Democrats take the House, Republicans keep the Senate
After months of a contentious and fierce political battle, one source of investor anxiety is mostly behind us.
As it stands, some votes still need to be counted in the tightest districts, but it’s safe to say that we have a split Congress in Washington. The Democrats managed to pick up at least 26 house seats – which takes them to a slight majority for the first time in eight years. The Republicans likely strengthened their foothold in the Senate winning at least 2 additional seats in key toss-up races.
Stock market reaction
The immediate market response is positive as U.S. equity markets opened higher this morning. Leading up to the election, however, markets were volatile. This is not uncommon ahead of mid-term elections, which have historically coincided with market drawdowns or seasonal weakness.
Now that the election is over, we expect stocks to continue their upward advance. While past performance is no guarantee of future results, in the post-WWII era, stocks have historically moved higher in the 12 months following the midterm elections. This is likely because the Presidents tend to focus on pro-growth policies in preparation for their own election. Additionally, the market tends to follow its fundamental drivers over the long term – the economy and profits. We don’t expect this time to be different.
Performance of the S&P 500 Index in mid-term election years (1946-2018)
Sources: Bloomberg, Standard and Poor’s (S&P), New York Life Investments, 8/17/18. Returns are calculated using only pricing based on the day of the mid-term election in that year. The S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stock market performance. Past performance is not a guarantee of future results. An investment cannot be made directly in an index.
In our view, elections and new governments generally do not have immediate impacts on the macro economy. The major overhaul to the tax code (including tax cuts) and increased federal government spending cannot easily be overturned; the ferocious pace of new jobs added to the economy each month is unlikely to be slowed by a few new congressmen and women; and, the administration’s trade negotiations and twitter feed operate separately from Congress.
A divided Congress, in this case, is the least likely formation to impact the economy due to gridlock, where the two sides do not agree, so little gets done. Changes to discretionary items like taxes or healthcare seem particularly unlikely. However, a potential infrastructure bill remains a possibility. Both the Trump administration and the Democrats have been vocal supporters of a major infrastructure package.
Looking ahead, any hint of uncertainty can be a meaningful driver of volatility – especially on mandatory items. In early 2019, Congress will need to vote on the revised NAFTA agreement and a new budget. A split government raises key questions about the government’s willingness to raise the debt ceiling, which will likely require 60 votes in the Senate and thus bipartisan support.
A return to fundamentals (sort of)
With elections results in and its uncertainty behind us, the market will likely return to its fundamental drivers – the economy and profits. As such, investors are likely to focus on two core uncertainties: The Federal Reserve and China.
We see the Federal Reserve (Fed) maintaining its course of gradual interest rate hikes. A hike in December is a near certainty and another four hikes in 2019 are highly likely. The question remains—at what level will the Fed choose to stop?
The recent ‘good news’ on trade was likely a mid-term campaign strategy for the Trump administration. In fact, we find it very unlikely that the Trade deal gets fixed this year. The Trump administration is much more likely to impose additional tariffs on China than to reach a deal that rolls back or freezes tariffs; this remains to be seen. Concerned investors should expect an additional 15% on $200b to come into effect in 2019, and investors should also be prepared for additional measures that could heighten trade tensions. If China and the U.S. choose to postpone additional tariffs, this could be a breath of fresh air – albeit unlikely.
The potential for deal-making will likely increase as the Trump administration looks ahead to 2020. Deal-making could refresh old uncertainties like the debt ceiling, and it could also bring new items to the table, like infrastructure, wages, and pharmaceuticals. Shifts in sector leadership within the stock market may be in store, as a new, divided Washington gets ready for new political battles.
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