The outcome of the US midterm elections were as expected: the Democrats seized control of the House of Representatives and the Republicans held on to the Senate.
One potential outcome of a divided Congress is an increased likelihood of political gridlock, as both the House and the Senate are required to pass legislation. There will be more oversight of domestic policies in the next two years – very different from the first two years of Donald Trump’s presidency which saw the enactment of significant tax reforms.
We expect fiscal policy to become less supportive of the economy, as the potential political impasse limits the government’s ability to pass through extra spending or raise the debt ceiling. As a result, the boost from tax cuts will wane - leading to slower growth as we head toward 2020. This will co-incide with the later stages of the business cycle.
But with the US unemployment rate at a 48-year low and wages rising at the fastest in a decade, a more neutral fiscal stance could reduce the risk of overheating. This would leave the Federal Reserve free to continue its current process of gradual policy normalisation. We expect two or three interest rate increases in 2019.
President Trump keeps control of trade
The President still retains power over trade policy despite the split Congress. For example, the use of Section 232 of the Trade Expansion Act of 1962 to impose tariffs based on national security threats bypasses Congress. It is likely that President Trump will maintain his aggressive policy stance toward China, though it is possible to read some softening in rhetoric in his recent tweets and announcements. Trump and President Xi are meeting at the G20 later this month.
In terms of financial markets we expect the outcome to translate into modestly higher equities, a flatter yield curve and weaker US dollar.
Historically, a split Congress has a mildly positive effect on share prices as the “status quo” is preferable to uncertainty. Although we believe growth momentum is going to slow, it reduces the risk of inflation and aggressive responses from the Federal Reserve, both of which are key ingredients for triggering a recession. The US yield curve is likely to flatten as short-term interest rates rise while longer-term interest rates price in slower future growth.
Again the split Congress outcome confirms our view that the US dollar will peak next year as US growth leadership starts to narrow. This would be beneficial for emerging markets as a weaker dollar is supportive to emerging markets asset generally.