The US midterm elections is taking place in less than a week on 6 Nov 2018, and will increasingly come into the market’s focus.
Our base case is that the Democrats will win control of the House of Representatives, while the Republicans will retain the Senate.
Under this scenario, one key implication of a divided Congress is that the chances of additional fiscal stimulus (including major infrastructure packages or Tax Reform 2.0), which already appear unlikely, will be further diminished.
It will be difficult for both parties to compromise on major spending, and the Democrats will also be reluctant to help the Republicans’ chances in the 2020 Presidential Election.
Because our base case is in line with market expectations, we see this outcome to be mostly priced in, and market reactions to this result will likely be muted.
Given the populist under-currents in the political backdrop, however, the dark horse outcome of a Republican sweep of Congress should not be ruled out.
A Republican-controlled Congress would translate to marginally higher chances for additional fiscal stimulus versus our base case, and would drive the market to price incremental strength in the US economy.
In this scenario, we could see knee-jerk reactions in terms of a stronger dollar and also a rise in long-term treasury yields.
Exhibit 1: 2018 US midterm elections – Potential outcomes and implications
Historically, we have seen increased equity volatility before midterms due to policy uncertainties.
After the midterms, however, equities tend to rally; the median performance in the fourth quarter of midterm election years is 8% (see Exhibit 2 below), significantly above the 4% median in non-election years.
That said, it is difficult to ascertain if the historical trend of a post-election rally would repeat in 2018.
While we did see a swift correction in the equity markets in October this year, it was largely attributed to concerns about peak earnings and rising rates, rather than midterm elections jitters.
Regardless of the midterm outcome, we do not see the elections being a positive catalyst for US-Sino trade tensions. The White House wields broad unilateral powers over trade, and the US trade agenda is one that enjoys (rare) bipartisan support.
With 1) the base case of a Democratic house win mostly priced into markets, 2) the dark horse scenario for a Republican sweep, which will be a near-term positive for markets, 3) and history pointing to some odds of a post-election rally, we do not see much scope for the midterm elections to be a negative catalyst for risk assets.
In terms of our asset allocation strategy, we maintain our neutral weight on US equities, and have a barbell approach favoring Defensive sectors (including Healthcare and Telecoms) and also Cyclical sectors (including Financials and Consumer Discretionary).
Exhibit 2: Historical midterm election results and S&P 500 performance
What is being contested?
In the House of Representatives, all 435 seats are up for elections. For any party to achieve a majority, 218 seats are required.
Exhibit 3: 218 seats are needed for a House majority
Currently there are 240 seats held by Republicans and 195 seats by Democrats. For the Democrats to win back the majority, they would need to gain 23 seats.
In the Senate, only 35 out of 100 seats are up for elections during this midterm, of which 26 are currently held by Democrats and 9 by Republicans.
Exhibit 4: Democrats need 2 seats to gain a majority
Source: House.gov, Bank of Singapore
The breakdown in the Senate is currently: 51 Republicans and 49 Democrats; and the Democrats will to win 2 seats to gain a majority.
Three potential outcomes and respective implications
1. DEMOCRATIC HOUSE/REPUBLICAN SENATE
(BOS Base Case)
In our base case, we see the Democrats gaining control of the House of Representatives, while the Senate majority remains with the Republicans.
This scenario is in line with market expectations.
Prediction markets currently price a ~85% chance that the Republicans retain control of the Senate, and also a ~65% chance that the Democrats will win the House.
Exhibit 5: Prediction market odds of Democratic control of Congress
Source: Predictit.org, Goldman Sachs, Bank of Singapore
Historical statistics also support this outcome, as the party with the presidency has historically lost seats during the midterm.
This has occurred in 92% of all midterms since the Civil War, with notable modern exceptions being 1998 (backlash to Clinton’s impeachment) and 2002 (reaction to 9/11).
A divided Congress will further diminish the chances of additional fiscal stimulus (such as infrastructure spending and further tax cuts) and also regulatory activity in areas such as drug pricing - as reflected by the recent correlation between pharmaceutical stocks and the likelihood of a Democratic House win in prediction markets.
Exhibit 6: Pharma stocks have tracked the likelihood of a Democratic House
Source: Factset, Predictit.org, Goldman Sachs, Bank of Singapore
Because this outcome is widely anticipated, it is mostly priced into markets and we expect a muted market reaction if it happens.
2. REPUBLICAN SWEEP
In the REPUBLICAN SWEEP scenario, the Republicans defy poll forecasts to retain control of the House and also, as widely expected, keep the Senate.
Given the populist under-currents in the US political backdrop, the dark horse outcome is a plausible one, and may surprise markets.
An aligned Republican Congress increases the chances for increased legislative activity versus our base case.
An aligned Republican Congress increases the chances for increased legislative activity versus our base case.
This translates to incrementally higher chances of additional fiscal stimulus ahead, especially as the White House would be keen to soften the economic impact of the current boost fading in 2020.
This outcome would drive expectations for a stronger US economy ahead and, as a result, we could see knee-jerk reactions in terms of a stronger dollar and higher long-term treasury yields.
3. DEMOCRAT SWEEP
In the DEMOCRAT SWEEP scenario, the Democrats gain control of both the House and Senate.
Under this surprise scenario of a Democrat-controlled Congress, the likelihood of additional fiscal stimulus would be most diminished versus other potential outcomes.
The risks of investigations and impeachment of the President would also rise, which could portend increased market volatility ahead.
Another implication is the US debt limit, as it could be more challenging for the Republican White House to extend the US’ current spending authority with a Democratic Congress, which is necessary as the US is forecasted to reach the debt limit next year.
One should remember that related shutdown fears in 2011 and 2013 had weighed on markets under the divided government of a Democratic White House and Republican Congress.
If the DEMOCRAT SWEEP scenario comes to bear, we could see some near-term market volatility, and the US dollar could also see some pressure as the markets further price down the odds of additional stimulus.
Implications on trade
Given that the President wields broad unilateral powers over trade and that the issue enjoys bipartisan support, we do not see the trade tensions between US and China getting meaningfully resolved with any of the above scenarios being direct catalysts.
If anything, a more obvious negative impact from trade tariffs on the US market or economy could be more persuasive for President Trump to change his current trajectory on trade than a weaker-than-expected showing in the US midterms.
That said, we believe that the Chinese would be more likely to initiate serious negotiations after the midterms, as they would want to see how the political dice fall and obtain more clarity on President Trump’s political situation before doing so.
With the Fourth Plenum of the 19th Communist Party Congress, and a potential Xi-Trump meeting coming up in November during the G20 meeting, there are some opportunities for both sides to reassess their stand on trade and also strike a more conciliatory tone.Disclaimer applicable to recommendation
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