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US Midterms Fulfill Market Expectations for a Divided Congress

Published November 07, 2018

In his first real electoral test since 2016, Donald Trump appears to be more beholden to historical norms than he might like to admit. The performance of his Republican party remained in line with past trends, suggesting that traditional polling continues to be useful in predicting US political outcomes. With a strong economy and a relatively unpopular president, the US electorate re-established its historical baseline, namely divided government.

While this virtually guarantees gridlock at the federal level, the likelihood of fewer policy surprises, more focus on domestic politics and greater importance of macro fundamentals means this election outcome should be positive for markets in the near term. Muted market reaction to the election suggested that a retake of the House by Democrats and continued Republican hold on the Senate were both priced in.

Returning to Electoral Norms

The House of Representatives vote is the most noteworthy, because Democrats have regained control with an addition of 33-34 seats. Figure 1 shows how election outcomes correspond to presidential approval ratings, with this latest result astonishingly close to the historical trend.

Why Does This Matter?

First, the outcome suggests that despite shifting the priorities of the Republican party and deploying unconventional tactics, Trump remains bound to historical norms around US voter preferences for shared power. That is the central insight from this result: the loss of total Republican control of Congress should somewhat constrain Trump’s potential for erratic behavior.

Second, the Democratic takeover of the House could exacerbate legislative gridlock and intensify Congressional oversight of the Trump administration. There are numerous allegations of impropriety, possibly criminal activity, among cabinet officials. A relentless stream of investigations into these allegations could distract or weaken the president’s agenda; not least, the Mueller investigation will be permitted to unfold, possibly exposing individual vulnerabilities. Under such circumstances, Trump’s room for manoeuver should shrink, though it is important to note that aside from tax reform this has been a fairly quiet legislative period.

Third, the midterm outcome does not affect the likelihood of Trump’s re-election prospects. That said, his 2016 victory relied on a very narrow majority in swing states. Three of the four most critical states – Pennsylvania, Michigan and Wisconsin – elected Democratic senators and governors in this latest election. Only Florida remained Republican but by the narrowest margin. In 2020, we expect turnout among Democrats would be at least equal if not higher than yesterday. In short, Trump may need to do more than rely on his base and a favorable economic backdrop to win in 2020.

Political Current Appears to Shift Away From Trump

To understand the importance of yesterday’s voting, we need to look beyond the House races to the Senate, governor and referenda contests. In line with polls, the Republicans were able to expand their majority in the Senate, adding two or three seats net. Trump has already taken credit for securing the Senate victory, pointing out that most of his campaign rallies took place in states where Republicans ultimately won. However, this ignores the fact that these campaigns were largely in deeply red states where his approval rating hovers near or above 50%. In other words, the Senate result does not contradict the House result.

More importantly, the gubernatorial races suggest that the political current has shifted away from Trump. The Democrats gained seven governorships net, restoring a more balanced distribution of 23-27 governorships across the country. This matters for the redistricting ahead of the 2020 elections and the mobilization of local voters. In addition, several ballot measures were passed that could further boost turnout in key swing states. For example, Florida restored voting rights to roughly 1.5 million former felons, and Michigan approved gerrymandering reforms and same-day voter registration.

Female Representation Surges

Another noteworthy trend has been the surge in female representation in Congress, with over 100 women expected to take their seats in the House of Representatives, in addition to 20 in the Senate. At about 23%, the US now ranks 26th among the 36 OECD countries, up from 31st place, in its proportion of female parliamentarians. 

Markets Should Benefit as Macro Becomes More Important

Initial market reaction has been positive as the outcome fulfilled expectations. While the chance of gridlock in Congress is higher, the result also reduces the probability of negative policy surprises. This increases the importance of macroeconomic fundamentals as a driver of equity performance. Since 1946, the S&P 500 has delivered positive returns in every 12-month period following a midterm election. Moreover, the fourth quarter of a midterm year typically generates the highest return of that year. While the past is not always a guide to the future, given the October drawdown and a stable election outcome, we think there is a strong likelihood of markets adhering to a similar pattern.

US-China Trade Tensions Could Lessen

We also think the result could help improve the trade stand-off between the US and China. While trade policy is one of the few domains in which US presidents can exercise executive power, the politics of the midterm result favors a course correction. With the arrival of several domestic challengers, Trump will refocus attention on domestic matters where he can leverage American polarization to his benefit. In this context, any Chinese proposals that offer improvement in the US trade balance and intellectual property protection could be sufficient for Trump to call a ceasefire in the trade war, at least until the dispute becomes politically useful again. This could remove a major market concern over the coming year.

 

Disclosures

The views expressed in this material are the views of Elliot Hentov through the period ended 11/07/2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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