Election reflections: The midterms and what really matters for markets

The post-mortem of the midterm elections—what went spectacularly right for Democrats and what went horrendously wrong for Republicans—will likely go on until the run-up to the presidential election primaries in early 2028, if not longer.

There are already major disagreements within both political parties and inside the Trump administration about why the Democratic Blue Tsunami occurred and how to proceed.

Regardless of how we got here, the historical performance data debunks the adage repeated by many on Wall Street the day after the election that “the market always loves gridlock in Washington.”

Divided government has indeed coincided with well above-average returns in some scenarios, but not the one the market is facing. The stock market lagged the most when a Republican president and Democratic Congress have shared the levers of power.

Average annual S&P 500 returns since 1953 by party control

Is U.S. stock market underperformance in this scenario a fait accompli for the next two years?

The good news is that the sample size of the above data is too small to be predictive or “statistically significant,” and there is wide variation in returns in the categories.

While it’s prudent for investors to consider the historical track record, we think it’s most relevant to focus on:

• Potential policy and legislative changes—if any—that could impact the U.S. stock market in the next two years.
• How RBC Capital Markets industry analysts view the new political party configuration.
• What matters more to stock market performance than elections.

What could change and what may not

RBC Global Asset Management Inc.’s Chief Economist Eric Lascelles views the election outcome as slightly negative for U.S. economic growth and the stock market. But he points out the results may modestly constrain inflation and bond yields.

Lascelles also notes the following:

• The White House retains firm control of tariffs, foreign policy and immigration through executive authority. These policies will not be significantly altered by the new Congress.
• In the next two years, there is diminished scope for fiscal stimulus—which normally boosts economic growth.
• But there could be limited scope for fiscal measures to support lower- and middle-income households, though this is merely an upside risk rather than a forecast.
• While the Democrats have historically been the less business-friendly political party, concerns about the risk of major Democrat-led tax hikes seem overblown.
• Congressional Democrats and President Donald Trump could partner to lower prescription drug prices as both have supported this in the past.
• Republican deregulation efforts—of greatest benefit to the financial and energy sectors—may be slowed but not necessarily halted altogether. Thus far during the Trump administration, much of this has been happening through executive orders rather than legislative actions.

Helima Croft, who covers Washington policy issues closely as RBC Capital Markets, LLC’s head of global commodity strategy and Middle East and North Africa (MENA) research, doesn’t see much change for energy policy.

She highlights the following:

• President Trump still holds the power of the veto, making wholesale policy reversals unlikely.
• The election outcome probably won’t result in major changes to the president’s energy dominance agenda.
• But a wave of hearings on energy agreements involving administration insiders is likely. Democrats will seek clarification on the regime change operation in Venezuela and the subsequent energy deals.
• Democrat-led committees will also likely turn their attention to Russia. Lawmakers have already asked several banks and port authorities to provide contracts, shipping and payment records, and communications related to the diesel deal. An effort to challenge the administration’s suspension of sanctions provisions within the recently passed Graham Act is also expected.
• Clean energy developers could benefit from heightened oversight of the administration’s restrictions on offshore wind and solar approvals, alongside renewed pressure to restore cancelled federal funding. However, presidential veto authority and existing executive powers would limit Democrats’ ability to reverse the administration’s policies.
• Regarding AI data centre construction, growing concerns over electricity affordability could shift the emphasis from accelerating development to determining who bears the associated costs.

Strong opposition to AI data centres: One of the issues that impacted election outcomes, especially at state and local levels

Poll question: Would you support or oppose the building of an AI data centre in your community?

An important non-consensus view that both Lascelles and Croft share: Trump’s policy toward Iran is unlikely to change meaningfully.

Just ahead of the election, Croft wrote, “The direction of travel still seemingly points to a near-term U.S. military escalation, despite regional talks … Certainly, the risks of a more devastating Iranian retaliatory response would increase if the U.S. opts for a more sweeping military campaign.”

After the election, Lascelles noted that “with no further elections ahead during the remainder of President Trump’s final term, it is more likely that the White House will continue on his bold course” against Iran.

Therefore, we think it’s prudent to take the recent decline in oil prices with a grain of salt. Energy market participants may once again be misjudging the situation in the Middle East, banking on a resolution that might not occur in the near term.

Not much impact on most sectors

A survey during the summer revealed that RBC Capital Markets equity analysts didn’t foresee much impact on their industries under coverage in the scenario where Democrats control both the House of Representatives and Senate.

They ranked their views on a scale of +2.0 to -2.0, with +2.0 being the most bullish impact and -2.0 being the most bearish.

