Investors prepare for government gridlock as Republicans seen gaining in U.S. midterms

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NEW YORK — Investors are expecting Republican gains in U.S. midterm elections, a result that will likely temper Democratic spending and regulation but set up a bruising fight over raising the U.S. debt ceiling next year.

Republicans are favored to win control of the House of Representatives, polls and betting markets show, with the Senate seen as a closer call. With Democrat Joe Biden in the White House, that result would lead to a split government, an outcome that historically has been accompanied by positive long-term stock market performance.

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Republicans were favored to wrest control of the House of Representatives based on early returns in Tuesday’s midterm elections, though the prospects of a “red wave” appeared to have dimmed.

The Senate, which Democrats currently control, remained too close to call, although their flipping of a Republican-held Senate seat in Pennsylvania bolstered the party’s chances of holding the chamber.

While macroeconomic concerns and Federal Reserve monetary policy have been the dominant forces behind market moves this year, Capitol Hill politics could exert influence on asset prices.

A strong performance by Republicans would likely allay investor concerns about higher fiscal spending exacerbating inflation and raise the chances of the party freezing spending via the debt ceiling, analysts at Morgan Stanley wrote this week. That could support a rally in 10-year Treasury bonds and help stocks extend their recent gains, they said.

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“The fact that we didn’t see a Republican landslide as a lot of people had expected does now raise questions about whether or not the Democrats will maintain control of the Senate,” said Danni Hewson, financial analyst at AJ Bell in London.

“You’re in a slightly different situation and it does look like the Biden Presidency has not been dealt a massive blow by these midterm elections, so the markets are in a wait-and-see mode.”

Historically, stocks have tended to do better under a split government when a Democrat is in the White House, with investors attributing some of that performance to political gridlock that prevents major policy changes.

Average annual S&P 500 returns have been 14% in a split Congress and 13% in a Republican-held Congress under a Democratic president, according to data since 1932 analyzed by RBC Capital Markets. That compares with 10% when Democrats controlled the presidency and Congress.

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“For the markets, a grid-locked administration should be positive for equities, given that it makes the Fed’s task that little bit easier,” said Stuart Cole, head macro economist at Equiti Capital.

Ahead of the election results, the S&P 500 finished up 0.6% on Tuesday. S&P futures were flat to slightly down on Wednesday. The benchmark index has risen about 5% over the last month, cutting its year-to-date decline to about 20%.

Still, a split government could lead to heightened tensions over raising the federal debt ceiling in 2023, setting up the kind of protracted battle that led Standard & Poor’s to downgrade the U.S. credit rating for the first time in 2011, sending financial markets reeling.

“This will almost certainly be the end of the tax rises the Biden administration had been talking about imposing on U.S. corporations and the well-off,” said Cole.

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“It also means the end of the loose fiscal policy Biden had been pursuing. This is particularly important, as it removes a source of stimulus from the economy and makes the job of the Fed in getting inflation back under control that little bit easier, to the extent that it may allow for a lower terminal rate.”

U.S. Treasury yields, which move opposite to bond prices, have soared this year, but government gridlock could help contain them – and the dollar – as it relieves concerns about heightened fiscal spending that could drive inflation.

Conversely, a Democrat surprise could mean a stronger dollar and higher yields as possible fiscal expansion could require more rate increases, analysts at Morgan Stanley said.

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With the U.S. equity options market positioned for relative calm, a surprisingly strong showing by Democrats could upend markets.

Options positioning on Monday implied a decline of 1.5% in the S&P 500 on the day after the vote should Democrats pull off a stronger-than-expected showing, according to Tom Borgen-Davis, head of equity research at options market making firm Optiver.

Republican gains could boost several areas of the stock market such as pharmaceutical and biotech shares, on diminished prospects for tougher prescription drug pricing rules, while big tech stocks could benefit from less likelihood of regulatory pressure and defense on expectations of more significant spending.

Conversely, Democrats holding power could see gains for shares of clean energy and cannabis companies.

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Cryptocurrency, meanwhile, spent millions on U.S. midterm races and may hope to influence laws as policymakers push forward digital asset legislation.

PERFECT TRACK RECORD

Many strategists are quick to cite the stock market’s perfect post-midterms track record: The S&P 500 has posted a gain in each 12-month period after the midterm vote since World War Two, according to Deutsche Bank.

But some investors cautioned against expecting a repeat this time, given uncertainty over how quickly the Fed will be able to tame inflation and end its market-bruising monetary tightening.

Indeed, while the election outcome could put some uncertainty to rest, investors remain on edge about the outlook for stocks, as shown by volatility futures tied to the Cboe Volatility Index trading at historically elevated levels well into next year.

One potential catalyst for volatility comes Thursday with the U.S. consumer price report, a data point that has spurred sharp market moves throughout 2022.

“Next year’s earnings estimates are still too high, Fed policy is still tight and tightening, inflation is still too high,” said James Athey, investment director at Abrdn.

“This is all bad news for equities.”

(Reporting by Bansari Mayur Kamdar, Saqib Iqbal Ahmed, Carolina Mandl, Laura Matthews and Lewis Krauskopf; Editing by Ira Iosebashvili, Megan Davies, Jonathan Oatis and Claudia Parsons)