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NERVOUS NELLIES

Here’s how markets will react to every possible outcome of the US midterms

Reuters/Andrew Kelly
How will markets react?
  • Gwynn Guilford
By Gwynn Guilford

Reporter

This article is more than 2 years old.

What’s happening in Washington has always had a big impact on global markets. That’s been especially true since Donald Trump won the US presidential election with his America First agenda, ushering an era of trade wars, tax cuts, and increased government spending.

Now with the US midterms, Americans will decide whether to give Democrats the power to check Trump—or reward the president with an even bigger mandate. Here are the three most likely election outcome scenarios, and what their implications would be for markets.

Blue wave (Democrats take House; Republicans hold Senate)

With 70% odds, this is the most likely scenario, says Michael Zezas, a strategist at Morgan Stanley.

This outcome would dim the likelihood of further economic stimulus. With Democrats controlling the House, the chance that Trump would prevail in extending or making permanent tax cuts from last December is “more or less zero,” notes Pantheon Macroeconomic’s Ian Shepherdson.

What about the $1 trillion infrastructure bill Trump promised on the campaign trail? “To call the nation’s infrastructure creaky is to be very kind, and the need for renewal and expansion is obvious,” writes Shepherdson. With Dems in charge of the House, such an initiative would seem to have broad support. However, says Shepherdson, deep disagreement over how to finance such spending is likely to scupper a major infrastructure package. Nomura strategist Jordan Rochester echoes that skepticism, adding, “Moreover, we think a Democrat House will be reluctant to support initiatives that Trump could use to advance his re-election chances in 2020.”

A “blue wave” would also inject more volatility into markets as a result of partisan sparring over government spending and the debt limit. Current law requires a budget cut that will hit in October 2019 unless Congress and the administration agree to raise spending caps. “Trump has already threatened to shut down the government to push Congress to pass immigration reform and build a wall on the US-Mexican border,” say analysts from Societe Generale. “To force action with a Democratic majority in Congress, he may be using this tool more frequently. The uncertainty and disruptions can plague markets and the economy.”

Then, of course, there’s the uncertainty associated with the heightened risk of impeachment. While the Republican majority in the Senate—which requires a two-thirds vote to impeach—greatly lowers the likelihood that Congress could oust Trump, the persistence of this possibility could still distress financial markets.

What it means for markets: Since polls have consistently signaled the “blue wave” outcome, it’s possible that markets won’t react much at all if Democrats take the House—simply because investors have already priced in these moves. As Morgan Stanley’s Zezas notes, “we expect this outcome would have the most limited impact for markets as it mostly holds the trajectory of fiscal, trade, and regulatory policy at the status quo.”

If markets did respond, it would likely be in the form of “a risk-off in equities and a flight to the safety of Treasuries,” meaning that investors will ditch stocks and high-yield corporate debt for the relative safety of US government bonds, says SocGen. Credit spreads would widen. And as borrowing costs rose, investors would be likely to favor sectors with strong balance sheets—like global pharmaceutical companies—and shun those that have borrowed a lot, such as US small-cap stocks (and, by extension, the Russell 2000 index), says SocGen. An added element of uncertainty here is whether the Federal Reserve would react to a stock market selloff and tightening credit conditions.

Mixed control of Congress would probably cause the dollar to weaken, says Morgan Stanley’s Zezas—the result of continued widening of the fiscal deficit and simultaneous contracting of global liquidity. Emerging markets would be little affected, he adds, since uncertainties about trade wars would offset the dollar’s decline.

Red wave (Republicans hold both chambers)

At about 18%, there’s still a small but distinct chance that the Republicans will keep their hold on both the Senate and the House.

The big question here is whether a Republican double-whammy win would lead to another fiscal stimulus. Trump has recently been promising individual tax cuts. However, even if Republicans retain control of both chambers, it’s not clear that “Tax Cuts 2.0,” as some call it, would pass, given that it would further widen deficits, something Republicans are supposed to disdain. For the same reason, Republicans are unlikely to champion Trump’s infrastructure plan.

