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

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, while polls remain open in some states. 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.

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.

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.

A gridlock scenario "does eliminate a bit of uncertainty," said Mona Mahajan, senior investment strategist at Edward Jones. "Some of the trends around fiscal spending and tax reforms had been concerning to some investors, especially in this inflationary environment."

"More broadly, it gives companies an opportunity to prepare, plan, budget knowing that there may not be new legislation, regulations, tax reforms etc passed in this environment," Mahajan said.

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.

A Republican Congress could end fiscal stimulus and make "the Fed's job a little bit easier to break inflation," said Troy Gayeski, chief market strategist at FS Investments.

Ahead of the election results, the S&P 500 finished up 0.6% on Tuesday. 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.

"If the Republicans really gain some power here, in the House and Senate, they can make (raising the federal debt ceiling) a really difficult process," said Tim Ghriskey, senior portfolio strategist at Ingalls & Snyder in New York.

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.

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.

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."