Gridlock means greater focus on inflation and the Fed
- The Democrats fared better than polls initially predicted, retaining the Senate and losing the House by just a slim margin. Gridlock means significant policy changes are unlikely to take place over the next two years.
- Markets appreciate the easing of political uncertainty, but inflation and central bank policy will have greater influence on market direction in the near term.
- Active management with a focus on defensive sectors and quality companies makes sense. Portfolios should continue to position for a rising rate and slowing growth environment.
Better than expected mid-term report card for the Democrats
The mid-term U.S. elections concluded last week, with the Republicans taking control of the House by a narrow margin and the Democrats retaining their majority in the Senate after winning several key states of Pennsylvania, Arizona and Nevada. While the result of a divided government was widely expected, the Democrats fared better in both House and Senate races than polls initially forecasted, losing the House by just a slim margin, and avoiding a red Republican wave.
It was a decent result for the Democrats. Mid-term elections typically features double-digit seat losses for the incumbent president's party in the House—the Democrats lost just nine seats. It is even more surprising given U.S. President Joe Biden's approval rating. In the past 50 years, only three mid-term elections have gone better for incumbent presidents. All three of those races featured presidents with approval ratings nearing 60%, while Biden's ratings were in the low 40s heading into this year's mid-terms.
Nonetheless, a divided government means President Biden will find it challenging to pass any major legislation through Congress in his remaining two years in office. Political gridlock means both parties will be unable to push through any major party agendas, both in terms of major government policies as well as fiscal packages.
Political gridlock means markets will care more about inflation and the Fed
Markets have typically delivered positively on the conclusion of mid-term elections given the lifting of political uncertainty. Political gridlock has also been a boon for markets in the past as it typically means a stable policy environment. However financial markets this year, unsurprisingly, has been less geared towards to the election contest. The market reaction to the results were positive, with the S&P 500 rising 5.9% during election week. That said, the rally had little to do with mid-terms and more to do with a softer Consumer Price Index print offering hope that the Federal Reserve (Fed) would not have to raise interest rates as high as previously expected.
Historically, fourth quarter returns during elections years have been strong, averaging 7% over the last 80 years, and overwhelmingly positive. However, there are two notable exceptions. Negative returns in 4Q of 2018 and 1994 likely had more to do with the Fed hiking rates than mid-terms, which will very likely to be the case this year, depending on inflation, labor market data and how the Fed responds.
Exhibit 1: S&P 500 performance around U.S. mid-term elections
Election date = 100, price return index
Fed may have to compensate for less expansive fiscal policy when economic momentum slows
While short-term inflation dynamics will have greater say on market direction than the mid-terms, a divided government may have some implications in terms of the Fed's response to slowing economic momentum in 2023 and the dosage of easing the Fed may have to apply. This is because a political gridlock means any proposal of fiscal measures would be unlikely to pass through the House. Even if unemployment rates pick up and public pressure forces some form of compromise, any fiscal package passed through would be relatively small. This may mean the Fed would have to do more of the heavy lifting when economic momentum weakens in 2023.
Less expansive fiscal packages over the next two years also means a divided government will help contain the budget deficit. This is important because tighter monetary policy works most effectively in concert with tighter fiscal policy, which we saw in 2022. Although this is an effective combination to fight inflation, if the economy does enter a recession next year, the flipside is monetary and fiscal policy could be muted, allowing the recession to linger.
Political gridlock also could lead to government shutdowns over the budget in the next two years which could lead to short-lived market volatility. We may also approach the debt ceiling in 2023, which, unless resolved during the lame duck session of Congress, could also cause some market jitters.
Looking through the political noise, we continue to position our portfolios for an environment of rising rates and firm inflation. Politics will always be a source of uncertainty for markets, but it’s policy, not politics, that is more influential for the economy and markets in the long run. Policy is likely to play a smaller role under divided government, reducing its impact to markets over the next two years.
Within equities, we continue to favor defensive sectors, as well as quality companies with strong balance sheets and cash flows. The valuation de-rating and possible peaking in U.S. Treasury yields should be constructive for growth stocks.
Within fixed income, while being short duration makes sense given the planned rate rises heading into the end of 2022 and beginning of 2023, adding duration may also make sense now that long-end yields have priced in most of the Fed’s hawkishness.
Active management will remain key as we head into an economy with slowing growth momentum, still high inflation, and tightening central bank policy.