Midterm elections: A policy playbook for a divided government
Under a divided government, investors may find more value in targeted policy themes than in a simple “red versus blue” market playbook.
Midterm elections often reshape market expectations, but they rarely rewrite the investment playbook.
Prediction markets suggest Democrats could regain control of the House of Representatives in November while Republicans retain the Senate.1 Expected slim majorities in both chambers likely will limit the potential for sweeping legislation.
But policy priorities, demand trends, budget negotiations, and regulatory developments still could create targeted opportunities across sectors and asset classes under a divided government.
Here are five midterm-driven policy themes investors may want to consider:
AI/Technology: A durable theme in any outcome
AI remains a strategic priority for both parties, given its importance to national security, economic competitiveness, and the broader push for US self-sufficiency. At the same time, rising concerns about AI’s impact on jobs, power demand, and consumer prices are likely to keep the technology in the political spotlight.2
As policymakers respond to these concerns, AI regulation could become a more prominent policy issue. Debate could focus on proposals to regulate or tax AI providers as well as restrictions on data center proliferation. This could layer in near-term headline driven volatility, all at a time where the tech sector relative volatility is rising and currently trading in the 100th percentile over the last 10 years.3 Even so, the AI capital spending cycle, public-private partnerships, and strong revenue growth may continue to support the broader investment theme.
With AI-related technology structurally supported, but regulatory scrutiny rising, consider:
- State Street® SPDR® S&P Semiconductor ETF (XSD) for targeted exposure to semiconductor companies, which are both key inputs to AI development and critical to national security priorities
- State Street® SPDR Portfolio Nasdaq 100 ETF (QNDX) for a core strategy with a growth bias and focus on innovation leaders related to AI and other transformative technologies
- State Street® Technology Select Sector SPDR® Premium Income ETF (XLKI) for exposure to the broader tech sector that seeks to turn the potential elevated risk premium into current income
Financials: Inaction may be a tailwind
For Financials, the key policy takeaway from divided government may be continuity. Many financial regulatory decisions sit outside Congress, with agencies such as the Federal Reserve (Fed), FDIC, and SEC playing central roles. And a divided Congress also is unlikely to derail favorable regulatory rules on the horizon. For example, the new capital rules released in March that are likely to become effective by the end of the year free up capital on bank balance sheets,4 providing banks with more flexibility to pursue higher-return initiatives.
This could help to extend the current fundamental momentum for Financials and banks. In Q2, 99% of financial firms either beat or exceeded expectations as the sector posted 21% earnings-per-share growth.5 Expectations have also been revised higher for full-year 2026 and 2027. In fact, Financials has seen the largest upside revision to 2027 earnings expectations following the Q2 reporting season.6
To position for the likelihood that the status quo continues, consider:
- State Street® Financial Select Sector SPDR® ETF (XLF) for broad-based large cap Financials exposure
- State Street® SPDR® S&P Bank ETF (KBE) for targeted banking industry exposure across the market cap spectrum
Defense spending should remain supported
Similar to AI, a divided government may alter the pace of defense spending without reversing the broader defense uptrend of recent years.
Defense spending rose by 40% over the past five years to $950 billion at the end of 2025.7 And the administration has requested a roughly $1.5 trillion defense budget for 2027—the highest level in history and the sharpest year-over-year increase (+60%) ever (Figure 2).8
While the final budget likely will come in below that request, defense spending should still trend higher as geopolitical tensions, national self-sufficiency priorities, and rearmament needs continue to support demand.
