Will the US midterm elections impact markets?
Equities tend to do better in the months after the hustings than in the lead-up, and the result typically makes little difference. However, this time round The Donald’s legacy is in the balance.
On Tuesday 6 November Americans will vote in the midterm elections. Sometimes known as off-year elections, the midterms occur every four years, between presidential elections. Politicians in the House of Representatives only serve two-year terms so all 435 of their seats are up for grabs. Senators serve six-year terms and work a staggered system whereby a third are elected every two years: this year 35 seats are on the table.
What’s going on in Congress?
Currently, the Republicans control both chambers of the legislature. They control the House with a 54.4% share, holding 237 seats to the Democrats’ 193 (5 seats are vacant). In the Senate, the Republicans (or the Grand Old Party) hold 51 seats to the Democrats 47, but two independents caucus with the Democrats, giving the GOP an effective 51% share.
History does not favour the chances of the sitting President’s party at midterm elections. We analysed the share of seats held by a President’s party before and after every midterm vote since the Second World War. Typically, losses seem almost inevitable. Democrats tend to suffer larger losses, but invariably start with a bigger share of seats. It’s rare for Republicans to be in the White House and control both chambers of Congress, and even rarer for them to hold on to this position after midterms. George W Bush achieved this feat in 2002; the last Republican to achieve it before him was Calvin Coolidge in 1926.
At first glance it may seem that the Republicans have a better chance of retaining the House than the Senate, where they have a much slimmer majority. But the staggered senatorial system favours the Republicans this year. Although 35 Senate seats are up for election, 26 of them belong to Democrat incumbents. Of those 26, 12 have a significant chance of swinging to the GOP, but only six seats held by Republican incumbents have a chance of swinging to the Democrats.
In our opinion, the Republicans could lose the House for five reasons:
1. According to the Cook Political Report/NY Times, 88 Republican seats have a chance of turning blue (the Democrats only need a net 24); while just 14 Democrat seats have a chance of turning red (3%). Real Clear Politics puts it at 77 versus 21. In both reports only two of the 30 to 40 seats most likely to swing are held by Democrats today.
2. An extraordinary number of Republican Representatives are retiring or running for another political office. In other words, they are giving up the considerable “incumbency advantage” well-proven to impact House races.
3. Historically, the Republican share in the House decreases by an average of 7% when a Republican is in the White House. The current majority is 4.4%.
4. There is a strong correlation between a President’s approval rating and House midterm results (much stronger than in the Senate). Over 40% of the variation in midterm results can be explained by Presidential approval ratings. Currently, Donald Trump’s approval rating is 41% (using the Gallup poll), putting the Republicans on track for a 9% loss of seats in the House.
5. In the absence of high presidential approval, a sitting President’s party has required an extraordinarily strong economy to hold on to Congress in the midterms. By extraordinary, we mean a much bigger deviation above trend for GDP in election year than the US is currently on track to achieve. And remember that wage growth has been relatively lacklustre this time round. Interestingly, the unemployment rate doesn’t appear significant. Unemployment reached a cyclical low just in time for the 2006 midterms, when the Democrats retook both chambers from George W’s Republicans; it had fallen by 2 percentage points in the two years to the 1994 midterms, when the Republicans retook both chambers from Bill Clinton’s Democrats.
Figure 1: S&P 500 performance six months before and after
Average of the past 13 US midterm elections.
Source: Datastream and Rathbones.
Of course, forecasting election results is far more art than science and we certainly don’t recommend basing an investment strategy on election predictions. About 90% of Republican voters approve of the current presidency (although a declining share of voters identify as Republican these days; the share identifying as Democrat has held steady). The formidable congressional district maps Republican-controlled state legislatures drew after the 2010 election are also a significant obstacle for the Democrats.
So will a Democrat victory even matter to financial markets?
Will markets react if Democrats emerge victorious?
Analysing the last 50 years, we find evidence that US equities tend to be rather directionless in the six months before a midterm election, with a little extra volatility. Over the subsequent six, equities tend to rise steadily (figure 1). But here’s the rub: it doesn’t seem to matter one jot whether or not either party loses, gains, kept or never had control of Congress in the first place.
2006 was the one incidence of a Republican president losing control of both chambers in Congress – the S&P 500 still went up. We plotted the market reaction to five midterms when a Republican President controlled neither chamber – before or after the election – and the general pattern is still there. The idea pushed by some commentators that Democrats in Congress is bad for business is not supported by equity market performance.
We found no evidence that midterms alter the path of US equities relative to global equities. The dollar doesn’t appear to deviate from the path it was already set on. Similarly, there’s no pattern to dollar performance and which party does well, poorly or indifferently.
We’ve dug into sector performance too and again no pattern emerges. Defence, healthcare and banking corporations are businesses that operate in politically sensitive environments, but the midterms don’t appear to make an impact. The defence sector, for example, underperformed the broader market after the Republicans retained control of Congress in 2002; they outperformed a touch when the Republicans lost control of Congress in 2006.
Now to be clear, there just aren’t enough data points to draw firm conclusions from the historic performance around midterm results. In other words, this time may be different (heaven forbid). The point we wish to make is that if the Democrats do retake the House, be careful not to overestimate the magnitude of the impact on financial markets and, in particular, equity sectors. Investors may just be glad to get back to studying earnings reports and economic releases. After all, the third year of a President’s term has delivered the most consistently positive returns.
The worst case for markets
If, however, the Democrats retake both the House and the Senate, equity markets may not be so sanguine.
US stocks have received a substantial boost from Mr Trump’s tax plan and if Democrats controlled both chambers they could undo it.* Most Democrat lawmakers are keeping quiet on their intentions here. US governments rarely reverse the previous one’s tax changes outright, but a redistribution away from the very wealthiest beneficiaries of Mr Trump’s tax plan seems inevitable. The key question is: will a Democrat Congress raise taxes and improve the budget balance, or raise taxes and spend the proceeds elsewhere? The latter is arguably more likely, and Democrats have talked about an infrastructure programme. But despite the large economic gains possible from improving infrastructure, markets will not want to see it funded by a much higher corporate tax rate.
Impeachment is a red herring. Even if the Democrats do recapture the Senate, they would need a 60% supermajority to impeach the President. As we discussed above, there simply aren’t enough swing seats in play.
For us, the big risk is what a Democrat victory – in either the House or the Senate – does for Trump’s trade agenda. Hamstrung in Washington, unable to enact the remaining policies on his to do list, Trump may focus all of his attention on the one thing for which he doesn’t require Congressional approval: stoking the trade war. (And Gary Cohn is no longer there to steal letters off his desk!)
* In fact markets have priced in too much of a boost, in our opinion: before the tax bill was passed analysts only assigned a long-term earnings growth rate of more than 15% to 15% of US companies; after the tax cut over 30% of companies are expected to grow earnings at that rate indefinitely.