Midterms and the market: 3 scenarios
In the aftermath of the most devastating month for stock markets in seven years, U.S. voters head to the polls on Tuesday for a midterm election that may play a significant role in deciding where equities go next.
The added interest in this 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 Republicans 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 run-up, and a postelection 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, all that could change.
Scenario 1: Democrats win the House; Republicans keep the Senate
Multiple polls conducted ahead of the election are pointing to this being the most likely outcome.
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 most likely will 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 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 $1 trillion to $1.5 trillion. Former White House economic adviser Gary Cohn told Reuters in September that he expects it to be the first thing that 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.
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.
Under a split congress scenario, it’s unlikely impeachment results 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. Scenario 2: Democrats sweep Congress
Polling website FiveThirtyEight projected Friday 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.
Going down that road would set off all kinds of market fireworks, and comes with 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 put an end to any hopes the Republicans may have had about repealing Obamacare.
Attempts to challenge or repeal any of Trump’s economic initiatives — such as the $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 probusiness agenda is stopped and not only stops but gets rolled back,” McCreadie said. 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 again at risk.
Trump also has 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 walked back that suggestion since.
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.
“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 so than we’re anticipating.”
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 in the long-term.
The short-term offers more intriguing possibilities for investors. Without Trump’s pro-business agenda impeded, 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.”