Midterms and Markets

Friday Reflection | November 18, 2022

Politics impact many aspects of our collective economy as lawmakers shape policy, government spending, and regulatory priorities. Investors, therefore, were paying close attention when US voters cast their ballots in the midterm elections last week.
 
Despite historical trends and forecasts for a ‘red wave,’ the result was that Democrats retained a slim majority in the Senate with 50 seats currently. The one remaining Senate race in Georgia will be decided in a runoff election on December 6. Even if Republicans win this race, Vice President Kamala Harris will continue to be the deciding vote in the event of a tie.
 
Republicans did succeed in flipping the House of Representatives, but the number of new seats for the party fell significantly short of what the GOP, polls, and markets were predicting. The result is that neither party has a resounding mandate in Congress, and gridlock is the likely outcome for the next two years of the Biden administration. History indicates that this may be favorable for financial markets, particularly if investors see signs that inflation is cooling.

The Democratic-controlled Congress now enters a lame duck period before the swearing-in of newly elected senators and representatives on January 3. This creates an urgency to enact specific policies before year-end, including passing the Appropriations Budget, as well as the 2023 National Defense Authorization Act.¹ The current administration has also signaled a desire to increase the child tax credit, which would require approval from the House of Representatives.² While important, most of these legislative items are expected to have minimal impact on financial markets.

The one issue investors are paying close attention to is raising the government’s debt ceiling, which has been a recurring headache over the past decade. The most notable example was in 2011, when a standoff with the GOP-controlled House over the debt ceiling sent stocks plunging, leading to Standard & Poor’s decision to downgrade the US credit rating for the first time in history.³ The current debt ceiling is expected to be reached in the summer of 2023. By voting on this issue during the lame duck session, Democrats may be able to avoid the pattern of brinksmanship that has previously rattled financial markets.

A divided government tends to deliver fewer major policy changes, which promotes a stability that is valued by markets. This often translates to fiscal restraint, with neither party able to pass much in the way of higher spending or significant tax cuts. Gridlock-induced spending reductions could be good for inflation, which is the primary concern for most investors. Regardless of Congressional composition, politicians have no direct influence over the Fed’s decisions to ease up on its aggressive tightening cycle. Just this week, James Bullard, President of St Louis Fed, reiterated that inflation is the highest priority and even dovish scenarios will require further rate hikes into 2023. 

The correlation between stock market performance and midterm elections is well documented. In 17 of the 19 midterms since 1946, the market performed better in the six months following an election than it did in the six months leading up to it.⁴ While six months is short timeframe, the consistency has been noteworthy. These correlations have held true regardless of which party controls which branch of government.

While financial markets may breathe a sigh of relief following midterm election results, the present reality is that ongoing concerns about global recession, high inflation, and tighter central bank policies could limit the enthusiasm of any post-election rally. Many market analysts expect stocks and bonds to be delivering positive returns this time next year, but the path is likely to be volatile and could include a recession. That will largely depend on the trajectory of inflation, especially high energy costs in the US and Europe, and the Fed’s ability to push forward their plans without stalling the economy.

BNY Mellon recently forecast the probability of a recession next year at 70%, which is near the average of most Wall Street firms. Consensus is not uniform, though, with Goldman Sachs just yesterday downplaying the odds of a recession at only 35% as they predict consumer income to rise as inflation retreats.⁵ Either way, it is important to remember that equity markets tend to find a bottom and start a new phase of growth well before the economy does. In the near term, caution is still warranted as corporate earnings remain volatile, and the Fed recently reasserted that it has further to go until it is finished raising rates.

Economic fundamentals and Federal Reserve policy, rather than politics, will ultimately drive the markets in 2023. Markets have rallied over the past two weeks after the Consumer Price Index (CPI) report showed inflation decreasing more than expected in October. It will take additional positive data points before our team, and the market broadly, can build confidence that we are entering a new phase.

For our clients, having an investment plan in place which aligns with their goals has a larger impact on financial resiliency than the balance of power in Congress. Our team at North Berkeley continues to focus on regular rebalancing as a way to systematically keep portfolios on target for the long-term, and strategic tax loss harvesting to minimize tax burden in the short-term. The current period of price declines and rising interest rates is uncomfortable, but staying invested is the best way to ensure you benefit when the market inevitably moves into a new chapter of sustained price growth.

Resources

¹ Congress returns for lame duck with long to-do list. 11/14/22 CNN

²  Year-End Tax Policy Priority. 11/15/22 CBPP.org

³ What Divided Government Means for Washington. 11/16/22 WSJ

⁴ Will Midterms Affect Market Performance? 9/13/22 Schwab

⁵ Dollar Has Room to Strengthen in Bumpy Ride Ahead, Goldman Says. 11/17/22 Bloomberg