Soaring inflation, a hawkish Fed, and rapidly rising interest rates mean US midterm elections may depart from history in several ways. And after the votes are counted, don’t look for a post-election market rally.
Investors’ obsession with the Federal Reserve’s (Fed) fight to defeat stubborn inflation has relegated the upcoming US midterm elections on November 8 to the back page. And with ugly political divisions, an embarrassing 22% Congressional approval rating, and expectations that election results will produce even more gridlock in Washington, who could blame investors for focusing their attention on today’s most urgent economic challenge?
Yet the midterms will see all 435 House of Representatives seats and 35 of the 100 Senate seats contested, while 36 of the 50 states will elect governors. And the shifting post-midterm political landscape will likely have big and small implications for diversified investment portfolios.
2022: The Most Restrictive Monetary Policy Environment in a Midterm Election Cycle
For all the handwringing about stock market losses this year, the S&P 500 typically suffers a 19% drawdown on average in US midterm election years.1 Consequently, the incumbent party routinely loses ground in midterm elections.
While this year’s roughly 25% decline2 is in the ballpark of historical averages, it is more painful. Soaring inflation, rapidly rising interest rates, and a hawkish Fed have created a difficult backdrop for US households. As a result, Democrats (the incumbent party) are expected to lose their majority in the House of Representatives but maintain control of the Senate by a razor-thin margin.
However, beginning in 2016 with Brexit and Donald Trump’s successful presidential campaign, polling has been wildly inaccurate and shocking election outcomes have become more normal. Momentum shifts during this election cycle also have complicated predictions.
In early spring, it looked like Republicans might sweep. But the Supreme Court’s late June decision to overturn Roe v. Wade, combined with the passing of the Inflation Reduction Act in August, provided Democrats with a summer surge, raising their hopes that they could defy poor midterm expectations.
The probability that the Democrats keep control of both the House and Senate is low, but it’s not zero. And that stunning election outcome could potentially roil markets. Investors don’t like surprises or unchecked power by a single political party — they prefer gridlock. Thankfully for investors, with only a few weeks left until voters hit the polls, a split Congress looks likely.
PredictIt 2022 House and Senate Control Odds (%)
Investors desperately seeking relief from this year’s market losses might take comfort in knowing that the S&P 500 has not declined in the 12 months following a midterm election since 1950.3 Fresh off midterm election losses, the incumbent party often seeks to bolster the economy through aggressive fiscal and monetary policies. Not surprisingly, partly as a result of these stimulative policies, the US has never experienced a recession in the year following a midterm election.
Subsequent 12-month S&P 500 Price Return Following Midterm Elections
Regrettably, this time may be different. Lofty inflation is likely to keep both monetary and fiscal stimulus restrained. In fact, the Fed is expected to continue increasing interest rates to curtail rising prices. And, political gridlock reduces any chance of a significant fiscal spending package successfully making its way through Congress to President Biden’s desk for signature.
Meanwhile, with the lagged effects of at least six aggressive Fed rate hikes expected to slow the economy in 2023, the odds of the first US recession in the third year of a presidency are rapidly increasing.
Could the threat of recession motivate voters to turn out on November 8? A recent poll finds two in three registered voters see this election as more important than past midterm campaigns. Interestingly, that’s the same percentage that viewed the 2018 midterm as more important than prior elections — and voter turnout that year was the highest in a century.4
And, of course, there’s still time for an October surprise.
1 Bloomberg Finance, L.P., as of 10/12/2022.
2 Bloomberg Finance, L.P., as of 10/12/2022.
3 Bloomberg Finance, L.P., as of 10/12/2022.
4 Dan Balz, Emily Guskin and Scott Clement, “Voters divided amid intense fight for control of Congress, poll finds,” The Washington Post, September 25, 2022.
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