Midterm elections can have major repercussions for the economy and markets. The Republican capture of the House of Representatives in 1994 led to a government shutdown — but then to an agreement on the first US balanced budgets in decades.
This is not one of those elections. Whatever the final results, what is clear is the American government will remain sharply divided, with only narrow margins of control by the winning party in each house and a large degree of gridlock.
Add to that a Biden administration strategy to front-load its policy agenda in anticipation of a difficult midterm and the final two years of this government will probably not be impacted much by the make-up of the House and Senate. Gridlock, and the stability it brings, may not be a bad thing for investors. But the Federal Reserve, not the government, will ultimately play a bigger role in determining the fate of the economy and markets.
History suggests the short-term outlook for equities is good. In 17 out of the past 19 midterms since 1946, the S&P 500 performed better in the six months following the vote than the six months preceding it, according to Charles Schwab. These correlations hold true regardless of which party controls which branch of government.
It’s not that parties and politicians are irrelevant to the markets — in Britain, Liz Truss and Kwasi Kwarteng recently proved that wrong. Equities tend to perform better after an election because investors like certainty. It would be more difficult to get legislation through a divided Congress, so there is more clarity on policy over the next two years.
On the margins, bonds could also be boosted by the election results, as a divided government is less likely to approve significant new spending. On balance, this should be less inflationary. According to the Hutchings Center Fiscal Impact Measure, under current legislation alone there will be a fiscal drag on the economy through at least the third quarter of 2024.
Where things could go pear-shaped is if the Republicans try to force the Biden administration into fiscal retrenchment. The incoming GOP House leadership has threatened to extract spending cuts by blocking an increase in the debt ceiling, which would prevent the government from paying its bills.
In 2011, brinkmanship over the debt ceiling caused market turmoil, including an unprecedented downgrade of the US sovereign debt rating by S&P. Democrats may try to lift the debt limit in the lame-duck session of the administration. But a recent survey by Bloomberg News found 78 per cent of respondents expect a debt-ceiling stand-off next year.
Meanwhile, the primary steward of corporate earnings and the economy now is the Fed, not the federal government. Although consumer price inflation came down more than expected in October, Fed officials are pledging to continue to hike rates — and hold them high. That means continued pressure on corporate profits and the possibility of recession in the second half of next year. Should that happen, a divided government would be unable to swiftly agree countercyclical measures. Uncertainty over interest rate policy may offset any short-term post-election boost to equities and bonds.
The Fed may also have more impact on sectoral winners and losers than the midterms. Corporate bonds, particularly junk-rated, will face interest rate headwinds. Stocks of homebuilders and real estate investment trusts are also at the mercy of Fed rates. The ongoing spend down of pandemic fiscal aid savings would aid consumer discretionary companies, but that should come to an end in 2023. After that, much will depend on the possibility of a so-called soft landing for the economy.
While some Republicans oppose more defence spending on Ukraine, the need to replace munitions and equipment already donated, along with the increase in tensions with Russia and China, should continue to boost defence spending.
Energy will also continue to outperform, whatever the make-up of the government. Republicans have always favoured fossil-fuel production. The war has created a need for more of it, something President Joe Biden has endorsed. An early test will be a vote on legislation proposed by West Virginia Democratic senator Joe Manchin that would make it easier to build new pipelines and refineries.
While seats will shift and gavels may pass, these midterms ultimately won’t shift the investment environment much. Other than a debt-ceiling showdown, gridlock in Washington is likely to represent more continuity than change. Ultimately, the composition of government will matter less in 2023 for the economy and markets than monetary policy.
The writer is an FT contributing editor and global chief economist at Kroll
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