US midterms: three outcomes and what they mean for markets

Midterm elections are rarely kind to the US president’s party. Of the 19 “midterms” held since World War II, only in 2002 has the incumbent managed to make gains in both the House of Representatives and the Senate. This was due to a “rally round the flag” effect following the 9/11 attacks translating into electoral success. Twenty years on, a very different war is being waged; this time on inflation, which until very recently looked set to cause a red wave to sweep over Washington.

Falling gasoline prices in combination with a key legislative victory with the Inflation Reduction Act and the Supreme Court’s decision to reverse abortion rights have helped turn the tide for the Democrats. While the Democrats could now retain control of the Senate, the Republicans remain on course to take control (or "flip") the House of Representatives. The Republicans - also known as the GOP - need to gain just five seats to achieve this, a low bar considering the president’s party has lost 26 seats on average in midterm elections. This task is made easier-still by the 31 Democrats not seeking re-election, while the recently completed once-in-a-decade process of ‘redistricting’ has redrawn the electoral map in favour of Republicans.

Still, matters could all change again before the Americans go to the polls on 8 November. On the one hand, recent allegations about their candidate for Georgia’s Senate race have dented the Republican Party’s chances in what seemed their best opportunity to pick up a seat. On the other hand, however, the decision by OPEC+ to cut oil production threatens to undo the slide in gasoline prices that has helped put the Democrats back in the fight. With this in mind, we examine three possible outcomes for the midterms and the likely market reaction.

Outcome 1: Divided Congress

As things stand, this is the most likely outcome. US equities have averaged annual gains of 12.9% when a president has had to contend with a split Congress. This compares with a more modest increase of 6.7% when a Democratic president has controlled both chambers.

Still, stocks have fallen over the course of most midterm years since 1958, before typically bottoming out in October. Non-political factors have sometimes been the root cause, not unlike this year’s 20% fall in the S&P 500, and we think equities have further to fall. Earnings expectations remain overly optimistic given our view that a global recession is imminent (see, Why recession looms for the developed world). Earnings expectations should adjust as we move into 2023, after which equities could begin to stage a recovery.

Outcome 2: Republicans sweep House and Senate

In this scenario, the GOP secures control of both chambers of Congress. This is a less likely outcome. Little in the way of legislation should be expected under this scenario, which ought to be supportive of equities. But Republicans may also take a more hardline approach to policing fiscal discipline. This could see a similar showdown to that which occurred in 2011, when Joe Biden (then vice-president) had to strike a last-minute deal with GOP leaders to avoid a US default. This was followed by the first-ever US credit rating downgrade, the combination of which wiped nearly 20% off the S&P 500.

Outcome 3: Democrats cling on to the status quo

Earlier in 2022, it may have been tempting to make a pledge about the Democrats maintaining their trifecta. But they now find themselves in a position where they could pull off what had previously been a pipe dream.

The Democrats would be emboldened to press ahead with the president’s agenda. Raising the top rates of corporation, income and capital gains taxes would all be on the table, as would tightening regulation in areas such as banking and healthcare. Affected sectors may well come under some initial selling pressure. And while broader risk sentiment may benefit from a looser fiscal stance, investors would need to weigh up the possible implications for monetary policy.

Still, this will largely hinge on the degree of success the Democrats might enjoy. The party has found it difficult to fully realise the president’s ambitions given its current weak grip over both the House and the Senate. This has particularly been the case in the latter, where centrist Democrats Joe Manchin and Kyrsten Sinema have resisted some of the more liberal reforms. Unless the party can pick up more seats in both chambers, they will continue to face the same challenges as the past two years.

Midterms matter for markets

For the midterms, the optimal outcome from an equity perspective would be one in which gridlock prevails on Capitol Hill. But stocks have historically performed well no matter the make-up of Congress. A bigger driver of sentiment over the next two years will be the extent to which the Federal Reserve (Fed) has to raise interest rates to bring inflation to heel. And that will partly depend on which party, if any, comes out on top in the midterms.

A sizeable Democratic presence would probably pursue policies that would ultimately be stimulatory, necessitating higher rates to be maintained for longer. Whereas a more evenly divided Congress increases the likelihood of policy paralysis, giving the Fed an unobstructed run at calibrating policy. And legislation is likely to be practically non-existent under a Republican sweep of Congress, albeit with the risk of another fiscal stand-off.

The midterms will also serve as a litmus test for Donald Trump’s chances of retaking the White House. While he has not explicitly confirmed he will run in 2024, he has a 25% chance of winning, according to Betfair.

It was a wild four years for markets during his presidency, characterised by strained geopolitical tensions and repeated attacks on the Fed. Ultimately, however, the S&P 500 saw an impressive annualised return of 13.7% over the period.

It remains to be seen what the outcome will be, with a lot still to play for. But at the end of the day, a bad midterm for both parties is a good outcome for investors.