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How Will the Midterm Election Results Impact the Markets?

11/07/2018

After one of the most contentious midterms in decades, the results are in and the 2018 election is finally (some might say mercifully) behind us. Given the close nature of many congressional races, predictions of which party would control the House of Representatives and the Senate were volatile right up to the end. True to form, equity-market volatility also picked up prior to Election Day, resulting in an October surprise most of us would just as soon forget.


So in the throes of our postelection hangover, what should we expect from the new Congress, and what impact will its actions have on financial markets? From our perspective, here are a few scenarios.


What’s not likely to change

Probably the easiest prediction to make is what the midterm election won’t change. Think of the factors most investors and commentators point toward to explain the recent stock- and bond-market drops. The US Federal Reserve won’t be changing its interest-rate policy due to the newly elected Congress—we can still expect further tightening in the near future. The tariffs on China and other countries rely entirely on presidential authority, so the Democrats’ control of the House will be immaterial to resolving the escalating trade wars and their impact on emerging-market economies. And disappointing earnings will remain disappointing, no matter the political calculus in Washington.


In terms of the bond market, the continued escalation of US Treasury issuance in 2019, paired with the Fed reducing its debt purchase program, will arguably cause interest rates to have an upward bias. This is only exacerbated by recent currency dynamics forcing many foreign investors out of the US government bond market and by auctions showing limited demand among domestic investors. Given these overarching factors, expectations should be kept in check regarding how much impact the results of the midterms can have on stock or bond prices.


However, elections do have consequences investors may want to keep in mind as they think about the next couple of years.


What could change with a Democratic-controlled House

With the Democrats taking control of the House and the Republicans keeping the Senate, there are a number of likely outcomes. First of all, the chances of a middle-class tax cut have gone from what would have been a tough enough push in a GOP-controlled House to all but impossible now, given the Democrats’ desire for social spending over cost cutting. Indeed, we’re most likely set for two years of gridlock, given that a split Congress makes it very hard for any bill to progress to the president’s desk and, in the case of Democratic-sponsored legislation, the party’s narrow margin isn’t sufficient to override a veto. If history is any guide, the only measures with a chance for bipartisan support will involve spending that isn’t balanced by a tax increase, such as an infrastructure bill.


But really, the most likely outcome given the animosity between the Democrats and the president is a political cold war, with both parties attempting to block the other from scoring political victories prior to the 2020 election. While there’s a risk of an extended House investigation of the president, market reaction to past White House scandals has been muted. As the charts below illustrate, neither the Iran-Contra scandal during the Reagan administration’s second term nor the Monica Lewinsky affair that led to Bill Clinton’s impeachment in the late ’90s had an appreciable effect on investor returns.


Iran-Contra Growth Chart

Source: S&P


Growth Chart

Source: S&P


Put this all together, and you have a slight positive impact on stocks (historically equity markets have preferred gridlock and elevated government spending) and a slight negative on bonds (it’s hard to paint a deteriorating deficit picture in any light that’s positive for bond prices). 


The bottom line

While the midterm election will have a large impact on the political agenda for the next two years, it’s less likely to change the dynamics of the debt and equity markets. US equities are reacting to continued tightening by the Fed, slowing global growth, and disappointing earnings. Foreign equities are reacting to escalations in US trade relations with China and Europe, concerns about the health of Europe (Brexit, Italy, and so on), and, for emerging markets, the rollover in technology and commodity stocks. The ability of the US Congress to change any of these dynamics is small but mildly positive for equities and mildly negative for bonds.


But make no mistake—events outside the political arena have a much higher potential to impact asset prices over the next two years, and these key drivers remain largely unchanged in a postelection world.


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Tim Atwill

Tim Atwill, PhD, CFA – Head of Investment Strategy

Mr. Atwill leads the Investment Strategy team at Parametric, which is responsible for all aspects of Parametric’s investment strategies. In addition, he holds investment responsibilities for Parametric’s emerging market and international equity strategies, as well as shared responsibility for the firm’s commodity strategy.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.

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