Markets And Midterms: Is Past Precedent?

There’s an argument to be made that the midterm elections in the US don’t matter all that much this time around.

I don’t think it’s a good argument, and I’m pretty sure analysts who float it are merely speaking in their professional capacity as dispassionate market observers whose job description entails speculating on the likely trajectory of asset prices over the near- to medium-term.

That’s about the only context in which you could suggest the 2022 US elections are immaterial. Unfortunately, I noticed on Monday that one analyst whose dailies I quite enjoy, and who has considerable editorial latitude compared to his peers at Wall Street’s largest banks, downplayed the existential nature of America’s current plight, consistent with an unfortunate penchant for entertaining various conspiratorial narratives popular on the right-most fringe of the country’s political spectrum.

To anyone similarly inclined, I’d offer this simple reminder: Entertaining counter-narrative and harboring a healthy skepticism for the “establishment” line needn’t entail the tacit endorsement of Clorox injections, figurative or literal. Also, if you reside in a country that depends on US military guarantees for security (so, all developed countries and a lot of emerging ones too), you might consider not fanning the flames of societal dissolution in America. There are two superpowers in the world. Only one is your friend.

Anyway, getting back to the kind of dry, dispassionate midterm analysis that makes for good placeholder articles and ostensibly serves as context, the figures (below, from Goldman) illustrate S&P 500 performance around election cycles.

“Since 1932, the 12 months following midterm elections have historically been the strongest year for equities in the four-year presidential cycle,” Goldman’s Ben Snider noted, referencing the figure on the right and adding that “during the last 90 years, equities have generated positive returns in 21 of 22 such years, with 1939 — alongside the start of WWII — the sole exception.”

Snider readily conceded that it’s “hard to read much into this pattern,” but did venture that “the historical strength of equities in the post-midterm year may partially reflect the decline in political uncertainty that often occurs during this stage of the government cycle.”

That’s unquestionably true, and the historical tendency for stocks to rally in “Year 3” could easily play out again given how singularly terrible 2022 was for most assets, not to mention the potential for a Fed pivot in the second half. Still, any “decline in political uncertainty” in the US would be of the “calm before the storm” variety. I don’t think I’m being needlessly hyperbolic to suggest that “certainty” won’t be a word anyone uses in connection with US politics for the foreseeable future.

The figure on the left (above) simply illustrates the conventional wisdom that divided government is good for stocks. I addressed that in “Markets, Strategy And Gridlock: Key Midterm Considerations.” I’d add that gridlock could be an incrementally bullish factor for long-end bonds to the extent fears of additional deficit spending and fiscal expansion are washed away by a Republican sweep. The idea is that long-end yields would fall given both the prospects for more fiscal discipline and higher odds of a recession given lower odds of fiscal stimulus.

As far as the market implications of various congressional permutations, you don’t have to be an analyst of any kind to draw some preemptive conclusions. But, I’ll quote some analysts anyway.

“Higher volatility more likely results from a better-than-expected night for Democrats than for Republicans,” Morgan Stanley’s Michael Zezas and Seth Carpenter wrote. In addition to wrong-footing consensus (which here just means polls and betting odds), such an outcome “would undercut the notion that inflation is an electoral liability for the Democrats [which] investors could see as freeing the party from the political and legislative constraints that kept Congress from enacting… fiscally expansionary policies,” Zezas and Carpenter went on to say, adding that in that scenario, “markets could assign a higher probability to further fiscal expansion, with Congress and the Fed effectively pulling in opposite directions on inflation.”

Needless to say, that’s very unlikely, though. Republicans were all but guaranteed to pick up seats and flip one or both chambers, leading to what market participants hope would be “benign neglect,” as Zezas and Carpenter put it. However, they cautioned against unhealthy complacency in the event of a Republican win. Gridlock, they reminded market participants, in the recent past “led to protracted debt limit standoffs and government shutdowns.”

“At present, the Republican leadership is signaling its intent to deploy the same tactics if the party wins majorities [and] while markets could easily dismiss these negotiations as political theater, as they have in recent years amid solid economic conditions, if the economic outlook sours in 2023 in unexpected ways, the specter of the Budget Control Act could weigh on markets,” they warned.

“If Republicans retake one or both chambers of Congress, sweeping fiscal policy changes seem unlikely over the next two years, absent a crisis like the one that occurred in 2020,” Wells Fargo’s Michael Pugliese said, in his own election preview. “Under this election outcome scenario, we doubt we would make any major changes to our forecasts for GDP growth, inflation or the federal funds rate as a result of the election,” he added. “Instead, status quo and political gridlock strike us as the most likely outcomes, with the possibility for some government shutdown/debt ceiling theatrics over the next two years.”

Zezas and Carpenter had one “piece of advice” for Americans vexed by political ambiguity: “Vote!”

If only it were that simple.