The Senate is currently split 50/50 with Vice President Kamala Harris casting tie-breaking votes on items that only require a simple majority. In the upcoming midterms, 35 Senate seats are up for election, 21 currently held by Republicans and 14 held by Democrats. If they can maintain their current seats, Republicans only need to flip one more to take control of the Senate, but the balance of power remains too close to call.

All 435 seats are up for election in the House of Representatives, and the Democrats currently have a four-seat majority. Typically, big swings occur in midterm election years. The president’s party has lost House seats in 17 of 19 midterm elections since World War II and Senate seats in 13 of 19. The average seat loss has been almost 27 seats in the House and three to four seats in the Senate. This historical pattern, compounded by the reapportionment and redistricting processes following the 2020 Census results, should favour Republicans.

To add to these factors, midterms are often a referendum on the new administration and the economy. The president’s approval rating has improved recently but is still near its lows, partly due to 40-year high inflation which is weighing on the consumer.

Policy: What is the outlook for policy before and after the midterms?

Politics attracts the headlines, but ultimately it is policy, not politics, that impacts the economy and markets. The administration notched two major policy achievements in 2021: a USD 1.9 trillion Covid stimulus package and a USD 1.2 trillion bipartisan infrastructure package. Although the first half of 2022 was quiet, multiple major legislative and executive actions passed this summer.

The first was the USD 280 billion bipartisan CHIPS and Science Act, which includes USD 52 billion for semiconductors and funding for science and technology research and development. The second was the Inflation Reduction Act (IRA), a package that includes climate spending, prescription drug pricing reform, and tax reform.

The third item is the extension of the student loan payment moratorium to 31 December 2022 from 31 August 2022, and forgiving up to USD 10,000 in student loans (up to USD 20,000 for Pell Grant recipients) for individuals making less than USD 125,000 a year.

Going forward, however, if the midterms play out as history suggests and we have some form of divided government, we are likely to experience political gridlock during the next two-year term. Republicans and Democrats have already compromised on infrastructure, semiconductors and technology, and defence spending in response to the war in Ukraine. There are few remaining areas for further bipartisan cooperation, and in fact we could see budget standoffs that lead to government shutdowns. Although both parties came together on fiscal stimulus during the last recession, if the US enters recession after the midterms, especially if it’s a mild one, we are unlikely to see fiscal stimulus from divided government.

From an economic perspective, less spending and therefore less borrowing should lead to lower deficits, which is positive for federal finances but prolongs the fiscal drag, resulting in slower economic growth.

Investment implications

Markets often experience lower returns and higher volatility during election years due to heightened uncertainty. Yet, there are limits to what averages can tell us because financial crises, tech bubbles, pandemics, and geopolitical crises do not follow the election calendar and have disrupted markets during past presidential or midterm election years.

Some investors are eager to sit on the sidelines until election uncertainty passes, but risk missing subsequent rebounds. The two most recent presidential elections in 2016 and 2020 are prime examples of this. In the early hours of 9 November 2016, futures plummeted as election results were coming in, but markets closed 1.1% higher after that day’s regular trading session when the results were finalised. Markets were up 7.3% in the week of the 2020 presidential election, despite not having an official result.

Although typically Q4 returns after midterms are strong, there are two notable recent exceptions: 2018 and 1994. The Federal Reserve (Fed) was tightening monetary policy during both of those periods, but crucially, pivoted shortly thereafter. The Fed paused its rate hikes after December 2018 and cut three times in 2019, and the Fed ended its rate hiking cycle in February 1995. Markets subsequently rebounded in both instances. Although the Fed is still some way off from a pivot or pause, we are likely closer to the end of the Fed hiking cycle than the beginning.

In short, when it comes to market drivers, the Fed is the signal, and the midterms are the noise.

Source: US Congress, J.P. Morgan Asset Management. Data as of 30 September.

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