The US midterm elections on Nov. 6 resulted in a divided Congress – commonly referred to as “gridlock” – that has several economic implications:
• President Donald Trump’s economic agenda – centered around tax reform, deregulation and renegotiated trade deals – is not likely to be altered materially. However, we now see the passing of a second tax reform bill as unlikely.
• Governing via executive orders and executive branch actions will likely continue. This implies that while we may see Democrats become more vocal in pushing back on over-reach in the president’s trade agenda, it is unlikely that Congress will achieve the bipartisan support needed to alter his approach officially.
• As 2020 draws closer, the work of Congress will shift gears increasingly toward the presidential, House and Senate elections, putting major legislative initiatives closer and closer to the back burner. As a result, we may not see much progress on either party’s agenda, as they will not want to give the other a “win” prior to the presidential election.
One of the biggest takeaways from the elections is that a Democratic House now provides some checks and balances to a Republican president and Republican Congress – or at least more vocal opposing views.
While the Democrat-controlled House could also increase its focus on legal proceedings related to President Trump – notably ahead of the 2020 presidential election – we do not ultimately believe Democrats will push for impeachment. Impeachment would require support from two-thirds of the Senate, which is highly unlikely.
There may be certain policy areas that may see a modicum of progress:
• Infrastructure. Both parties had indicated they wanted to put an infrastructure package in place. The total will likely now be less than the US$1 trillion proposed by the Democrats, and there may be debate on how to fund such a bill. However, this could be one of the few areas that appeal to both parties and their constituents.
• Drug pricing. Healthcare is an issue on which many Democrats based their elections, and both Trump and the Democrats generally favor lower drug prices. Implementing this policy would not only support the lower- and middle-income US consumer, but appeal to the president’s base as well; it would however negatively impact certain pharmaceutical and drug companies.
• Government spending. We may see less defense spending under a mixed Congress, as Trump may have to compromise to get a spending bill in place in 2019. However, the Democrats may favor higher spending in general, which seems in line with the president’s overall philosophy as well.
• Social issues. Legislators may focus more on key social issues, including gun control, addressing the opioid crisis and immigration reform. Of these, the president has expressed interest in managing the opioid epidemic and has shown some, albeit wavering, support for incremental gun control legislation.
Generally, we believe that the markets – particularly US equities – were well-positioned heading into the midterm elections, given that the S&P 500 Index had already experienced a 7 percent correction in October. This is in line with the historical narrative that the markets tend to be volatile prior to midterm elections, and then outperform in the 6-12 months after elections.
Outlook for equities
Gridlock could be positive for equities. The fiscal stimulus of tax reform and much of the deregulation agenda is already “locked in” and the Democrats may push back on some of Trump’s trade policy proposals that have weighed on markets. Markets historically moved upwards by an average of 12 percent in the 12 months after elections resulted in a split Congress and a Republican president.
Among the sectors that may fare well:
• Industrials and materials, if infrastructure reform is enacted.
• Technology, if trade tensions dissipate.
• Healthcare, since gridlock reduces the risk of major policy overhauls (excluding pharmaceutical/drug companies if reduced drug pricing is enacted).
Among the sectors that may feel pressure:
• Financials, if rates soften and Democrats push back on deregulation.
• The defense sector, if Congress reaches a compromise to restrain spending (although we may get some compromise here as well, if Democrats favor overall increased spending).
Effect on rates/currencies
We believe increased gridlock in Washington will likely dampen investors’ appetite for risk, putting downward pressure on rates. It essentially eliminates the chances of additional tax cuts, and could also portend higher spending and a regulatory environment that is less favorable for business. This would likely reduce the long-term growth outlook and create downward pressure on the US dollar.
Impact on emerging markets
Gridlock could give a small boost to developing markets, since the US dollar could soften or stabilize under the policy uncertainty created by a split Congress. The rhetoric from the Democrats may not be as protectionist in nature, particularly with regard to US allies.
What’s next after the elections?
Now that the uncertainty around midterm elections has been resolved, we believe investors will refocus on the key issues at hand for 2019. Chief among them are the Federal Reserve’s normalization path, the trade conflict with China, and whether the US decoupling from a softening global economy is sustainable. These may be the primary market drivers in the near future.
• Equities have historically done well after midterm election uncertainty has been resolved, and markets may be set up well for solid year-end performance – albeit with ongoing volatility.
• Markets tend to like gridlock, which generally means the status quo will be maintained
• Sectors that may fare well: industrials, materials, technology and healthcare.
• Sectors that may feel pressure: financials and possibly defense.
• Emerging markets could get a modest boost from a softer US dollar.
• Investors will soon refocus on broader economic issues: the US Fed, trade and global growth.
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