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Midterm Elections: What’s Next for America?

Market Thoughts 11.7.18

More than 230 years ago, as Benjamin Franklin left Independence Hall, he was asked, “Well Doctor, what have we got—a republic or a monarchy?” Franklin answered, “A republic, if you can keep it.” Yesterday, in what may have been the largest midterm election turnout in history, millions of Americans chose to keep it.

We estimate that more than 113 million free women and men exercised their right to vote yesterday. Today, some are pleased, others are disappointed, and some are just thankful for a pause in the relentless and often harsh campaign rhetoric. Hopefully, we can all claim a common victory in the privilege of participating in the process.

Across the globe, the freedom we share is far too scarce. Freedom House estimates that only 45 percent of countries, representing just 39 percent of the world’s population, are free. Regardless of the outcome—and despite the hard edges of the process—we can all take solace in our freedom to participate.

As the saying goes, “It has been said that democracy is the worst form of government, except all those other forms that have been tried from time to time.”

As of this writing at 6:00 AM EST on Wednesday, November 7, the Democrats will control the U.S. House of Representatives with 219 seats (with 23 seats still too close to call). The Republicans will control the Senate with 51 seats (with 4 seats still too close to call). The Democrats have gained 25 seats so far and are projected to win another 11 seats—for a total of a 36-seat pick-up.

Predictions showing that Democrats were favored to capture the House have come to fruition with a result that adhered to poll projections and to the historical average of a 28-seat pick-up for the minority party in a midterm election.

Historically, stock prices are volatile leading up to midterm elections. Since 1962, midterm election years have seen a peak-to-trough market selloff of nearly 19 percent on average. This year, we have seen two 10 percent selloff events. However, history holds hope for higher prices; since 1950, stocks have appreciated every time in the 12 months following a midterm election, with an average increase of more than 10 percent. So, if historical patterns hold true, investors can expect smoother sailing in the next year compared to the choppiness experienced so far in 2018.

Today, market participants are busy parsing last night’s results for potential implications to policy, markets, and even to President Trump’s reelection chances in 2020. Some of the policy impacts of a divided congress could include:

  • Initiatives with declining odds for completion. President Trump had proposed additional tax cuts and making the existing tax cuts permanent. Trump was also seeking Congressional funding to construct a border wall.
  • Initiatives with increasing odds for completion. The passage of a bill to increase infrastructure spending and new legislation or executive action to freeze or reduce drug prices appear more likely to happen.

Even before the last of the midterm confetti filters to the floor, the 2020 election cycle is beginning. A president running for reelection seeks to stimulate the economy to increase his reelection chances. Although not our base case, if President Trump is able to work with Congress to pass further economic stimulus, we could see stock prices rise—along with the risks of overstimulation and the risk of interest rates rising faster than current expectations.

Rising rates act as a constraint on the economy. For example, the current 30-year mortgage rate of approximately 5 percent is already proving to be impediment to the housing market. If mortgage rates were to climb to 6 percent, new home construction would be stymied, potentially counteracting the stimulus by contributing to slower economic growth.

A more likely scenario is gridlock. In a gridlock scenario, few new legislative initiatives are successful unless they are bipartisan. In the past, the stock market has been able to appreciate in a gridlock scenario, which can lock policy and the markets into the status quo.

If the Democrats were to regain control of the White House and both congressional chambers in 2020, might some (or all) of the tax reform legislation be rolled back? While last night’s results are evaluated—and mindful that a lot can change within the political climate over a span of two years—we want to reiterate that the U.S. economy remains strong, business confidence is high, and jobs remain plentiful. Although we continue to expect volatility to increase from the abnormally low levels of the past decade, short-term market fluctuations highlight the benefit of diversified portfolios, and history shows that investors who embrace a long-term time horizon are well rewarded.

We will continue to focus on the implications of the election results on the markets and will update you as needed.