Market Reaction: October 1, 2018
Global equities finished the week slightly lower. However, on a quarterly basis, U.S. equity markets posted solid gains with the S&P 500 up 7.2%. The Dow Jones rallied 9.0% during the quarter as trade fears eased. Emerging market shares were the laggard – finishing the quarter 1.1% lower. The 10-year U.S. Treasury yield finished the week unchanged at 3.06%.
With trade tensions starting to ease a bit, investors will likely shift their attention to the upcoming U.S. mid-term elections. The odds appear to favor the Democrats in the House and the Republicans in the Senate. The base case scenario seems to be a Democrat-led House and a Republican-led Senate. However, analysts have clearly gotten it wrong before.
Gridlock in Washington is nothing new and equity markets have traditionally rallied post mid-term elections (regardless of the result). Though knee-jerk reactions to the downside remain a possibility.
All Eyes on Washington
With the U.S. mid-term elections on November 6th quickly approaching, all eyes will be on Washington (as if they weren’t already). Just like many other people, we secretly like to talk about politics, but this medium does not grant us the leisure of doing it in hushed tones. However, given that the U.S. mid-term elections could impact financial markets, we feel obligated to share some thoughts (most of which will be limited to potential outcomes).
We believe that there are four scenarios that could play out (Republicans could expand their majority, simply maintain control, lose the House to the Democrats, or lose both the House and the Senate to the Democrats). In terms of the first scenario, it seems unlikely that Republicans will expand their majority based on historical examples. If we look at mid-terms dating back to 1910, the President's party has lost 31 seats in the House on average. However, if we look at more recent elections, the average loss shrinks. Since 1950, the loss has averaged 24 seats and since the mid-1980s, the average loss has been 20 seats. In this mid-term election, Democrats need to flip 23 seats to take control of the House. Clearly, in the realm of possibility.
On the Senate side, the President's party has averaged a loss of 4 seats. However, in this mid-term, the odds favor the Republicans as Democrats need to defend 26 seats while Republicans have to defend just 9 seats. On top of this, 10 of the Democratic seats are in states that President Trump carried in the 2016 election. Again, there’s no guarantee and this is not an endorsement of any particular party, but the odds appear to favor the Democrats in the House and the Republicans in the Senate.
Given this landscape, a base case scenario would appear to be a Democrat-led House and a Republican-led Senate. If this were to occur (we emphasize if), a divided Congress would likely mean a higher chance of Washington gridlock. Almost any legislation would require compromise from both sides. We do not see this as necessarily negative for equity markets as there have been plenty of examples when the both the U.S. economy and equity markets have excelled under the umbrella of a divided Congress. We do think that there’s some chance that a divided Congress could agree upon an infrastructure spending bill, but with Federal deficits projected to increase, it’s not clear how much momentum such a bill could get (see Figure 1).
Currently, the House is talking about Tax Reform 2.0, which would make the individual and small business tax cuts included in the Tax Cut and Jobs Act permanent. If the Republicans are able to hold both the House and Senate, then there’s a greater chance of that happening, but the GOP may be forced to use the budget reconciliation process to do so. If passed, we could envision a scenario where risk assets respond positively. A Republican Congress may also consider indexing capital gains for inflation or making additional changes to the laws such as Dodd-Frank.
In terms of market-moving policy, the legislative side is probably less important than the executive side of things. Importantly, de-regulation and trade policy still fall under the President’s jurisdiction, so that’s not likely to change. In theory, it’s possible that Congress could seek to reign in President Trump’s authority on trade, but the odds of that happening are probably low with Senate Majority Leader Mitch McConnell recently stating, “I think the honest answer is legislation (to limit trade authority) probably would not be achievable even if it were desirable.” We should also point out that in the case of a Democratic sweep of both chambers, that President Trump still has veto power and Democrats would likely not have enough votes to overcome such a roadblock (leaving Congress in gridlock).
Assuming that the base case does happen (the House goes to Democrats, Senate stays Republican), it doesn’t seem like markets will react too strongly. If we look back at mid-terms dating back to 1990, the S&P 500 usually sells-off a bit heading into the elections with Defensive sectors outperforming and then the market tends to rally in the six months following with an average return of about 12% (see Figure 2). That type of return seems excessive given that we are in the ninth year of an economic expansion, but both Brexit and the 2016 U.S. Presidential election certainly displayed similar patterns (see Figure 3).