Morgan Stanley
  • Wealth Management
  • Nov 5, 2018

Three Ways Midterms Could Impact Markets and the Economy

Tuesday’s U.S. elections could influence how long the current economic upswing lasts and what happens when it ends.

With the S&P 500 down 7% in October and market leadership shifting from the growth style to value style, it seems increasingly clear that the end of this long period of economic growth may be in sight. The midterm elections may provide the next catalyst that either brings the conclusion of the current business cycle into clearer focus or extends it even longer.

For example, if the Republican Party retains control of both the House of Representatives and the Senate (not considered the most probable outcome), that could lead to more fiscal stimulus, prolonging the economic cycle. But it could also result in a more abrupt end to the cycle if inflation spikes and the Federal Reserve gets more aggressive about raising rates.

Alternatively, if there is a Democratic majority in the House, but the Senate remains Republican (that’s the consensus view), the economic cycle may end sooner, but wind down more gradually. We may see what’s known as stagflation—when growth cools, but inflation rises. That’s not great, but it could mean the Federal Reserve dials back on plans to raise interest rates, a positive for equities.

The connections between public policy and public markets aren’t always direct. However, there are three key policy areas where the midterms could have an impact on the economy and markets:

  • Fiscal Stimulus: Should Republicans keep majorities in both chambers of Congress, odds are decent that there would be continued spending and stimulus—perhaps even another tax cut. More fiscal stimulus could cause the economy to overheat, which might lead to a more abrupt end to the current economic cycle than if the economy had the opportunity to gradually cool. That stimulus would also likely lead to bigger deficits, which can correlate with higher interest rates.
  • Interest rates. Inflation has been rising this year, prompting the Federal Reserve to raise interest rates. It is expected to continue to hike rates into next year, which would tap the breaks on economic growth, taming inflation. If Congress is divided, there probably wouldn’t be more stimulus, the economy would cool and that could influence the Fed to pull back on some of its rate hike plans. That could be positive for equities since stock valuations typically rise when interest rates dip.
  • Dollar Strength: If Republicans stay in control of both the House and the Senate, the dollar would likely strengthen as markets anticipated more fiscal stimulus and higher interest rates. Dollar strength isn’t usually a plus for U.S. equities since it makes U.S. products and services more expensive overseas (and foreign products cheaper domestically). But if Republicans lose the House and fiscal stimulus isn’t increased, the Federal Reserve might pause its hiking plans, which could weaken the dollar.

Bottom Line: Neither of the two midterm scenarios I’ve described are great for markets, which I expect to remain range-bound and volatile this year. However, markets usually benefit when there is gridlock in Washington. A strong Democratic showing could lead to a downtrend in the dollar that may provide opportunities in emerging markets and commodities. Either way, watch the dollar’s reaction to election results. It may hold the key to what comes next.