

Held at the mid-point of a presidency every four years, members of Congress, the legislative branch of the US government, face re-election.

Congress is split into two branches: the House of Representatives and the Senate.

All 435 members of the House of Representatives are up for election every two years, with 35 of 100 seats of the Senate up for election. Members of the Senate serve staggered six-year terms.

Who controls Congress at the moment?

The Republicans, the party of the president, control both the House and the Senate.

They hold 240 seats in the House compared with 195 for the Democrats, with 218 needed for a majority. The Democrats need to flip 23 seats in order to take back the House.

In the Senate the Republicans hold 51 seats compared with 49 for the Democrats. Fifty-one seats are needed for control of Senate. To take back the Senate, the Democrats need to defend their existing 26 seats and win two extra from the Republicans.

Why are the midterms important?

The election will decide if the Republicans remain in control of Congress and therefore the legislative process.

Some of President Trump’s key agendas and campaign promises, such as the repeal of Obamacare, could be revived if Republicans hold control.

Losing control of Congress makes it more difficult to pass bills into law.

How has the ruling party performed historically in midterm elections?

Midterm elections historically have not been too kind to the sitting president's political party.

Since 1966, midterm elections have resulted in an average loss of 28 seats in the House of Representatives and Senate by the political party whose president occupies the White House.

Only twice since 1966 has the ruling party picked up seats:

• 1998 – the Republican party’s attempt to impeach President Clinton galvanised support for the popular Democrat president.
• 2002 – the country rallied behind its president following the September 11 attacks.

How the ruling party performed in the midterms since 1966

Source: Schroders.

What might happen in the 2018 midterm elections?

The Democrats must win at least 23 Republican-held seats to retake the House.

The Schroders Economics team’s model suggests a closer call in November than one might expect from glancing at the approval ratings, with the Democrats gaining six seats in the House and therefore Republicans retaining control. The model found consumer confidence to be a significant a factor in how people vote, which is why it is more favourable towards the republicans.

Frederick Schaefer, Head of Equities Management, US at Schroders, said: “As things stand it appears highly likely that the Democrats will gain control of the House of Representatives and equally as likely that the Republicans will retain control of the Senate.

“The Republicans may even add one or two seats to their slender two seat majority.  The market seems to be anticipating this outcome and is likely to view it favourably.

“US government gridlock has generally been positive for the market in recent history as the US government is constrained from sharp action in such periods. 

“The likelihood of a surprise seems quite low, but one can never count it out.  It is most likely that any surprises will be at the level of individual races rather than the aggregate results.

“Unknown events between now and the weekend would be the likely cause of a major surprise and by their nature they are essentially unpredictable. We believe the outcomes will be as described – House for the Democrats and Senate for the Republicans.”

How might markets react?

The table shows how the US stock market, the S&P 500, has reacted to midterm elections since 1966.

Please remember that past performance is not a guide to future performance and may not be repeated.

How the S&P 500 performed around the midterms

Source: Schroders. Thomson Reuters Datastream data for S&P 500 price index correct as at 31 October 2018.

What is the bottom line for investors?

While midterm election years have tended to exhibit positive trends, it is important to remember that each year is different and follows its own path. Midterm elections — and politics as a whole — generate a lot of noise and uncertainty. But the reality is that long-term equity returns are generated by the performance of individual companies over time. Elections can cause short-term spikes in volatility, the key is to maintain a long-term focus.

Marcus Brookes, Head of Multi-Manager at Schroders, says there is a distinction to be made between the current bull market in US equities, and previous ones.

“During the tech boom, a small number of companies were on very high valuations,” he said “In today’s market, there are a far greater number of companies on high valuations.”

He is also cautious about overall economic conditions in the US: “The problem is that the backdrop is actually one where economic growth has probably peaked for the cycle, we have trade disputes and we have monetary tightening in the form of central bank stimulus being removed or interest rates being raised.

“It’s far from the perfect mix of conditions.”