In the aftermath of the most devastating month for stock markets in seven years, U.S. voters are heading to the polls Tuesday for the midterm elections that may play a significant role in deciding where equities go next.
Historically, voters have had little interest in midterm elections. In 2014, less than one-third turned out to boost the Republican Party’s majority in the House of Representatives and see them win back the Senate for the first time since 2006.
The added interest in this year’s election, CITI Research North America economist Dana Peterson said, is due to how much is riding on them for U.S. President Donald Trump, whose fellow Republicans currently control both the House of Representatives and the Senate.
“Usually, no one pays attention to them but they are this year because it’s going to act as a referendum on President Trump’s policies,” Peterson said.
Despite the low turnout, midterm elections tend to have a direct impact on Wall Street, with the uncertainty depressing markets in the runup and then, a post-election rally regardless of which side emerges victorious.
According to Kevin McCreadie, president and chief investment officer of AGF Investments Inc., the market has not declined in the 12 months following a midterm election since 1946. The average boost, post midterm, he said, was 15.3 per cent.
But with more at stake this year, especially when it comes to economic policy, that all could change.
Scenario 1: Democrats win the House; Republicans keep the Senate
Multiple polls point to the most likely outcome being a split of Congress. The Democrats are widely expected to gain control of the House while the Republicans are the clear favourites to maintain their majority in the Senate — and perhaps even increase their strength there.
The split is so expected that Wall Street has already priced it in as the most likely result, said Hugh Johnson, chief investment officer at Hugh Johnson Advisors, a New York-based firm. If it happens, he said, it will most likely be met with a yawn.
In this scenario, the markets may undergo their usual post-election rally, but the divide in Congress may lead to policy “gridlock” in the coming months — not necessarily a bad thing for investors.
“For Wall Street, less is more and if you’re talking about virtually nothing coming out of Washington, that’s less and might be pretty good news,” he said.
Seeing the two parties work together through the next two years of Trump’s term would be rare, but there are a few policy issues that could offer the rivals a chance to do so. Trump is widely expected to work with the Democrats in the House on a new infrastructure bill projected to be in the range of US$1 trillion to US$1.5 trillion. Former White House economic advisor Gary Cohn told Reuters in September that he expects it to be the first thing the two sides work on post-election. CITI, Peterson said, already has the deal “baked in” to GDP growth projections — she expects the deal will add 0.2 per cent in 2020, allowing growth to reach 1.8 per cent.
A new infrastructure bill projected to be in the range of US$1 trillion to US$1.5 trillion could be the first thing Trump works on with the Democrats
McCreadie expects the markets to bounce in November and December, but uncertainty can creep back into investors’ minds as soon as January when the new House sits for the first time.
That’s when the whispers about Democrats potentially moving to impeach Trump could begin. Party leaders have been silent on the possibility on the campaign trail, focusing instead on investigating the president in connection with Russian meddling in the 2016 election.
Under a split Congress scenario, it’s unlikely impeachment would result in a conviction in the Senate because it would require two-thirds of the Republican-dominated chamber to vote in favour. Even if the process goes nowhere, McCreadie said the markets will become volatile due to headline risk.
“(The market) will be noisy but not corrective — unless something shows up in that stuff that says they’ve got him,” he said.
Scenario 2: Democrats sweep Congress
Polling website FiveThirtyEight was projecting on Friday afternoon that the Democrats have a 15 per cent chance of winning a majority in the Senate. In fact, they’re widely expected to lose a seat and inflate the Republican advantage in the chamber to 52-48. But if the Democrats pull off the unexpected, they could have a clear path to impeaching Trump.
While going down that road would set off all kinds of market fireworks, it comes with all kinds of political risks for the Democrats as well.
Assuming they don’t move to impeach, gridlock may once again be the order of the day, Johnson suggested, because Trump will be able to wield his veto power on Democratic legislation.
“Nothing is going to happen because it’ll hit a wall when it gets to the White House,” Johnson said.
A few exceptions would be an infrastructure bill and perhaps some kind of co-operation with Trump to resolve the China trade war. The Democrats would also be able to successfully put an end to any hopes the Republicans may have had about repealing Obamacare.
The fear in the market is that the tax reform and pro-business agenda is stopped — and not only stops but gets rolled back
Kevin McCreadie, president and CIO, AGF Investments
Attempts to challenge or repeal any of Trump’s economic initiatives — such as the US$1.5 trillion in tax cuts announced last year or new measures to tackle the debt — could be worrisome for investors, McCreadie said.
“The fear in the market is that the tax reform and pro-business agenda is stopped — and not only stops but gets rolled back.”
A sell-off in equities would soon follow. McCreadie said bonds would then become positive as investors make a move to fixed income instead.
Scenario 3: Republicans sweep Congress
Should the Republicans maintain complete control of Congress, “whatever Trump wants, Trump will get,” Johnson said.
Under this scenario, there will be no impeachment and Obamacare is once again at risk.
Trump has also flirted with additional cuts and strangely suggested two weeks ago that he was looking into a 10 per cent tax cut for the middle class. The GOP has since walked back that suggestion.
The tax cuts that Trump made in 2017 will not be rolled back and Congress will instead look for a way to make individual cuts permanent as they’re set to expire in 2025, Peterson said.
… from the point of view of markets and the economy, we have our best chance — I hate to say this — that the Republicans retain the House and the Senate. That’s the best outcome
Hugh Johnson, CIO, Hugh Johnson Advisors
“If you do that, there’s no benefit to the economy in the short run,” Peterson said. “You’re not going to see it until 2026 and in the meanwhile you’d signal that you’re going to run up budget deficits even more than we’re anticipating.”
The tax cuts were mostly responsible for the ballooning budget deficit in 2018, which increased 17 per cent to a six-year high of US$779 billion. Further debt increases, Peterson said, could lead to the U.S. running a risk of a downgrade of sovereign debt.
In the long term, continued stimulus will lead to the Fed continuing to increase interest rates so that Trump does not overheat the economy. “They’ll have to go it alone under these conditions and you bet they will,” said Johnson, who added that rising rates could eventually derail the bull market.
The short term offers more intriguing possibilities for investors. With Trump’s pro-business agenda unimpeded, the equities markets may heat up in the next two years, Johnson said.
“As hard as it is for me to say, from the point of view of markets and the economy, you probably have to say we have our best chance — I hate to say this — that the Republicans retain the House and the Senate,” Johnson said. “That’s the best outcome.”