When U.S. elections occur, and certainly surrounding the recent midterms, Washington becomes larger than life. All eyes are focused on it around the world. It’s easy to assume that Washington plays a vital role in shaping the U.S. stock market’s path.
In reality, the natural ebb-and-flow of the economy, corporate earnings trends, and Federal Reserve policy play greater roles. The power of private sector businesses and American households should not be understated at times like this, and the power of Washington should not be overstated. The domestic economy remains our North Star, and we expect this long expansion to persist for the next year, at least.
So the fact that there will be a dramatic change in control of the House of Representatives does not change our view of the U.S. market and economy. We were constructive before the election and we’re constructive now.
The Trump administration proposal that could impact the market the most has already been implemented: tax cuts. They won’t be repealed, although the president opened the door to some modifications in exchange for a new middle income tax cut.
Even though the stock market is not at Washington’s beck and call, with every election there are issues that can intersect with market performance that investors should consider. Following, we discuss infrastructure spending, prescription drug pricing, trade, House investigations of President Trump, and risks of a government shutdown and debt ceiling battle.
Equities usually the winner of midterm elections
We interpret the election outcome to be more about gridlock than sweeping policy changes. Normally the equity market welcomes gridlock, otherwise known as split government or divided government.
A study by RBC Global Asset Management found that the S&P 500 outperformed in four of the past five instances of a split Congress, and rose 15.6 percent on average compared to a 7.7 percent average gain during all periods. A split Congress is less common than one might think. This is only the sixth instance since 1951.
The historical performance surrounding midterm elections is the strongest of the seasonal equity market cycles we track. In 21 midterm elections since 1934, the S&P 500 rose 15.7 percent, on average, in the year following the election compared to an 8.2 percent average gain in all years during this period.
S&P 500 annual returns under a split Congress
Source - RBC Global Asset Management, Bloomberg; Data from January 1, 1951 to October 31, 2018. Reflective of S&P 500 price returns (excluding dividends)
Post-midterm performance has been strong historically
S&P 500 returns after midterm elections (1934–2015)
Source - RBC Wealth Management, Bloomberg
Any common ground to be had?
For the upcoming Congress, opportunities for compromise seem few and far between given the political and policy realities. Infrastructure and health care are potential areas of cooperation, but the path toward passing legislation seems narrow.
For infrastructure, just about everyone agrees there is great need to replace decaying structures and to build new innovative structures similar to what many other countries already have. But there is a fundamental philosophical disagreement about how to get it done.
Republicans seek to form an infrastructure “bank” and largely attract leveraged private sector funds with a small portion of federal dollars as seed money. In contrast, Democrats seek to fund infrastructure spending by issuing 30-year bonds, with the intention of paying them off from increases in federal and fuel taxes by indexing the latter to inflation. The end goal of this structure is to avoid adding to the national debt.
Perhaps the two sides will ultimately find a point of compromise, but it will likely take a lot of give-and-take and goodwill at a time when these traits are in short supply.
The high cost of pharmaceuticals is one issue an overwhelming proportion of voters care about, according to the Kaiser Family Foundation. There are points of agreement between some Democratic proposals for pharmaceutical price reform and President Trump’s statements during the presidential campaign and soon thereafter.
We think there is more uncertainty about this issue than the pharmaceutical stocks reflected when they rallied immediately following the midterms. We’re not convinced they will escape a new pricing regime, or at least a debate about one.
Status quo for trade
Trade policy is largely under the Trump administration’s purview, so the change in House control will have little impact on tariffs overall or the U.S.-China dispute.
Congress does play a role once trade agreements are struck. We think the updated North American trade deal, otherwise known as USMCA, will ultimately pass in the new Congress because there is bipartisan support for regional trade and the overwhelming majority of states benefit. But Democrats could push for concessions in the legislation to implement the trade agreement.
Investigations affect politics more than economics
There could be multiple showdowns between House Democrats and President Trump if oversight hearings and investigations begin.
Senior House members who are likely to assume leadership roles in powerful committees have previously signaled that hearings and investigations would occur on various fronts ranging from allegations of irregularities at administrative agencies, to President Trump’s tax returns, to events surrounding the 2016 election, and more. Committee leaders have broad subpoena power. At this stage it’s unclear if the soon-to-be speaker of the House will proceed cautiously over these grounds, aggressively, or somewhere in between.
This could create bouts of volatility for the equity market, but we doubt it would impact economic momentum much, if at all, unless something serious is revealed that isn’t already known.
Post-midterm performance well above average in most years
S&P 500 annual returns in the calendar year after the midterms (1935–2015)
Source - RBC Wealth Management, Bloomberg
We believe the new divided government increases the risks of a debt ceiling battle and/or a government shutdown given that budget and spending priorities differ meaningfully between the two parties.
Government shutdowns are transitory events. In the past, the market usually experienced a brief pullback, and then resumed its previous trajectory. After the government resumed full operations, little to no discernable economic impact was detected in recent shutdowns, according to RBC Capital Markets.
Corrections are common in midterm years, and so are follow-on rallies
S&P 500 returns surrounding midterm elections (1934–2015)
Source - RBC Wealth Management, Bloomberg; performance before and after 21 midterm election years
This current lame-duck Congress will need to pass a bill to fund the government, at least on a temporary basis, by December 7 or many functions will shut down. After that funding deadline is dealt with, another one will likely be established, possibly in the spring of 2019, for the new Congress to handle.
In our view, debt ceiling battles—another matter entirely—can only go so far given the stakes are so high. Key players on both sides of the aisle have said as much previously. Debt default is not a practical option for a country that claims to be leading the world. Elected officials have tremendous incentives to raise the debt ceiling, although it can be a torturous process to get there. The debt ceiling will become an issue again in Q1 2019 as it needs to be raised in early March.
Keep your bearings
From a portfolio standpoint, rather than focusing on Washington, the more important task is to keep the compass pointed toward the North Star—the domestic economy. As long as the major forward-looking indicators continue to signal that growth can persist, these public policy and political issues can be managed. It’s the economy, corporate earnings, and the Fed that will define this late cycle period, in our view.