US midterms: What would gridlock mean for markets?

Midterm elections in the US decide which party controls the Senate and the House of Representatives. If a sitting president loses control of both chambers, they are usually hamstrung in how much of their agenda they can implement.

Election day is set for November 8, so the race has now begun in earnest.

The Democrats currently have a narrow grip on both the House and the Senate, but even in this supposedly commanding position, the Biden administration has experienced some difficulty getting legislation passed.

What do American voters really care about?

​Given high gas prices, rising inflation and the President’s low approval rating, the Republicans want to make this election a referendum on Biden. As has become routine, they are centring their messaging on emotive issues like illegal immigration[1] and crime which appears to be yielding more favourable betting odds recently. Over the summer, some key developments appeared to tip the scales toward the Democrats, before losing steam somewhat as we entered autumn.

The so-called ‘Dobbs decision’ by the Supreme Court to effectively overturn the Federal right to abortion could spark increased turnout from voters[2], while Biden’s decision to follow through on his campaign promise to cancel student debt appears popular, particularly amongst younger voters.

Fuel prices have also fallen slightly, which will disproportionately affect the median US voter, although prices remain high relative to historic levels. There has traditionally been an inverse relationship between gas prices and the success of the president’s party in midterms.

Meanwhile, former president Donald Trump’s ongoing campaigning could both energise Democrat voters and sway independent voters. Candidate quality is an issue in this election: numerous candidates perceived to have extreme views have been successful in the Republican primaries. Nonetheless, dynamics in previous midterms have not tended to favour the party in the White House, as we will explore below.

What are the bookies saying?

With a backdrop of high inflation, high fuel prices, controversy over reproductive rights and the ongoing fallout from the 6 January Capitol attack, this could prove to be one of the most divisive midterm elections on record. So it’s a difficult one to predict.

That has not stopped punters from trying: betting odds suggest the GOP are likely to gain control of the House, and as of the last few day, the Senate also.

In the last three midterm elections, Republicans have tended to improve their positioning by around 3-4 points between Labour Day (the first Monday in September) and the election, which we have seen play out in recent weeks. Additionally, since 1954, the party in control of the White House has managed to gain seats in the house in a Midterm Election on only one occasion (2002).

These are bad omens for Democrats, so they will be hoping some of the factors mentioned above will motivate their voters to come out, although this would buck the trend of recent midterms.

What does this mean for markets?

Historically, the S&P 500 Index surges into the midterms and in the months following them:

However, there remains the small matter of stubborn inflation and a potential recession in 2023 – the consensus view among economists. Historically, the two post-war elections where inflation was accelerating – 1974 and 1978 – were the two where the S&P 500 failed to rally[1].

Markets tend to favour gridlock in Congress.

The only outcome that could, we believe, see anything meaningful passed through Congress would a clean sweep by the Democrats. Again, this is unlikely based on current betting, but if the democrats manage to win the House, it’s almost certain that they will win the Senate, and may even add a couple of seats. If they reached 52 seats or more Senate seats, this would be enough to remove the influence of current senators Joe Manchin and Kyrsten Sinema, two of the more right-of-centre leaning Democrats. If this does happen, we would expect an expansion of some of the party’s social spending agenda such as the Child Tax Credit, which is set to expire in December 2025.

We could also see the Biden administration implement tax hikes on the wealthy and on large corporations. Essentially, the more unfettered a party emerges from an election, the more markets tend to react unfavourably initially, so we would expect a worse reaction to this typically then a situation with a tighter  margin in the house, or gridlock. This of course has no real bearing on the longer-term effect of a controlling party’s policies on the economy or markets which unfurl over time.

How could things differ this time? Gridlock in Congress makes it more difficult to effect fiscal policy measures, so at a time when the US might be heading for recession, markets might favour a Democrat majority in Congress.

We expect to see an increase in attention paid to the midterms in the coming weeks, which could throw more uncertainty onto an already murky backdrop.

Regardless, we will monitor developments and follow our mantra to prepare and not to predict. We currently maintain our slightly positive view on equities while monitoring several key indicators.

[1] Source: LGIM, Bloomberg as at 30 September 2022

[1] https://www.reuters.com/world/us/tears-uncertainty-migrants-depart-marthas-vineyard-amid-political-standoff-2022-09-16/

[2] https://www.politico.com/news/2022/08/02/kansas-voters-block-effort-to-ban-abortion-in-state-constitutional-amendment-vote-00049442