Midterms: Markets Are Ready For Blue Wave, Not Blue Tidal Wave

Midterm elections to the U.S. Congress have had no impact on markets or provided reasons for investors to make major changes to their investment plans historically. Rather, analysts told International Business Times, stocks have generally made gains after congressional midterms.

Amid expectations of a divided government -- with Democrats widely expected to take the House and Republicans keep the Senate -- and worries of what that would do to the markets, analysts are asking investors to let history guide them.

“It’s critical to take a step back and let history be our guide,” Oppenheimer Funds said in a note.

Wells Fargo pointed out in its note that, historically, U.S. equity markets have experienced volatility in the run-up to a significant election and then delivered positive performance following the election.

Wisdom Tree said although the configuration of relative power between and among the two houses of Congress and the White House varied greatly over four decades, equity returns were consistently strong post the midterms.

“Total returns for the S&P 500 index in the calendar year following midterm elections suggest changing configurations in Congress rarely spell trouble for stocks,” it said in a note.

Analysts have said they expect the S&P 500 to rise moderately following the U.S. midterm elections as the broader economic fundamentals remain strong. Read the story here.

“The only negative scenario is really not just a blue wave, but a blue tidal wave where there is an overwhelming majority of Democrats in the House, and the Senate also went to the Democrats,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “That's something that the market is probably not well prepared for.” But he sees “a very low probability” of this happening.

Hugh Johnson, chief investment officer at Hugh Johnson Advisors, does not expect his forecasts for S&P 500 to change because of the election, but only if it looks like there will be a change in fiscal policy relating to the outcome of the election.

“If the Democrats take over the House and Senate (unlikely), and they move toward rolling back the tax cuts (as they did in 1982 Reagan tax cuts), then I would reduce my forecasts for the U.S. economy, earnings, and stock prices,” he said. “I am not confident they can do anything that will withstand a Presidential veto. Look for less from Congress, not more.”

Wells Fargo said the president’s party has lost House seats in 35 of the past 38 midterm elections. Only Franklin D. Roosevelt (1934), Bill Clinton (1998) and George W. Bush (2002) were able to avoid this. And the size of the loss in the House has been directly related to the president’s job-approval rating.

Trump’s job approval rating has slipped in the week ending Oct. 28 to 40 percent, from a high of 45 percent reached end-January and mid-June, according to data from Gallup. This compares with a 45 percent approval rating for Barack Obama in November 2010, when Democrats lost 63 seats in the midterms.

‘BENIGN SCENARIO’

All analysts expect the baseline scenario of a divided government, with the most likely one where Democrats control the House and Republicans the Senate. Wells Fargo and ABN Amro allocate a 50 percent probability to this outcome.

Yung of BMO Wealth Management said markets are probably assuming this will most likely happen, and that it is probably “margin positive” for the markets because it provides a little bit of clarity going forward.

He expects a “benign scenario” where the Democrats take the House with about a 30-odd seat majority, as a stabilizing factor. “We are expecting more stabilization post-election,” he said.

But Yung also said if the Democrats were to pick up a massive majority -- about 60 seats or more -- in the House, it would be more concerning for the markets. It would lead to more political fighting, with very little agreement or positive fiscal developments coming out of Washington.

Here are some possible outcomes that analysts expect on key issues if Democrats were to take the House:

Spending to rise: Wells Fargo said infrastructure spending could rise, as this is something that both the president and the Democrats would agree on.

Tax reforms: Oxford Economics said there’s a solid chance that Democrats in the House will pass a tax bill that reverses some of the provisions of the Tax Cuts and Jobs Act (TCJA) that specifically benefit corporations and the wealthy, but there is no real chance of such a bill passing a Republican-controlled Senate.

Wisdom Tree said the major issues that some Democrats are running on this fall -- repealing parts of the Trump tax plan, a passage of Medicare for All, free (taxpayer-funded) college education, a $15 federal minimum wage -- will not gain traction in a Republican-run Senate.

Trump impeachment, Russia and tax investigation: Wisdom Tree said a Democrat-controlled House may well start impeachment proceedings against the president, though gaining a two-thirds majority in the Senate will be much harder.

FocusEconomics said a Democrat-controlled House may increase political instability, by renewing pressure on Trump in the Russia investigation; and likely start Congressional investigations of Trump’s potential conflicts of interest and tax dealings. However, it said the chances of Trump being forced out of office are still slim, given it would require a two-thirds majority in the Senate.

Trade: Oxford Economics said the midterms alone won’t change Trump’s course on China. Support for trade politics isn't necessarily partisan. While there has been some Congressional opposition to the trade tactics used against China, many Democrats and Republicans agree on a more protectionist stance toward Beijing.

TRUMP’S RATING KEY

Wells Fargo sees a 30 percent probability of the Republicans taking control of both the House and the Senate and a 20 percent probability of the Democratic party taking control of both the House and the Senate after the midterms.

Bill Diviney, senior economist at ABN Amro, sees a 25 percent probability for each of these scenarios.

If the Democrats take both the House and the Senate, ABN Amro said some Republicans would be more likely to turn against the president -- depending on the Trump’s approval ratings at the time. This would raise the risk that they join Democrats in voting for his removal in any impeachment proceedings.

The most important implication of the Republicans retaining both the House and the Senate would be the potential for additional fiscal stimulus once the current round runs its course in the latter half of 2019, ABN Amro added.

“With an eye on the 2020 presidential elections, and with concern among the public over the deficit much lower than it was in the Obama presidency, we believe Republicans would push for increased deficit spending to sustain economic momentum leading into the elections,” Diviney said in his note.