The US midterm elections take place in three weeks' time and markets will be "closely watching" an event which Merrill Lynch says could have "meaningful implications for fiscal policy and foreign relations". Some commentators reckon the elections could hurt stock markets; others say they will likely lift stocks to new highs; still others suggest they will have little impact either way. What gives?
All 435 seats in the House of Representatives are up for election, as are one-third of the seats in the Senate. Typically, the party in power suffers during midterm elections, with the president's party only making gains in the House three times and in the Senate five times in the 21 midterm elections that have taken place since 1934.
Next month’s elections are likely to follow that pattern. The Republicans currently hold a majority in both the Senate and the House, which has allowed them to pass markets-friendly legislation pertaining to corporate tax cuts and deregulation. That’s expected to change, with the Democrats odds-on favourites to regain control of the House of Representatives.
Betting odds suggest the Republicans will retain control of the Senate, although the party’s narrow majority (it holds 51 of the 100 Senate seats) and Donald Trump’s sagging approval ratings mean this is no sure thing. The election results “could affect the likelihood of certain pro-growth measures”, says Merrill, such as making individual tax cuts permanent as well as “new incentives for retirement savings and research and development”.
More importantly, perhaps, Democrat gains might ratchet up political uncertainty, allowing them to open multiple investigations into Trump or to attempt to impeach him.
Given that US indices have carried global markets this year – the US stock market has gained roughly $2 trillion this year, while markets outside the US have lost an equivalent amount – the elections are likely to be watched as keenly by investors outside the US as those inside the country.
History
History offers some encouragement to concerned investors. A recent UBS analysis noted the S&P 500 has gained an average of 14.5 per cent between August and March of the last 17 midterm elections since 1950. That's more than twice the 6 per cent gain markets averaged over the same period in non-election years. Stocks tended to decline in the months running up to the elections, UBS found, only to take off from October onwards.
Markets hate uncertainty, the theory goes, resulting in the S&P 500’s price/earnings ratio tending to be about 10 per cent below appropriate levels prior to the elections. Once that uncertainty is resolved, valuations rebound and stocks head higher, with growth-oriented stocks especially benefitting. This happens irrespective of the outcome. In fact, stocks have actually tended to enjoy slightly bigger gains on the occasions where the president’s party lost either the House, the Senate or both.
The UBS analysis is echoed by Goldman Sachs, which found stocks tend to stagnate in the May-September period of a midterm election year before then taking off, gaining an average of 8 per cent over the subsequent October-December period. This excellent three-month period is also noted by Deutsche Bank, which points out that only once in the last 21 midterm election years have stocks actually declined over the October-December period. There are some caveats, however. Firstly, history is a guide, not a guarantee, and 2018 has already bucked historical precedent in that, instead of stagnating, stocks have enjoyed strong gains recently, advancing in each of the five months between April and August.
Secondly, although UBS points to the traditional midterm rebound in valuation ratios as evidence that the resolution of political uncertainty is the driver of market gains, Deutsche Bank suggests other factors may be at play. S&P 500 returns around midterm elections are strongly correlated to changes in the Institute for Supply Management’s activity index, it says, which “suggests that it was growth and not the midterm elections per se that was the key driver of the rallies”.
Impeachment
Doubters might also argue the political stakes are higher in 2018 than in normal years. In September, the odds that Trump would be impeached in his first term hit a new high of 47 per cent on the predictions market website PredictIt.
Including dividends, the S&P 500 has gained 40 per cent since Trump was elected in November 2016, with the US president warning stocks would crash and “everyone would be very poor” in the event he was impeached. Still, the S&P 500’s strong performance in recent months suggest investors are not unduly bothered either way.
They are right to be nonchalant, according to a recent note by Barclays' William Hobbs. Yes, stocks fell heavily in the period surrounding Richard Nixon's impeachment process in 1973-74, but the main driver was the global oil price shock rather than politics, says Hobbs. Similarly, bullish economic sentiment meant stocks soared higher when Bill Clinton faced the threat of impeachment in 1998-99. The "wider economic context matters most for capital markets", says Hobbs.
That's echoed by Dr John Cochrane, a right-leaning economist at Stanford. "Impeachment would mean that we just sit and yell at each other for a couple of years," says Cochrane. "Markets respond to economics. If the economy is going well, markets will do fine." Financial markets' tendency to shrug off political controversy has only grown more obvious during the current administration, to the extent that one might wonder if markets are now immune to political upheaval. In August, Trump's political fortunes hit new lows after his lawyer, Michael Cohen, pleaded guilty to financial crimes on the same day that his former campaign chairman, Paul Manafort, was convicted of fraud charges. Within a week, however, the S&P 500 had hit fresh all-time highs.
Volatility
That’s not to say the midterms are incapable of catalysing volatility. The consensus is the Democrats will retake the House of Representatives but that the Republicans will retain control of the Senate, an outcome that would likely be greeted with relief by markets. Stocks may take a tumble should the Democrats also win a surprising majority in the Senate, but political uncertainty is not going to undo the corporate tax cuts and the deregulatory measures that have already been enacted.
"Even if the unthinkable occurs and Donald Trump is driven from office, the context of the overall market will remain very much the same," says Dr Sam Natapoff of Empire Global Ventures. His likely replacement, vice-president Mike Pence, would continue market-friendly policies "but without President Trump's 'threat to the Republic' elan".
That's echoed by William Hobbs. The so-called Trump rally mainly has its roots in the period before rather than after the 2017 presidential election, he says, and is based on favourable economic factors. "The forward momentum of the world economy, and therefore its capital markets, has little to do with the actions of the White House, " says Hobbs. "We doubt that capital markets would collapse if President Trump's administration was endangered, either electorally or indeed legally."
