Investment consequences of the US midterm elections

Thursday, November 15th, 2018

Event

  • The US midterm elections saw the Democrats win control of the House and Republicans retain the Senate. Both outcomes were predicted by the polls and betting markets, so there were no surprises – in contrast to Brexit and President Trump’s 2016 win
  • Trump has offered to cooperate with the House Democrats on public infrastructure spending
  • Equity markets initially rallied in response then moved on to focusing on the Fed’s monetary policy meeting.

 

Political consequences

  • The president is more constrained now. While the ‘blue wave’ of opposition to Trump the president’s opponents hoped for didn’t materialise, Democrats’ takeover of the House restrains his conservative agenda. It also enables investigations into Trump’s scandal-plagued administration, 2016 presidential campaign and family business empire
  • However the Democrats are very unlikely to get the required 67 out of 100 Senate votes to remove Trump from office unless he is shown to have done something egregious
  • There will now be more legislative gridlock in Washington. Some of Trump’s signature campaign promises, such as the construction of a border wall with Mexico, are in doubt. The president’s worst excesses can now be thwarted, at least domestically
  • Trump now faces a fundamental choice: attempt to reach bipartisan deals on infrastructure and healthcare or stick to a strategy of stoking passions on immigration and other issues that resonate with his base
  • Trump will retain a largely free hand in foreign and trade policy, which doesn’t depend on who controls Congress. Expect little change to the pursuit of unilateral tariffs on China and other trading partners, or withdrawing from pacts like the 2015 Iran nuclear deal and the approach to North Korea and Russia
  • Attention now shifts to the 2020 presidential election and the question is whether Democrats can build this week’s gains into a successful campaign to stop a second Trump term.

 

Investment consequences

  • The outcome fell broadly in line with market expectations, so US equities rallied and the VIX fell as uncertainty about the outcome ended. One major risk has dissolved, allowing investors to return their attention to other fundamentals for markets
  • While the Democrat House can prevent Trump from cutting taxes further it won’t be able to wind back last year’s tax cuts, reverse Trump’s deregulation of the economy or change his trade policy. The divided Congress leaves the direction of existing policy unchanged, with minimal incremental effects on the economy or growth rates – and therefore on stocks
  • A remote possibility is bipartisan support for an infrastructure bill. Trump’s election promises on infrastructure were a key reason for the 2016-17 ‘Trump Trade’ rally on global equity markets, so markets should respond well to further infrastructure spending
  • While there could be conflict around government shutdowns and extension of the debt ceiling, the election outcome should overall be positive for equity markets because it means less policy uncertainty
  • Divided government is the norm in the US. There is a risk Trump takes it personally and ramps up the populism but if he wants to get re-elected in 2020, which he does – and assuming he is rational – then he won’t want to do anything that damages the economy. This points to a trade deal with China and the removal of tariffs before the 2020 election
  • Since 1946 the S&P 500 has risen over the year after all midterm elections (see Figure 1 below), probably because the president starts to focus on re-election and tries to boost the economy. Figure 2 shows how US equities also tend to rally when there is a Republican president and Democratic House
  • The split of Congressional power between a Democratic House and a Republican Senate, and the return of political gridlock, probably reduces the risk the Fed finds itself in a confrontation with Trump over further fiscal stimulus. A Republican House might have opted for further fiscal stimulus, whether through unfunded tax cuts, unfunded extra spending or both. This would have led the Fed to tighten monetary policy to prevent the economy from overheating and inflation from accelerating. Once the media called the House for the Democrats, Treasury yields rallied immediately
  • So for equity markets, this is looking like a ‘Goldilocks’ scenario:
    • The chance of even more borrowing and wider budget deficits has diminished
    • The tax cuts and deregulation so far are unlikely to be reversed
    • With Republicans in control of the Senate, there is minimal risk Trump will be impeached. Politics could be poisonous, but nothing that really scares markets
    • The best-case scenario is Congressional Democrats and Trump somehow agree on a meaningful infrastructure program. It is unlikely, but markets would love it.
  • There are two risks:
    • Brinkmanship over the federal budget. Republicans will remember their government shutdowns when trying to undermine President Obama but the Democrats might try the same thing. Any doubts the federal debt ceiling wouldn’t be lifted could be damaging, as happened in 2011
    • Trade policy. On China there appears to be some rare bipartisanship developing: both parties seem to support a more confrontational posture towards China than existed under the last few administrations. Many Democrats are as suspicious of China’s trade policies as the Trump White House is. There will be renewed interest in the renamed NAFTA and any further trade agreements, where Democrats will probably move for a tougher deal on labour and environmental standards.

 

Considerations

  • Investors could now consider a more positive view of how US politics drives markets over the year ahead
  • Investors should continue to assess the consequences for economies, companies and markets of the trade conflict with China. Further volatility could present opportunities
  • Some kind of US trade deal with China is probable before the 2020 presidential election campaign
  • The direction and extent of revisions to US, Chinese and world growth forecasts, and the actions of central banks, remain central to equity index returns and volatility.

 


Figure 1. US equities typically rally after midterm elections
Source: Bloomberg

 


Figure 2. US equities tend to rally moderately with a Republican president and Democratic Congress
Source: Bloomberg 

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