RBC equity analysts see full Democratic control of Congress as modestly negative for all industries combined, but there are differences by sector

RBC Capital Markets equity industry analysts’ assessment of Democratic control of the House and Senate

For all sectors combined, the survey indicated a mildly negative market performance assessment with a score of -0.35—nowhere near a very bearish score of -2.0. And the scores for most sectors had a similar negative bias.

Scores for only two sectors deviated meaningfully. Consumer Staples ranked somewhat bullish at +1.0, and the Utilities sector ranked very bearish at -2.0.

Consumer Staples and consumer stocks in other sectors could benefit from any Trump administration policy changes and/or bipartisan legislation that could offer financial relief to middle- and lower-income households who have suffered the most from inflation and the overall high cost of living. This is why we think consumer stocks rallied sharply the day after the election. Whether such policy developments actually take place, time will tell.

Regarding Utilities stocks and particularly those most leveraged to the AI data centre buildout, we don’t anticipate Trump would even consider signing legislation that would restrict data centre construction at the federal level. But the Blue Tsunami reached the state and local levels, and this is where powerful regulatory authorities could increase costs associated with data centre construction or slow down, cancel or prohibit some projects. Regulators may make it more difficult for utilities to recover data centre-related capital investments from non-AI utility customers (households and businesses) and could increasingly expect large technology firms to bear a greater share of the electricity grid investment costs than they are currently, according to RBC Capital Markets.

However, we think this has already been factored into Utilities sector share prices to at least some degree, as the sector retreated 15 percent from late July through late September partly due to the regulatory pushback that had already begun and election concerns. While the sector has rebounded somewhat since then, it remains almost nine percent below its all-time high reached in February.

What matters more than elections

Elected officials in Washington and in state capitals have the potential to positively or negatively impact the country, or their policy actions can result in a mixed bag (and often do). But when it comes to the stock market’s performance over time, they have limited influence, in our assessment.

We firmly believe four factors matter more to the U.S. equity market’s medium- and long-term performance than elections:

• Corporate innovation trends: Here we’re not just referring to the current AI boom or other advancements that have taken place in the Technology sector previously like the advent of the internet and personal computer. Most sectors and industries have experienced innovation spurts at some point. Consider the leaps in medical device and pharmaceutical technologies decades ago, or advances in oil and shale drilling as just two among many examples. We think innovation will continue to drive profit growth and share prices for many stocks in the future.
• The Federal Reserve’s monetary policy decisions: This includes good, bad and so/so interest rate policies and calibrations. When the Fed has been too slow to raise interest rates (think back to the initial post-COVID inflation wave), the economy and households have been negatively impacted. When the Fed has raised rates too much and/or too fast, that has historically exacerbated economic downturns and stock market selloffs. But when the Fed gets it right, the economy and stock market usually benefit from longer expansion cycles.
• The natural ebb-and-flow of the business cycle and economy: We don’t think the basic lessons in Economics 101 class will be refuted. The business cycle has its own rhythm, moving from expansion phase, to peak growth, to slowdown, to contraction (recession) and then to a trough point—and then back again to expansion and so forth. The U.S. private sector is too large, and free enterprise is too entrenched as a system and in American society for Washington to manage it by pulling various levers.
• Corporate earnings trends: The three above factors have had far more influence on corporate profit growth over time than political party control inside the Beltway, in our assessment. And corporate profit growth—often called the “mother’s milk” of the market—has historically had a very tight relationship with S&P 500 performance.

Elections come and go: Stay focused on long-term investment plans

We don’t think the midterm election results should prompt long-term individual investors to meaningfully alter U.S. equity allocations or sector positions in portfolios.

We continue to believe the most prudent approach vis-à-vis elections is to:

• Give deference to the long-term investment strategy that you already have in place.
• Avoid the temptation of making drastic asset class or sector changes based on the election outcome.

In other words, if you’re enthusiastic about the Democrats retaking Congress and serving as a check on Trump’s power or blunting it altogether, don’t get out over your skis in terms of stock market exposure or sector positioning.

Almost a dead heat

S&P 500 and S&P 500 earnings per share indexed to 100 at 1945 (logarithmic scale)

Conversely, if you’re concerned the priorities of the new House and Senate Democratic majorities could take the country in the wrong direction, don’t let emotions get in the way of sound investment decisions.

Regarding near-term market performance, we would focus instead on:

• The potential impact of the Fed’s current interest rate policies (a misstep is possible).
• Domestic economic and earnings trends (we expect continued growth for both in 2027).
• Corporate innovation, specifically the AI development cycle (there are a number of uncertainties about the next phase of the cycle and its potential winners and losers).

The biggest threat to the U.S. stock market, in our assessment, would be indications that a recession is on the way. But we see little evidence of that. Regular pullbacks and corrections notwithstanding, we think the prospects favour more new highs for the S&P 500 in the next 12 months. We continue to recommend holding Market Weight exposure in U.S. equities.

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