In theory, the GOP’s consolidated power could give it the chance to push through cuts to Social Security, health care, and welfare benefits—which, in turn, could cause a contraction in fiscal spending, says Morgan Stanley’s Zezas. While he’s skeptical that there’s political appetite for such cuts to the social safety net, he notes that could change if an unexpected recession revives Republican enthusiasm for “fiscal responsibility,” as it did in 2010 and 2011.

While a Republican victory would likely reduce uncertainty in the markets, one glaring exception is Trump’s trade war policies—and the increasing worry that these could hurt long-term growth prospects even as inflation keeps rising, says SocGen.

What it means for markets: Since a GOP sweep is one of the less likely electoral outcomes, markets would be likely to react fairly dramatically. In the coming days and even weeks, such an outcome could spark a renewed embrace of risk, which (until recently) has prevailed since Trump’s surprise victory in November 2016.

The boost to US markets could hurt those abroad. Increased speculation about further fiscal stimulus and the prospect of more tariffs could be bullish for stocks and “would increase the risk that US credit diverges from European credit and emerging markets,” says SocGen. However, US equity markets might also not budge much, says Morgan Stanley’s Zezas, since hopes for more tax cuts aren’t enough to counterbalance the slowdown in corporate earnings growth and worries that a bigger deficit would prompt more aggressive Fed tightening. Expectations of more tax-slashing could also push up Treasury yields.

Looking abroad, a stronger dollar and the increased risk of Trump trade wars leaves Asian currencies vulnerable, says Zezas—notably the Korean won, the Singapore dollar, and the new Taiwan dollar, though the currencies of the Philippines, India, and Indonesia are also at risk.

However, some of these effects may subside if Republicans hold off on another round of fiscal stimulus. On top of that, the decreased risk of political uncertainty should clear the way for the Fed to tighten more, dousing any relief rally in US stocks. “Resulting tightening would increase ‘end-of-cycle’ concerns, undermining risk assets,” says Morgan Stanley, while also cautioning that a “key risk is if earnings growth remains strong, sustaining the rally for longer.”

Blue tsunami (Democrats take both chambers)

Polls and forecasters give this scenario only a 10% or so chance of coming to pass. Even if it did, Trump’s tax cuts would probably be safe; given the president’s veto power, it’s unlikely that a Democrat-controlled Congress would succeed in rolling back tax reform, says SocGen.

At the same time, Dems and Trump should be able to reach an agreement on raising spending caps that go into effect in October 2019. There’s also a much greater chance of passing a big infrastructure spending bill—though, as Pantheon’s Shepherdson previously noted, that likelihood might be smaller than expected.

In these hyper-partisan times, a Democratic Congress and a surly Republican president are a sure recipe for gridlock and political arm-twisting, such as the aforementioned risk of Trump shutting down the government. Plus, Democratic control of Congress would likely aggravate uncertainty about how Trump wields executive power and how impeachment proceedings might play out.

What it means for markets: ”This scenario would be the most negative for the equity market,” say analysts from Societe Generale, as the increased risks of impeachment and government shutdown whip up volatility. In particular, the risk of government shutdown would punish sectors for which the US government is a major customer—certain US software firms, for example. Investors ditching risky assets would favor US government debt. The dollar would also be likely to weaken faster than expected. The greater chance of infrastructure investment could benefit US construction and building materials sectors, says SocGen—as well as US investment-grade bonds, relative to those in Europe.

Blue and red wave switcheroo (Democrats win Senate; GOP wins House)

Markets would likely go completely haywire if this happened. But no one thinks it will.

Looking to 2020

Of course, the results of today’s vote will shape the stakes in the next presidential election, in 2020. One of the bigger impacts may be what it reveals about how much clout moderate Republican and independent voters have, in contrast to Trump’s base

Given how Trump has defied his party’s core principles on everything from trade and immigration to fiscal policy, the more resounding economic consequences of today’s vote will be felt in years to come. “If Democrats win the popular vote tomorrow by eight or so points, as per the polls,” says Shepherdson, “a large number of Republicans will be reckoning that their best hope of winning re-election in 2020 is to put serious distance between themselves and the toxic president.”

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