LCG Research: How will markets respond to US midterm elections? By Jasper Lawler, Head of Research

 

Background
The markets will be watching the US midterm elections closely on Tuesday. Midterms are not typically a major market event but under President Trump- this time could be different! Policy decisions that could impact on the economy, consumer spending and corporate decision making will hinge on the outcome. So as America heads to the polls on 6th November, what will it be? Political gridlock, Democratic sweep or Republicans gain seats?

Who is up for election?
Both Chambers in the US Congress. The full House of Representatives, whose members serve two years. One third of the Senate, where Senators serve a staggered six-year term. 35 Senate seats are in play.

What does History say?
It is usual for the party occupying the White House to suffer a net loss of seats in the midterm elections. This has been the case in all but 2 mid term elections from 1946 to 2014

What do the polls say?
House of Representatives: Polls are pointing to history repeating itself. The polls suggest that the Democrats will take the House of Representatives. FiveThirtyEight has the Democrats with a 6 in 7 chance of achieving this.

Senate: Owing to the Senate cycle, most of the seats up for grabs are already held by Democrats. Just 9 of the 35 Senate seats up for election are held by Republicans, most of which are considered safe. The Senate is widely expected to remain with the Republicans with FiveThirtyEight giving the Republicans a 5 in 6 chance of holding the Senate. This means that the most likely outcome from the midterms is a split government.

What do we say?
Trump has a well-established track record of victory in the face of polls predicting his defeat. The majority of polls tracking in favour of Democrats is very reminiscent of the 2016 Presidential election. We don’t know if the Democrats can turn the House of Representatives Blue. What we can know via polling and market pricing is that the possibility of Congress staying all red is much higher the consensus.

How different asset classes could respond?

US Stocks
Split Government: Democrats flipping the House of Representatives could create some uneasiness in the US stock markets. On a more general level, a split government lends itself to political instability. Political gridlock would be expected to reduce the possibility of any major policy changes. We view part of the reason for the recent shake out in the market as investors pricing in of a divided US government. Should this be the case, the US stock market reaction could be limited under this scenario.

Democrats sweeping the board is considered highly unlikely. If it were to happen it would take the market completely by surprise and push US stocks lower. An all-out Democrat win would increase the chances of the tax reforms being rolled back and impeachment proceedings being started, neither of which are market friendly.

Republicans retaining control of both houses, especially since it is not considered likely, should be positive for US equities. Relief at a resumption of the status quo could see the US stock markets regain some of the heavy losses from October. Once the dust has setted, the effect may be more nuanced since further stimulation of the economy under an unimpeded Trump White House could encourage the Fed to steepen their planned path of rate rises. Higher expectations for interest rates and higher borrowing costs hinder corporate growth, dampening demand for equities. In an all-out Republican win, the markets will keep a close eye on the Fed’s next steps.

The Dollar
Split Government: Should the Democrats flip the House of Representatives; a split government should be considered dollar negative. We think it best to view the election through the prism of bond yields. Higher spending and the trade war are expected to be inflationary and have pushed up yields under Trump and a Republican Congress. Higher yields have been the biggest worry for US equity investors this year. The other consideration under a split government, is the prospect of a complete government shutdown as we saw in 2011 and 2013. If the Democrats use the threat of a government shutdown as a tool for negotiations, then we could see demand for the dollar pick up thanks to its safe haven status.

Democrats taking all could put a negative spin on the dollar. They could try to roll back Trump’s tax cuts, but the President is likely to veto such attempts. The focus is more likely to be on the need for responsible spending and keeping debt in check. Furthermore, Democrats in both houses could help reduce tensions in trade talks with China. The safe haven dollar has benefited from the rising trade war tension. As easing of this tension could see flows leave the dollar.

Republicans gaining seats could send the dollar higher. As mentioned, any further stimulus from Trump’s administration could send the dollar soaring. However, the budget deficit will also become an increasingly concerning problem. Additionally, the increase in geopolitical tensions under Trump following his introduction of trade tariffs has seen the dollar rally thanks to its safe haven status. Extreme policies are more likely to continue under an all Republican government, boosting the dollar thanks to its safe haven.

Emerging Markets
Spilt Government: The resultant political gridlock from a divided government could cause the dollar to weaken (see above). This would be good news for emerging markets which trade inversely to the value of the dollar.

Democrats sweeping the board could see a strong rally in emerging markets. Not only would be expect the value of the dollar to ease, we would also expect trade tensions to cool. In short, a win win for emerging markets.

Republicans keeping control of both houses could send emerging markets sharply lower. As we mentioned, the dollar could continue climbing and trade tensions, which have impacted on Chinese economic growth will continue to hit emerging markets.

The information and comments provided herein under no circumstances are to be considered an offer or solicitation to invest and nothing herein should be construed as investment advice. The information provided is believed to be accurate at the date the information is produced. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Please note that 79 % of our retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing money.

 

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About the author

Jasper delivers regular commentary, seminars and webinars on market news, trading analysis, strategy and psychology. He is regularly interviewed by BBC News, Bloomberg, CNBC and Sky News, and has featured in The Times, Guardian and Daily Telegraph. Jasper hosts a weekly charting analysis webinar. He is qualified as a Chartered Market Technician (CMT) with the Market Technician Association, and has a degree in Finance and Economics.