In brief

• History and President Biden’s approval rating suggest the Republican party could regain control of the House of Representatives
• Some form of divided government is likely to bring political gridlock in 2023-2024 and reduced probability of fiscal stimulus in the case of a recession
• Any market impact from the elections is likely to be temporary. Inflation, recession concerns and the Fed Reserve policy outlook are still key in driving asset returns in the months aheadEuropean assets have unsurprisingly fallen out of favour as the headwinds from the energy crisis, elevated inflation and tightening financial conditions wash over the region. However, compelling absolute and relative valuations across equity and credit markets have raised investor interest.

How might the balance of power shift in Congress after midterms?

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. Republicans only need to flip one seat if they maintain their current ones to take control of the Senate, but highly competitive races have made the balance of power in the Senate 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 3 to 4 seats in the Senate. This historical pattern, compounded by the reapportionment and redistricting processes following the 2020 Census results, should favor Republicans.

To add to these headwinds, 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. Although unemployment is near 50-year lows, inflation at a 40-year high is weighing on the consumer.

Exhibit 1: Gains and Losses of seats in the last seven House elections

Source: U.S. Senate, U.S. House of Representatives, J.P. Morgan Asset Management. In 2018, North Carolina’s 9th congressional district did not certify a winner due to allegations of election fraud and a special election was held in 2019, which was won by a Republican. In 2020, Libertarian Rep. Justin Amash of Michigan did not seek re-election and therefore one seat was lost from the Libertarian Party. *Attributes vacant seats to party that held them previously (all Republicans). Data reflect most recently available as of 10/07/22.

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 bi-partisan infrastructure package. Although the first half of 2022 was quiet, multiple major legislative and executive actions passed this summer.

The first was the US$280 billion bi-partisan CHIPS and Science Act, which includes US$52 billion for semiconductors and funding for science and technology research and development to maintain the U.S.’s competitive edge. 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, which was set to expire on August 31, to December 31, 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 defense spending in response to the war in Ukraine. There are few remaining areas for further bi-partisan 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 U.S. 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 know 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 November 9, 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 finalized. Markets were up 7.3% 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 a ways 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.

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