Analysis—US midterm elections could add more risk to a shaky stock market

FILE PHOTO: U.S. Capitol building in Washington

Republicans are expected to vote on Nov. 8, creating an atmosphere favorable to many investors as it splits President Joe Biden’s Democratic-controlled government. Historically, a divided government has been more favorable to stakes than Democrats controlling both the House and Senate with the presidency.

But the odds for Biden’s Democrats are improving, according to betting and polling websites. A close race has worried Wall Street that Biden could raise taxes on investors and corporations while tightening regulations in sectors like health care and banking.

Walter Todd, chief investment officer at Greenwood Capital, said the growing uncertainty ahead of the election “could be a source of market volatility”.

12 Sep Republicans had a 74% chance of controlling the House, up from 88% on July 13, according to data analysis website FiveThirtyEight. That gave Democrats a 69% chance of controlling the Senate, while Republicans’ chances were more than 50% at the end of July.

At betting website PredictIt, the price of a contract predicting Republicans will win the House has fallen to 75 cents from more than 90 cents in late June. Pays $1 if contract is correct.

Chart: Bets on House Republican Wins

Is a prop good?

Electoral worries haven’t had much of an impact on markets this year, as investors are keen on massive interest rate hikes implemented by the Federal Reserve to curb rising inflation.

However, concerns about the referendum may increase as November approaches. Many investors believe that a divided government makes the investment climate more stable and makes major reforms less likely to pass.

“The market wants a stalemate,” said Nadia Lovell, senior U.S. equity strategist at UBS Global Wealth Management. “I think it’s fair to say that what investors expect and what’s being settled now is a divided government.”

Historical data shows that stocks generally perform better during periods of divided government, though investors cautioned that the data is limited and that markets have generally risen over time regardless of government composition.

According to data analyzed by RBC Capital Markets since 1932, the S&P 500’s average annual return was 14% in a divided Congress and 13% in a Republican Congress. By comparison, 10% when Democrats were president and in Congress.

A Close Call” In a report this week, Goldman Sachs analysts said the result was a “close call,” adding that early election results and some polls “suggest Democrats are in better shape than they were a few months ago.”

A Democratic Congress would give Biden a better chance to implement much of his agenda, perhaps including plans to raise top corporate, capital gains or personal income tax rates, Goldman said. Investors generally view such tax measures as market-friendly.

Stocks in some sectors can be particularly volatile if the election tilts toward Democrats. For financial services, a Republican victory in Congress “represents a best-case scenario … as the GOP will resist efforts to curtail the operations of large financial institutions,” UBS analysts said in a report.

For health care, most legislation affecting the industry is “unlikely to make much progress if both houses of Congress are controlled by Republicans,” according to UBS.

The S&P 500’s financials sector is down 11.7% this year at Monday’s market close, while the health care sector is down 7.1%. The S&P 500 is down 13.8% year to date.

Despite the potential for short-term volatility, the broader market performed well in the 12 months following the midterm vote.

Since 1950, the benchmark S&P 500 has risen in all 18 12-month periods after midterm elections, according to LPL Financial. “There is political and policy uncertainty going into the midterms, which will be removed after the election, and stocks tend to see a relief rally from that,” said Jeffrey Buchpinder, chief equity strategist at LPL Financial.

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