How much do midterms matter? Morgan Stanley analyzed historical trends and third-party probabilities to rank outcomes and understand the impact for fixed income and equity markets.
With less than two months remaining before the U.S. midterm elections, pundits and prognosticators have spared little ink weighing in on the possible outcomes for House and Senate. However, for investors, the midterms are unlikely to change policies that could become headwinds for markets: namely, increasing trade protectionism and waning fiscal stimulus.
For investors, the midterm elections come down to: Will the outcome allow current policies to continue, stall them, or signal a coming reversal?
Historically, midterms have led to a calming of the policy variable, not an intensification. To examine this trend, Morgan Stanley Research recently cataloged all major legislation since 1992 that passed both houses and became law. Their findings showed that Congress was less productive in passing the president's agenda after midterms in nearly all circumstances. “Even a surprise Democratic sweep of both the House and the Senate likely would not immediately alter the investment outlook,” says Morgan Stanley U.S. Policy Strategist Michael Zezas.
Despite an extraordinary political backdrop, the course of fiscal stimulus would likely be unchanged. Trade dynamics would also largely stay the same because authority over tariffs has gradually migrated to the executive branch over the course of the 20th century. “We think Congress could take action to shift the president's strategy on trade, but only if the market or economic reaction is widespread enough to compel them to act, regardless of who controls,” Zezas adds.
This isn't to say investors should be ambivalent about election day. Rather, it's important to look past the political rhetoric to see how changing tides could help or hinder asset classes. “For investors, we argue the midterm elections come down to the following question: Will the outcome allow the current policy agenda to continue, stall it, or signal its coming reversal?” says Zezas.
Probabilities, Policies and Purse Strings
To understand how midterms may sway the current policy agenda, Zezas and his colleagues first analyzed historical trends in post-midterm election legislative activity, then used an average of third-party probabilities to rank the likelihood of various election outcomes. Finally, they considered the policies most impacted by those results—along with the key implications for fixed income and equity markets.
Here are the three likely outcomes and their investment implications, in order of probability.
Blue House (Senate: Republican, House: Democrat)
As with every midterm, all 435 seats in the House of Representatives are up for grabs, and some polling suggests Democrats will regain control of the House. The party needs to gain 23 seats, and experts believe nearly 70 seats are in play. The math is more difficult for Democrats in the Senate, where they must defend 26 seats versus 9 for Republicans.
Market impact: A Democratic House will likely have a muted effect on equity markets since most legislation would be routine or need bipartisan support to pass. Morgan Stanley believes trade tensions would continue, while spending would not change materially.
“This is good for U.S. Treasury rates, which we think have priced-in the current deficit trajectory. However it’s more challenging for the U.S. dollar, which could weaken as deficits expand into tightening global liquidity,” says Zezas.
Democrats are favored to win the House but not the Senate
Midterm Elections 2018 by the Numbers
|23||Number of seats Democrats need to win the House|
|30||House seats ranked as toss-ups|
|+8.2||Democratic margin in generic ballot|
|70%||Third-party average probabilities that Democrats win the House|
|26 v 9||Senate seats Democrats are defending vs. seats Republicans are defending|
|8||Senate seats ranked as toss-ups|
|15%||PredictWise odds that Democrats win the Senate|
Red Repeat (Senate: Republican, House: Republican)
Republicans appear to be the underdogs for the House, but if they do buck the odds and keep control of the House and Senate they may try to extend individual tax cuts and pursue other technical tax changes.
Market impact: Such an outcome would likely be neutral for U.S. equities as a whole, but could be mildly bullish for pharmaceuticals, healthcare services, REITs and telecoms; it would be somewhat bearish for U.S. Treasury rates, U.S. corporate credits and emerging markets.
“A Republican win keeps deregulation on track by limiting risk of Congressional interference in confirmations,” notes Chief U.S. Equity Strategist Mike Wilson. “It also limits risk of legislative curbs to drug pricing, and opens the door to using budget reconciliation to extend tax cuts, pass tax corrections and repeal the Affordable Care Act.”
It could also improve the odds of further fiscal stimulus, but investors should view this in context. “Given we are fresh off a round of stimulus, we doubt the magnitude of any incremental spending will be enough to meaningfully offset expected economic deceleration in 2019,” says Zezas, noting that more spending could ultimately be a negative for equities.
Blue Sweep (Senate: Democrat, House: Democrat)
Although Democrats appear to be gaining traction, a Blue Sweep faces an uphill battle. In addition, even if Democrats did take control of both Houses, they would still lack enough votes to override a potential presidential veto or end a filibuster.
Market impact: A Blue Sweep doesn't immediately shift policy, but it could mellow trade protectionism and pave the way for rollbacks of deregulation and fiscal stimulus—and raise expectations for a more progressive agenda a few years down the road. This could challenge pharmaceuticals, telecom, and REITs, among other sectors while benefiting U.S. Treasuries.
Putting Politics in Perspective
Regardless of what happens this election cycle, investors should not let politics cloud their views of what matters most for equity markets—fundamentals. “A lack of realistic high stakes policy outcomes that are material for equity markets means there is not a lot priced-in that could change based on election outcomes in November,” says Wilson, adding that investors who ignored political volatility in 2016 and 2017 were well served.
“Outside of trade policy, we suspect that most of the policy changes in the realm of possibility will actually not alter the course of these fundamental variables all that much, and so we will prefer to spend our time reviewing incoming data and earnings reports instead of parsing polls and sentiment on Sunday morning news shows.”