The midterm election frenzy is reaching its peak as U.S. voters head to the polls this week. The election could bring two-party control of Congress–with implications for the future of key policies such as tax cuts, against the background of growing uncertainties that have unnerved markets.
There is a growing sense of unease in the U.S. stock market. We take a look at what’s behind the market moves. We divide the drivers of U.S. stock returns into growth and non-growth varieties, drawing on the methodology of this 2014 IMF Working Paper. The latter, a proxy for uncertainty, likely reflects rising concerns over the impact of trade conflicts and the sustainability of strong corporate earnings–and possibly political uncertainty ahead of the elections. It is this basket of elements, rather than worries about slower growth or rising rates, that have weighed on the stock market in recent weeks. We see the midterms likely sparking some near-term market volatility, but believe other drivers are more important over the longer term. We view global trade tensions as a chief driver, and the greatest downside risk to the global expansion. De-escalation of such tensions would cheer risk assets such as equities. A likely meeting between U.S. President Donald Trump and Chinese leader Xi Jinping later this month will be a key signpost of whether tensions are set to ease–or heat up further in 2019.
Polls and prediction markets suggest the most likely outcome of Tuesday’s vote is that Democrats take over the House of Representatives and Republicans retain control of the Senate. We see this scenario having few market implications for now, given the low risk of rollbacks to the administration’s tax cuts and regulatory policies in the short term. A divided Congress means policy stasis and has historically tended to benefit equities, but we see potential disruptors: U.S.-China tensions, given bipartisan support for cracking down on China’s trade and intellectual property practices; and increasing partisan confrontation as the Democrats have vowed to use their oversight powers to investigate Trump’s business practices and a host of other issues.
A less likely scenario, according to polls, is that Republicans retain control of both chambers of Congress. This outcome may have the biggest impact on the fixed income market. A Republican-led Congress could introduce more tax cuts, leading to higher budget deficits, more issuance of U.S. Treasuries–and potentially higher bond yields. Republicans may seek to extend the life of individual tax cuts and try again to repeal the Affordable Care Act. This scenario could provide the clearest path to the approval of “NAFTA 2.0”. Democrats winning both chambers would be the greatest surprise for markets. Such an outcome likely would bring heightened concerns that earnings-boosting corporate tax cuts may be wound back in a future administration. In any scenario, neither party would likely command the 60 votes needed to enact most legislation in the Senate, pointing to gridlock.
We see few sustained market implications if the midterms result in a divided Congress. Our base case sees strong U.S. growth underpinning the global expansion, yet the range of possible economic outcomes is widening with a skew to the downside. We remain pro-risk, but advocate building greater resilience into portfolios. We favor quality companies, especially those with strong balance sheets, and find those predominantly in the U.S.