Midterms and markets

Summary Bullets

•  The longest night belonged to the pollsters and pundits, whose predictions for a “red wave” did not come to fruition. Markets, too, are now reckoning with an unanticipated outcome--uncertainty--which contributed to the day-after equity market selloff.
• Looking at historical relationships between elections and market outcomes is flawed, as outcomes are often specific to each period. Generalization is thus difficult.
• Markets generally like the prospect of divided government because gridlock prevents extreme policies. However, investors may find that legislative gridlock will reduce policy flexibility when they may need it, specifically if the Federal Reserve (Fed) is the only one tasked with bringing the economy out of recession a year or so from now.
• Gridlock could also bring back the specter of using the debt ceiling as a political tool. It has happened twice before, and it could happen again.
• At the sector level, divided government will ease regulatory, tax and other policy threats to the energy and pharmaceutical sectors. It may also take some wind out of the sails of renewables or infrastructure, though existing legislation that underpins those sectors is unlikely to be unwound.

 The midterm elections matter this time

Political strategists, pundits and your barstool mates probably agree on one thing—the 2022 midterm elections were the most consequential in living memory. The 2022 polls confronted voters with “the future of democracy,” abortion access, generational highs in inflation, falling real incomes, rising crime rates, an epidemic of mass shootings, and degrees of lying and misinformation unparalleled in postwar US history. All of that took place in the echo chambers of social media and what passes for “news” on cable television that amplified partisanship and quashed reasoned discussion in ways never before seen in US history. Given all of this, one of the biggest surprises is a small shift in the House of Representatives’ majority for the Republicans, rather than a clear mandate from the voters.

As for markets, we will probably hear much analysis along the lines of what typically happens now that gridlock is arriving in Washington. But that sort of analysis is generally flawed because the average contains so much variability between different elections that inference is dubious at best.

In what follows, we explore why the midterms should—and should not—matter to investors. In subtle ways, the midterms matter. Our job, therefore, is to discard hyperbole and exaggeration, and focus on the stuff that is typically overlooked, but probably matters most for investors.

Healthy skepticism

It is important to begin with a note of skepticism. Much of what passes for analysis of the elections and market outcomes is little more than naïve pattern recognition. Highlighting how markets “typically” perform before and after elections suggests that what happens in Washington matters more for stock or bond performance than fundamentals such as growth, inflation, interest rates, profits and valuations. True, changes in the balance of political power in Washington can have impacts on those fundamentals, but big shifts in taxation, spending or regulation are the exception, not the norm, of election outcomes. Ascribing broad market performance to a single variable (the outcome of elections) discards too much useful information about what drives asset returns. Accordingly, historic pattern recognition is of limited use. We won’t do it because it obscures more than it reveals.

Instead, it is appropriate to focus on what divided government—that is what voters probably delivered on November 8 (the exact results may not be confirmed for days in the House of Representatives and in December for the Senate)—means for the macroeconomic and industry fundamentals that matter for financial market returns.

Fiscal policy impacts

Let’s start with macroeconomics. Divided government in Washington removes the fiscal lever—taxes and spending—from the policy toolkit. In the near term, that might be a good thing. After all, the last thing an overheated US economy needs is big increases in government spending or large tax cuts. And since Washington rarely delivers fiscal restraint, removing Washington from macroeconomic demand management is appealing to many observers. Also, with big changes in taxes or spending unlikely before 2025, investors can focus their attention elsewhere.

As noted, that sounds like a good thing. Unless, of course, the economy slams into a brick wall or the financial sector undergoes one of its periodic fits. In that case, partisan divisions could mean that avoidable crises are not avoided. Look no further than the 2008 political impasse that delayed the passage of bank bailouts (Troubled Asset Relief Program or TARP) for what happens when financial stress confronts political obstinance. Investors who welcome gridlock today may rue it in the future.

Gridlock also means that not only is the Fed alone tasked with reducing inflation today, but it will be the only institution trying to engineer a recovery once inflation has been slayed. That is troubling because if we have learned one thing in recent decades, it is that it takes a lot of monetary easing to restore the economy to full employment. Here, too, myopic observers who welcome roadblocks to fiscal policy today, may be thinking differently by 2024 if the economy is then stuck in a rut.

In short, we won’t be surprised if many market pundits embrace gridlock as a positive today but ignore what that might mean down the road.

The final macroeconomic consideration is the debt ceiling. Twice in our lifetimes—the late 1990s and after 2010—Democratic presidents faced off against Republican majorities in the House of Representatives. And twice the impasse resulted in political gamesmanship when it came to raising the debt ceiling (i.e., granting the government authorization to increase Treasury issuance to meet its obligations). In 2011, concerns the US might suffer a technical default on its debt resulted in major credit rating agencies downgrading Treasury debt from its coveted ‘triple A’ status. In 2011 a technical default was barely avoided, and markets were roiled.

Could it happen again? Some political commentators think not, given the voter backlash against Republicans in those earlier episodes. But the fact that the 2011 shutdown and near-default occurred a mere dozen years after similar tactics cost Republicans dearly at the polls ought to make one wonder if they will pay heed to history.

What is the impact on capital markets?

In terms of investment opportunity and risk, much depends on the asset class. Removing the risk of unhelpful fiscal stimulus and further inflation pressures helps, at the margin, long duration US Treasuries such as the 10- and 30-year bond. High volatility of stocks and bonds, driven by inflation and Fed uncertainty, could decline. In contrast, with little ability of the federal government to offset the recessionary impacts of Fed tightening, credit spreads may now have to factor in larger risks of extreme outcomes (“tail risks”).

Within equities, divided government ought to create winners and losers. Sectors that might have faced greater regulatory or legislative obstacles, such as “dirty energy” (oil, coal, and even natural gas) or pharmaceuticals under Democratic majorities in Washington, will likely enjoy a reprieve. On the other hand, sectors that might have benefited, such as renewable energy or infrastructure, could be seen less favorably. That said, legislation already passed—such as this year’s Inflation Reduction Act—will not be reversed, as Republicans fall far short of the two-thirds majority required in the US Senate to override a presidential veto.

Lastly, if investors interpret the split government as a headwind in the face of a possible impending recession, this may nudge them toward US Treasury bonds as a safer haven. The election may help certain equity sectors, but over time the fault lines of divided government are larger than the benefits. It is easy for investors to overstate the importance of elections and politics more generally. In our opinion, the bigger mistake today is to exaggerate the short-run benefits of gridlock and to underestimate the longer-run risks.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks, including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year.

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