The consistency of the US electoral calendar offers a longer set of data series on how markets respond to changes in policy expectations. For first-term presidents, the third calendar year – i.e., the year after the midterms – tends to generate the highest equity returns during the four-year cycle, with an average of around 20% annual gain (covering the post-1948 period).
The common explanation for this phenomenon is that the midterms generally deliver a divided government, which ensures policy predictability in its aftermath. The upcoming year is likely to mirror this pattern, but not necessarily for the above reason.
Figure 1 illustrates the short-term pattern of equity performance six months prior to and after the midterm elections. Markets tend to gain confidence about the election outcome in October and start rallying. In 2022, too, the pre-midterms followed this pattern albeit with much more volatility. Returns for October were near 8% after dropping nearly 10% in September. This begs the question: will the post-election returns follow the same pattern?
Figure 1: Average Returns 6 Months Before and After Midterm Elections Since 1974
For financial markets, the election outcome is relatively clear in that the Republicans will gain control of at least the House of Representatives, ensuing a likely political gridlock. While it is still unclear whether Democrats will continue to control the Senate, the outcome will have limited relevance for the prospect of legislative initiatives. But this is certainly not news, as polls and President Biden’s approval rating have been signaling it for several months. This implies that market performance is likely to hinge on macro dynamics rather than on policy implications.
In the near term, this is more likely to be a headwind to risk assets before offering an entry point during the first half of 2023. From a policy perspective, a divided US Congress is likely to diminish chances of fiscal stimulus regardless of an economic downturn, and an annual fiscal drag of about 0.4% of GDP should continue through 2024 (possibly accentuated by a government shutdown). In short, we are skeptical that the classic monthly pattern will hold, whereas the annual performance should align more closely as markets recover when the economy bottoms.
Midterms Could Raise Debt Ceiling Event Risk
The composition of the US Congress will not only affect the fiscal path in the coming two years but also a slew of other issues. Foremost, the next Congressional period will need to raise the debt ceiling again. After the Congress raised the debt ceiling by US$2.5 trillion in December 2021, the renewed lifting is currently expected to be needed latest by next summer. In other words, the debt ceiling will return as a market driver a few months earlier. However, this time, the political risks of an accident are much higher. Republicans wish to tie the debt ceiling to popular changes to energy policy, whereas Democrats believe Republicans will be blamed for any market turbulence.
Over the past decade, the increased politicization of the debt ceiling has heightened market sensitivity. For instance, recent debt ceiling disputes are causing earlier and greater risk premia in the short-term Treasury market (Figure 2). However, this risk premia do not even address the tail risk of a calamitous financial accident in the political game of chicken. Only a renewed lifting of the debt ceiling during the November-December lame duck session could remove this market risk.
Figure 2: Change in 1-Month Treasury Bond Yields Around Debt Ceiling Deadline
Other Issues to Watch Out For
Foreign policy is the domain of the President, but Congress controls spending, including on foreign aid. The US has already committed to over US$40 billion in humanitarian and military aid to Ukraine and some Republicans have warned that future funding would be reduced. Even in such a scenario, we do not see a material impact on the outcome of the war, as future funding would only reach Ukraine by mid-2023 (at the earliest) when the battlefield is likely to have stabilized.
Other issues to monitor include the politicization of ESG regulation. While meaningful changes are emanating at the state level, a Republican Congress is likely to highlight ESG regulation and perhaps slow the pace of decisions over the course of 2023-24. Similarly, a Fed-induced recession in 2023 could invite more Congressional scrutiny. Only one seat on the Fed’s Board of Governors needs to be filled during the next Congressional session, but high inflation and a downturn expose the Fed to greater politicization.
Finally, the US midterms should set out the risks of a constitutional crisis in the 2024 elections. Here the outcomes of governor races in key swing states (such as Arizona, Nevada, Pennsylvania and Wisconsin) matter and will serve as signposts for the institutional integrity of the next presidential election.
In contrast to previous US midterms and despite the recent market rally, we caution to wait for a later entry point into equities. In 2018, equities bottomed just around the date of the final rate hike, not before. An annual outperformance in 2023 is likely, but there is more monetary tightening to come before a market bottom. Risks around debt ceiling may provide opportunities to sell short-term Treasuries and together with global geopolitics, this justifies adding some tail risk insurance.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.
The views expressed in this material are the views of Elliot Hentov through 03 November 2022 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.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
All information is from State Street Global Advisors unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Past performance is not a guarantee of future results. Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
For EMEA Distribution: The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.
Images of NYSE Group, Inc. are used with permission of NYSE Group, Inc. Neither NYSE Group, Inc. nor its affiliated companies sponsor, approve of or endorse the contents of this program. Neither NYSE Group, Inc. nor its affiliated companies recommend or make any representation as to possible benefits from any securities or investments.