In fact, the administration has made specific defense modernization funding requests, including the $18 billion for the operationalizing of the Golden Dome, a next-generation, space-based missile defense and sensor shield.9
These factors also continue to support defense outlays:
- Defense spending has increased by more than $300 billion over the past decade, across periods of divided and unified governments.10
- Geopolitical risk remains elevated, and the Pentagon has asked defense firms to increase production of key systems.11
Greater spending has meant more revenue for firms in the Aerospace & Defense industry. In Q2, Aerospace & Defense firms grew earnings by 44% this year (one of the drivers behind the industry outperforming the broader equity market by 9% in 2026) and its fifth consecutive quarter of double-digit growth (a time period coinciding with the industry outperforming the broader market by 41% since the start President Trump’s second term).12
Because a divided government may be divided on defense spending, consider:
- State Street® SPDR® S&P Aerospace & Defense ETF (XAR) for targeted Aerospace & Defense industry exposure throughout the market cap spectrum
- State Street® SPDR® S&P Kensho Future Security ETF (FITE) for a thematic allocation focused on both select traditional and next-generation defense systems makers
Energy politics: From production to power demand
The energy sector has posted strong gains over the past year (41% versus 21% for the S&P 500 Index) supported by broader macro shifts affecting supply chains, production, and inventories.13
But the tailwinds behind Energy’s recent outperformance may become less concentrated. Consensus expectations suggest a sharp moderation ahead, with the energy sector poised to post the strongest earnings growth in 2026 (+77%) and the weakest earnings growth (-11%) in 2027.14
Rising electricity demand from AI data centers and cloud computing is adding pressure on the power grid, putting renewables at the center of both grid-capacity needs and the broader debate over alternative sources of energy and affordability.
That backdrop could make the midterms another hurdle for a repeat double-digit year of broad energy sector outperformance. It is also unlikely to lessen sector’s volatility profile, where relative volatility levels are currently trading above their 10-year averages—a byproduct of the fragmented macro regime.15
A divided government could increase legislative headwinds for additional fossil fuel deregulation, while creating more support for renewable power, grid investment, and utility exposure.
For this shift in the energy debate, consider:
- State Street® SPDR® S&P Kensho Clean Power ETF (CNRG) for an exposure focused on renewable power generation
- State Street® Energy Select Sector SPDR® Premium Income ETF (XLEI) for an energy exposure that seeks to turn the sector’s potential elevated risk premium into current income
Don’t expect a reset of the macro regime
Each policy discussion above targets a specific market segment. But the bigger question is whether the midterms will change the macro regime itself. The answer is likely no.
The forces shaping markets today—tariffs, geopolitics, deficits, and the shift from globalization toward self-sufficiency—are unlikely to be reset by a divided Congress. Gridlock may lower the odds of major legislation, but many of the policy levers driving asset volatility sit with the executive branch. As a result, while legislative uncertainty may fade, broader fiscal policy-driven volatility may persist (Figure 3).
That distinction matters for portfolios. Historically, both US large-cap and small-cap equities have posted more positive returns after midterms as the political overhang clears.16 This cycle could still follow that pattern, especially with resilient earnings and improving economic surprises supporting risk assets. In other words, the election alone may not justify a broad move to cash.
But gridlock doesn’t mean all macro risks fade. Fed policy, not Congress, will remain the main driver of rates. And deficits are unlikely to be meaningfully addressed, given slim majorities and limited political incentive to tackle spending, tax policy, or the scale of public borrowing.
That leaves investors wrestling with rising term premia, stubborn inflation, elevated Treasury supply, and fiscal credibility concerns. Bonds may continue to play an important role, but they may not be the same reliable diversifier they were in the prior disinflationary regime.
Gridlock may also create near-term volatility shocks through debt-ceiling debates or potential shutdowns. Those episodes can be disruptive, but they usually resolve. That’s why diversification may matter more when growth, inflation, rates, policy, and geopolitics are less synchronized. Portfolios built around one dominant risk factor—or relying too heavily on the traditional stock-bond relationship—may have less resilience in this environment.
In a midterm cycle likely to deliver more gridlock than a meaningful macro regime shift, consider these broad multi-asset diversifiers:
- State Street® Bridgewater® All Weather® ETF (ALLW) for a multi-asset strategy built to help investors navigate shifting economic environments by combining global stocks, bonds, commodities, and gold in a single portfolio
- State Street® Multi-Asset Real Return ETF (RLY) for a multi-asset real return strategy focused on inflation sensitive assets to help add inflation resilience and diversification to portfolios
Beyond a red-versus-blue market playbook
In a market shaped by gridlock, executive action, fiscal risk, and geopolitical uncertainty, investors may need to look beyond the election outcome and focus on policy themes where demand and fundamentals remain supported.
That makes preparing for the 2026 midterms less about predicting results and more about building portfolios that can participate in targeted opportunities, from AI infrastructure and defense modernization to financial regulation, energy demand, and multi-asset diversification.