A Cross-Asset Guide To The U.S. Midterms

I seriously doubt whether there are too many readers out there who are still thirsty for more posts about the market implications of the U.S. midterms, but then again, it’s always a mistake to underestimate the “more cowbell” phenomenon.

Over the course of the last two weeks, we’ve variously documented the consensus view on equities, which is basically that gridlock (i.e., divided government) might very well be the best case scenario, as it would preserve the market-friendly aspects of Trump’s policy platform while perhaps limiting the scope for escalations on multiple fronts that could have decidedly dour market implications (e.g., ratcheting up the tensions with China and potentially opening new fronts in the trade war).

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Not everyone agrees with that assessment. Perhaps most notably, SocGen on Monday weighed in, warning that “the political and economic agenda has driven the financial markets for the past two years, so political gridlock and uncertainty will not come without pain.”

Perhaps, but remember, a “noisy status quo” can actually be bearish for volatility to the extent the market becomes frozen in time, with nothing to do but wait (conceptually, a vol. seller is simply a seller of that time spent waiting).

“US equities have historically performed well following midterm elections, regardless of the outcome”, Goldman wrote on Tuesday evening, as the polls began to close, adding that “since 1974, the S&P 500 has rallied by an average of 12% between the start of November through 1Q of the following year, posting positive returns in 10 of 11 episodes.”

(Goldman)

As far as the out-of-consensus outcomes (i.e., Republicans retain both the House and Senate or Democrats retake both), Barclays reminds you that a “Blue Tsunami” scenario would likely be bad news for stocks.

“Democrats taking both chambers of Congress, would likely be a net negative for equity market sentiment”, the bank says, before warning that “without fiscal stimulus/deregulation as a catalyst, the possibility of calls for impeachment and increased investigations would likely intensify the overhang on sentiment [and] though trade policy/deregulation would continue to be an area where the president could enact his agenda, Democrats could build a bipartisan agreement to limit his authority.”

On the other hand, a “Red Wall” could catalyze a sharp rally in stocks as it would  “embolden President Trump, most likely expand his influence within the GOP, and result in increased scope for further fiscal stimulus [and] tax cuts plans”, the bank goes on to say, before cautioning that in that scenario, “trade war concerns are likely to persist, as they are driven by executive powers rather than legislation.”

(Barclays)

You should note that this type of analysis has implications (i.e., is useful) regardless of how things turn out, given that markets are likely to analyze the results in the context of how close or not close they are to the two extremes.

As far as the dollar goes, the consensus is that the more support there is for Republicans, the more upward pressure on the greenback, for obvious reasons. A split government would likely be ambiguous for the dollar, while a Democratic sweep would be bearish.

In rates, Republican strength is pretty clearly a steepener, as markets would attempt to price in the economic impact of more stimulus and, perhaps, more pressure on Jerome Powell.

One interesting thing to note about the gridlock scenario is that while the S&P on average does well under split government, YoY returns following a midterm election tell a slightly different story. “The best returns were following a midterm election when any president (regardless of party) lost both chambers of Congress, while the lowest returns were when any president (regardless of party) had a mixed Congress”, BofAML observes.

(BofAML) 

On the bright side, the bank reminds you that “on average, S&P annual returns following a midterm election have been stronger than overall annual average market returns since 1952.” Here’s another way to visualize the same chart you’ve seen over and over lately:

(BofAML)

So that’s something to be bullish about – I guess.

At the end of the day, it’s not clear that history is any guide whatsoever this time around, because let’s face it: This is a referendum on Donald Trump.

He knows that, which means that if Republicans put up a better-than-expected showing, it’s entirely possible that whatever euphoria you get in equities from the prospect of more stimulus will eventually give way to the reality that the President would feel like he has more scope to tighten his grip on power and push the envelope even further on controversial policies.

On the other side of the aisle, Democrats are obviously hell-bent on doing anything they can to stymie this President, which means a stronger-than-expected showing from them could well lead to vitriolic politics “the likes of which nobody has ever seen” (to use a Trump-ism).

For whatever this is worth, we’ll leave you with one final graphic which is just cross-asset performance around midterm elections via Deutsche Bank.

(Deutsche Bank)