The 2018 midterm elections will likely have little effect on the economy or on legislation, but they could have a significant impact on the stock market and its volatility. Midterm elections are notorious for shifting congressional seats away from the president’s party, and this time is no different: Polls predict Democrats will gain control of the House, and Democrats hope to take the Senate as well. Either way, the current partisan environment suggests any legislation over the next two years will be nullified – by the Senate in one case, or by presidential veto in the other. The resulting political gridlock may be good for the stock market, but media focus on potential Democratic-party objectives, such as higher taxes, increased regulation, and impeachment proceedings, will not sit well with foreign or domestic investors. As a result, even if corporate profits and economic strength push equity prices higher, investors should expect greater stock market volatility in 2019 as partisan rhetoric adds to investor uncertainty.
Equity performance after midterm elections. While midterm elections have generally produced a meaningful shift in Congressional seats away from the President’s party, equity performance in the period following the election has been impressive, as the graph below demonstrates.
Since 1945, in the 12 months following a midterm election, the S&P 500 has risen an average of 16.7 percent, according to research firm CFRA; in fact, over this same timeframe, the S&P 500 has registered a positive 12-month return after every midterm election. This persistence of positive returns suggests that conditions surrounding midterm elections influence market behavior. These conditions include resolution of political uncertainty that arose prior to the elections, the political gridlock following most midterm elections that generally prevents meaningful new legislation from being passed, and the continued benefit of any stimulus that may have been enacted in the first two years of the political cycle. The recent market volatility, expected election outcome of a split congress, and the economic effects of tax legislation and deregulation represent conditions today that align with market patterns that have evolved around past midterm elections.
A Split Congress. Democrats are expected to capture more than the 23 seats needed to take control of the House; such a shift is within the context of past midterm elections. In the 2006 midterm, President Bush lost 27 seats, and in 2010 President Obama lost 63 seats to the opposing party. The Senate is less likely to shift, given that the GOP is defending just nine seats of the 35 seats on the ballot, while Democrats are defending the remaining 26 – 10 in states that Trump carried in 2016. Thus, a split Congress, where Democrats assume control of the House and Republicans continue to control the Senate, is expected by numerous political polls.
Historically, stock market performance has been favorable with a Republican president and a split Congress. As the chart below illustrates, since 1950, with a Republican president, the S&P 500 has done better with a split congress than with any other Congressional combination.
The stock market reaction to this combination may in part be related to legislative gridlock and the resulting political certainty; however, in the 2018 midterm elections, markets may not get the political certainty they typically enjoy under Congressional gridlock. A Democratic House will assume leadership of a record number of Committees, enabling them to pursue a series of investigations that could include President Trump‘s personal finances, as well as renewed examination of Russia’s interference with the 2016 elections. Such investigations, which will involve record requests and congressional testimony from administration officials, will not be well received by foreign or domestic investors. Volatility may also unfold if a new NAFTA agreement is not passed by January – the likelihood of which would increase as House Democrats seek concessions that distinguish their contribution to this important legislation. Thus, although equity markets over the next 12 months are still likely to be driven by strong corporate profits and continued US economic strength, expect partisan politics and trade policy uncertainties to contribute to periods of meaningful market turmoil. On the other hand, one Democrat priority that is also important to President Trump is infrastructure, and this may offer the one opportunity for bipartisan legislation before the next presidential election, even if necessary funding involves adding to the deficit.
A Democratic Senate. If the Democrats control both the House and the Senate after the midterm elections, markets could take a substantially different course. With a Republican President, this outcome would still produce legislative gridlock, but markets would immediately reflect concern that the election results empower Democratic Presidential candidates for 2020. Expectations of Democratic priorities that include higher corporate taxes, increased taxes on wealthy individuals, more regulation, revitalization of universal healthcare, and a higher minimum wage could weigh on stock prices despite record earnings and a strong economy. At the same time, a unified Democratic Congress would allow impeachment proceedings to begin and – even without the votes to succeed – provide basis for significant disruption to equity and currency markets.
If Republicans retain both houses. In the unanticipated event that Republicans retain control of both the House and the Senate, the stock market could rally, driven by increased political certainty over the next two years as well as the hope of a business-friendly environment continuing after 2020. Republicans would pursue legislation making personal tax-cuts permanent, deregulation would continue, and the new NAFTA agreement could be passed with fewer adjustments; such an outcome would be market friendly but does not seem to be consistent with voter sentiment (if polls accurately reflect participation on November 6).
- If midterm elections produce a split Congress, expect greater volatility, as House investigations could increase conflict with President Trump while strong underlying economic fundamentals provide a counterbalance. One investment strategy in this scenario may be to increase focus on infrastructure, as one area that the administration may feature to help sustain economic growth and Democrats can support to provide well-paying jobs.
- A unified Congress under control of Democrats could adversely affect both stocks and bonds. Impeachment proceedings in 2019 – combined with concerns of a Democratic agenda of higher taxes and new regulations in 2020 – would affect corporate profit expectations, compromising stock prices as well as the dollar. In this case, investors may wish to reduce US equity exposure and increase non-US equity holdings with better valuations and less political uncertainty.
- Although unlikely, Republican control of both houses should produce confidence in the US economy and persistence of US corporate profits. Making the personal US tax reform permanent should benefit consumption and promote business investment. Increasing equity exposure to domestic-centric companies that benefit from growth could be an effective strategy in this situation.
HighTower St. Louis is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.
All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.
This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.