In focus

US midterms: three outcomes and what they mean for markets


Midterm elections are rarely kind to the president’s party. Of the 19 “midterms” held since World War II, only in 2002 has the incumbent managed to make gains in both the House of Representatives and the Senate. This was due to a “rally round the flag” effect following the September 11 attacks translating into electoral success. Twenty years on, a very different war is being waged; this time on inflation, which until very recently looked set to cause a red wave to sweep over Washington.

Falling gasoline prices in combination with a key legislative victory with the Inflation Reduction Act and the Supreme Court’s decision to reverse abortion rights have helped turn the tide for the Democrats. While the Democrats could now retain control of the Senate, the Republicans remain on course to take control (or "flip") the House of Representatives. The Republicans - also known as the GOP - need to gain just five seats to achieve this, a low bar considering the president’s party has lost 26 seats on average in midterm elections. This task is made easier-still by the 31 Democrats not seeking re-election, while the recently completed once-in-a-decade process of ‘redistricting’ has redrawn the electoral map in favour of Republicans.

Still, matters could all change again before Americans go to the polls on 8 November. On the one hand, recent allegations about their candidate for Georgia’s Senate race have dented the Republican Party’s chances in what seemed their best opportunity to pick up a seat. On the other hand, however, the decision by OPEC+ to cut oil production threatens to undo the slide in gasoline prices that has helped put the Democrats back in the fight. With this in mind, we examine three possible outcomes for the midterms and the likely market reaction to these.

Chart_1.JPG

Outcome 1: Divided Congress

As things stand, this is the most likely outcome. Betfair odds give the Republicans an 80% probability of taking the House. But they are the underdogs in the Senate, where the Democrats have a 60% chance of retaining control. From a legislative perspective, this is problematic. A Republican House would blockade partisan bills introduced by the Democrats. It would also spur a wave of congressional probes, eating up the administration’s time and resources.

But from a market perspective, gridlock on Capitol Hill would be supportive of risk assets. Being forced to compromise serves to moderate the more extreme inclinations of each party, providing a more stable policy backdrop for investors. The data supports this. US equities have averaged annual gains of 12.9% when a president has had to contend with a split Congress. This compares with a more modest increase of 6.7% when a Democratic president has controlled both chambers.

Still, stocks have fallen over the course of most midterm years since 1958, before typically bottoming out in October. Non-political factors have sometimes been the root cause, not unlike this year’s 20% fall in the S&P 500, and we think equities have further to fall. Earnings expectations remain overly optimistic given our view that a global recession is imminent (see, Why recession looms for the developed world). Earnings expectations should adjust as we move into 2023, after which equities could begin to stage a recovery.

Chart_2.JPG

Outcome 2: Republicans sweep House and Senate

In this scenario the GOP secures control of both chambers of Congress. They flip the House and pick up the one seat required for a Senate majority. This is a less likely outcome, as although all 435 seats in the House will be contested, only 35 of 100 Senate seats are up for grabs. And of the 14 being defended by the Democrats, the Republicans’ best prospects of Georgia and Nevada are both toss-ups. That the Democrats are tipped to snatch Pennsylvania is an added headache for the Republicans.

That said, the GOP has recently regained lost ground which, if sustained, could land them both the House and the Senate. Apparent control of Congress, however, would not allow them to pass partisan bills. Such legislation would be vetoed by the President, whose decision can only be overridden by a two-thirds ‘supermajority’ in both chambers. Even a blockbuster Republican revolution that saw them unseat all 14 Democratic incumbents whilst retaining their own 21 would still leave them three short.

Little in the way of legislation should therefore be expected under this scenario, which ought to be supportive of equities. But Republicans may also take a more hardline approach to policing fiscal discipline. This could see a similar showdown to that which occurred in 2011, when Biden (then vice president) had to strike a last-minute deal with GOP leaders to avoid a US default. This was followed by the first-ever US credit rating downgrade, the combination of which wiped nearly 20% off the S&P 500.

Chart_3.JPG

Outcome 3: Democrats cling on to the status quo

In 2017, politics professor Matthew Goodwin promised to eat his book if Labour secured more than 38% of the vote in that year’s UK general election. They won 40%. And he kept his word by eating his book live on Sky News. Earlier this year, it may have been tempting to make a similar pledge about the Democrats maintaining their trifecta. But they now find themselves in a position where they could pull off what had previously been a pipe dream.

The Democrats would be emboldened to press ahead with the president’s agenda. Raising the top rates of corporation, income and capital gains taxes would all be on the table. As would tightening regulation in areas such as banking and healthcare. Affected sectors may well come under some initial selling pressure. And while broader risk sentiment may benefit from a looser fiscal stance, investors would need to weigh up the possible implications for monetary policy.

Still, this will largely hinge on the degree of success the Democrats might enjoy. The party has found it difficult to fully realise the president’s ambitions given its current weak grip over both the House and the Senate. This has particularly been the case in the latter, where centrist Democrats Joe Manchin and Kyrsten Sinema have resisted some of the more liberal reforms. Unless the party can pick up more seats in both chambers, they will continue to face the same challenges as the past two years.

Chart_4.JPGMidterms matter for markets

For the midterms, the optimal outcome from an equity perspective would be one in which gridlock prevails on Capitol Hill. But stocks have historically performed well no matter the make-up of Congress. A bigger driver of sentiment over the next two years will be the extent to which the Federal Reserve (Fed) has to raise interest rates to bring inflation to heel. And that will partly depend on which party, if any, comes out on top in the midterms.

A sizeable Democratic presence would probably pursue policies that would ultimately be stimulatory, necessitating higher rates to be maintained for longer. Whereas a more evenly divided Congress increases the likelihood of policy paralysis, giving the Fed an unobstructed run at calibrating policy. And legislation is likely to be practically non-existent under a Republican sweep of Congress, albeit with the risk of another fiscal stand-off.

The midterms will also serve as a litmus test for Donald Trump’s chances of retaking the White House. While he has not explicitly confirmed he will run in 2024, he has a 25% chance of winning, according to Betfair.

It was a wild four years for markets during his presidency, characterised by strained geopolitical tensions and repeated attacks on the Fed. Ultimately, however, the S&P 500 saw an impressive annualised return of 13.7% over the period.

It remains to be seen what the outcome will be, with a lot still to play for. But at the end of the day, a bad midterms for both parties is a good outcome for investors.

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

Contact Cazenove Charities

Achieving your charity's investment objectives takes time and thought. To find out how we can help you please contact:

James Brennan

James Brennan

Portfolio Director james.brennan@cazenovecapital.com