Investors Are Missing The MidTerm Market Risks
Authored by Steve Englander via Standard Chartered Bank,
Investors are ignoring the US mid-terms so far
A big Democratic House win could shift expectations for 2020 in a less market-friendly direction, but would probably help bond markets, weaken the USD and unwind EM risk aversion
Republicans keeping the House would probably be modestly asset market- and USD-friendly
The question for investors is, how ‘big’ is a big win?
What happens if the Democrats win the mid-terms?
Investors are not paying much attention to the US mid-term elections so far. We focus on the implications of the House elections for asset markets, because the two-year cycle makes the results easier to analyse compared to the timing and composition of Senate elections, which are staggered every two years, with about a third of the Senate up for re-election this year. Given Republican electoral advantages this year, loss of the Senate would be a major negative sign for the Republican Party across the board in 2020.
How big a majority would the Democratic Party have to win in the mid-terms for investors to worry about a sharp shift further ahead in the political climate for business? We also consider what would allow the Republican Party to retain Congress and the White House in 2020.
We present four scenarios for the House. Several of these are negative for US equity markets and the USD; however, EM and other G10 currencies could benefit. The current administration’s policy moves have been very friendly to US asset markets, but may have had negative spillover abroad. Many of these effects, but not all, could be reversed if Democrats regained power.
No Democrat in the House or Senate voted in favour of the Republican tax bill last year, and there are indications that the Democratic Party’s grassroots movements are turning much more progressive. We see a real possibility that a Democratic Congress would repeal or sharply revise the tax reform bill.
If investors believe that a ‘big blue wave’ is coming, they should consider how asset markets will look, even if it takes the wave two years to reach shore. As the Electoral Heatmap points out, winning the election is less about converting voters from the other side than mobilising voters. A big Democrat win in elections that normally generate low participation would suggest that President Trump inspires more passion among his detractors than among his supporters.
Tax reform revision is very unlikely before the 2020 election, in our view. The president can veto legislation if Democrats win Congress; a veto-proof Democratic majority looks very unlikely. Of the 33 Senate seats up for election, 25 are held by Democrats or independents who lean Democratic.
Most generic polls show Democrats with a wide lead over Republicans. Republicans keeping control of the House would be a partial, but far from full, surprise. As incumbent parties typically lose seats in the mid-terms, investors must decide what would be ‘good enough’ and what would be an abysmal outcome for Republicans.
President Trump lost the popular vote in the 2016 presidential election, but had a comfortable majority in the electoral college by winning in ‘swing’ states. Despite the smaller size and larger numbers of congressional districts, similar considerations apply in the mid-terms. Figure 1 shows the Republican share of the combined Democrat + Republican vote, and the Republican House majority in the past four elections. In 2012, Republicans had a 34-seat majority with 49.3% of the vote, and in 2016 they had a 47-seat majority with 50.5% of the vote. Based on these results, a 50-50 vote split would give Republicans about a 40-seat majority. Some argue that the Republican advantage became clearer after 2012 because of their control of many states.
By contrast, the Democrats took 54.1% of the vote to win a 31-seat majority in 2006, and 55.5% of the vote to have a 78-seat majority in 2008. Most analysts think that subsequent changes to electoral districting make it even harder for Democrats to gain control. Some estimates suggest that Democrats need a 10-12% popular vote advantage to win Congress (a far bigger margin than in the 2016 presidential election); other estimates are as low as 4%.
Most generic polls show Democrats ahead – some at double-digit levels, others with a much narrower lead. But which party’s adherents are more likely to turn out to vote? Democrats probably need a 53-47 majority in the popular vote to have a real chance of gaining the House, which is in the range of many, but not all polls.
Scenarios for markets
1. Republicans keep the House
There is debate on whether Republican economic policy is good or bad in the long term, but little debate on which party is friendlier to US business. Abroad, trade and fiscal policy probably has had negative effects. If Republicans keep the House (and Senate), further fiscal stimulus for other asset market-friendly measures could be implemented. With the S&P north of 2,800, this outcome points to a decent probability weight in market pricing, despite polls that show Democrats ahead.
FiveThirtyEight shows Democrats ahead by 47% to 40%, but as discussed, there is no direct mapping from popular vote polls to House outcomes. Given the record of incumbent setbacks in mid-term elections, keeping the House and Senate would likely keep the president’s programme in play. This should positive for the USD and the equity market; however, given the focus on stimulus and the lack of emphasis on fiscal deficits, bond yields would likely rise.
2. Republicans lose the House by less than 10 seats
Given how political parties have historically voted as blocs, we think this scenario would take meaningful legislation off the table except in emergency circumstances. The Democratic House could pass bills, but these probably would not get past the Senate. Democrats are likely to see any majority as a chance to continue their opposition and effectively block almost all legislation. While this could lead to compromise, recent congressional behaviour does not make it a likely outcome.
This scenario would likely be negative for asset-markets and the USD at first, probably on sticker shock that House control had changed, and tail risk that a Democrat house might aggressively investigate the president. But a small Democrat win in the mid-terms would probably be ‘seasonally adjusted’ into a respectable Republican showing, given that incumbent parties typically lose large numbers of seats in mid-terms; the medium-term consequences may be less than the short-term sell-off. Moreover, given the legislation already passed and what the president can do on his own discretion, the business-positive environment could remain in place. There would be no presumption of a Democratic sweep in 2020.
3. Democrats have a 10- to 35-seat win
This is the grey zone, with little chance of significant legislation and equally little clarity on what this means for 2020. It could signal an impending Democrat swing, so asset markets would likely begin to consider such risk. It could be the normal midterm swing, which could be reversed in 2020. Democrats would argue that the policy of absolute resistance is working; but it is hard to imagine a scenario in which any significant legislation gets passed. Even some of the tidying-up bills that have been passed with some bipartisan support in the current Congress might be held up if a Democratic Congress swung to the left.
4. Republicans lose by a lot – Dems have a 35+ seat majority
This would be the most difficult scenario for markets, as it would be tempting for investors to conclude that Republicans would lose in 2020. This is not the only possible scenario, in our view, but it is plausible, as it would suggest a big popular vote swing for Democrats. We see little evidence that investors are considering this scenario, so it probably would have the most dramatic effect. With such a big swing, Republicans could lose the Senate as well, in 2020 even if not 2018. Investors would have to factor in the possibility of personal and corporate income-tax increases, and a big shift in spending priorities.
Paradoxically, some investment spending and income realisation could be advanced, so activity could be supported initially and as much income as possible realised. Equity markets would probably unwind some of the post-tax reform gains, especially if individual investors took profits to lock in current tax treatment. A gradual equity market move lower, accompanied by lower Fed hike expectations and lower Treasury yields, may provide support to emerging markets, as long as the US equity move does not induce a wave of risk aversion and sharply higher volatility. Non-China EM might outperform China, because the incoming segment of the Democratic party could be sceptical of globalisation. The rest of G10 and rates-sensitive emerging markets could gain from the unwinding of tightening worries.