The midterm results are in: Where do we go from here?

A perspective from E*TRADE Securities1

11/09/18

The voters have spoken. Say hello to a divided Congress.

Americans went to the polls in record numbers on Tuesday, and, by and large, things went as expected. Democrats recaptured the House of Representatives by a convincing margin, while Republicans expanded their majority in the Senate.

In the House, 218 seats were required to flip the chamber. By gaining the necessary 23 seats and then some, Democrats now control the House for the next two years. In the Senate, Republicans increased their majority position by picking off previously Democratic-held seats in North Dakota, Missouri, and Indiana, despite losing Nevada.

What does a divided government mean for investors?

For one, we’re likely to hear the term “gridlock” a lot more often. With a divided Congress, there will be limits to the amount and type of legislation that can be passed. Tax cuts will no longer sail unimpeded through Congress, and a House Democratic majority is likely to put the brakes on legislation that undermines environmental and financial protections.

Here are some key issues to watch out for:

• Tariffs and trade: In a remarkable reversal from historical party positions, it is now Republicans advocating for tariffs and trade barriers. In fact, the Trump administration has imposed nearly $500 billion in tariffs on China alone, and these measures are likely to stand.

However, the president’s revamped trade deal with Mexico and Canada has yet to be voted on, and even Republicans have expressed doubts that the deal has enough support to make it through Congress. That is especially relevant now that Democrats control the House. This isn’t to say what’s being billed as the "USMCA Agreement" won’t pass, but it becomes more difficult. Bottom line: President Trump will have to rely on executive actions to effect trade policy.

Verdict: Democrats have limited ability to keep the president from levying tariffs by executive order, which may keep export-dependent large caps and international equities under pressure.

The budget deficit: A massive tax cut in 2017, coupled with increased military spending, has ballooned the federal budget deficit, which is now on the doorstep of $800 billion and could easily surpass $1 trillion in 2019.

US budget deficits

Source: Congressional Budget Office

In turn, rising budget shortfalls have left little room for stimulative polices in the event that the current economic expansion runs out of steam. This is likely to remain the case in a divided Congress, with neither party able to fully control the levers of fiscal policy.

Verdict: Unless fiscal policy changes, budget deficits should continue to increase, which could exacerbate any potential market downturns.

• Fiscal policy – taxes: Budget deficits may be on the rise, but this has not dissuaded President Trump, who recently pledged an additional tax cut. That is now unlikely to happen. Republican-sponsored tax bills would first have to get past the House Ways and Means Committee, which will be controlled by Democrats. Conversely, House bills drafted by Democrats could die in the GOP-led Senate Finance Committee.

Verdict: Barring bipartisan approval, meaningful tax legislation is likely dead until 2021 at the earliest. Investors will have to weigh in on whether they view that as good or bad.

• Fiscal policy – government spending: This could take two possible forms: proposed cuts to entitlement programs—think Social Security, Medicare, and Medicaid—and infrastructure spending. President Trump has wavered on both issues, but Democrats and moderate Republicans are likely to resist any cuts to entitlement programs.

Shockingly, both the Trump administration and most Democrats agree on the need for increased infrastructure spending. However, the two sides differ over how it should be carried out. In the event that a bipartisan bill is agreed on, more infrastructure spending could result in higher federal budget deficits, expanded Treasury issuance, and the potential for higher interest rates. That’s because the Treasury bonds needed to fund deficit spending would require higher long-term yields to attract investors.

Verdict: The potential for higher government spending increases at the margins. The bad: the possibility of higher interest rates and larger deficits. The good: government spending makes up a whopping one-third of US gross domestic product.

• Regulation: Are regulations anti-growth measures or necessary steps to keep polluters and predatory lenders in check? Regardless of your viewpoint, the president still controls cabinet-level appointments to Energy, Commerce, and 13 other executive departments. Other federal agencies, such as the Small Business Administration and the Environmental Protection Agency, are independent in theory but are accorded cabinet-level rank, giving Republicans the edge. As for any potential legislation, only bills with bipartisan approval will get through a divided Congress. And in today’s environment, a bipartisan handshake is as likely as a pterodactyl sighting.

Verdict: A wash. A perceived halt to regulatory rollbacks could spook investors. Conversely, the markets have historically done just fine during periods of heightened regulation.

• The financial markets: With a divided Congress, we’re likely to hear a lot of chirping about who’s to blame if the markets go south. But will they? It’s impossible to say, of course, but history actually paints a promising picture. In looking at presidential terms dating back to 1946, the S&P 500® Index has generated its best performance during the fourth quarter of midterm election years. The second-best returns have come over the ensuing two quarters.1

This time around, however, there are other forces at work, and the current economic expansion has already outlegged what many thought possible. Moreover, the S&P 500’s post-war historical record is the weakest when a Republican president and split legislature have bookended Pennsylvania Avenue, as seen in the graphic below.

S&P 500 performance under different governing scenarios

Source: Standard & Poor’s Equity Research. Returns reflect full calendar years for midterm election years.

Verdict:  Another wildcard, although assigning blame in the event of a downturn is guaranteed.

The bottom line

While it may seem like two-party rule and gridlock are euphemisms for a do-nothing Congress, investors won’t necessarily suffer. Consider that the House was under Republican control for six of President Obama’s eight years in office, while Republicans controlled both the House and the Senate during the president’s final two years. Despite six years of two-party rule, the US economy grew measurably, and the S&P 500 gained a cumulative 234% during the president’s two terms.2

In the final analysis, it’s not about politics. It’s a about a plan. Worried about an equity downturn? Fixed income allocations could provide a partial offset. Think US stocks may decline? Consider taking a closer look at international equities. Uncomfortable with volatility? Perhaps paring riskier assets is in order.

Ultimately, it’s up to investors—not politicians—to determine their financial goals and risk tolerance, and to allocate assets accordingly. Both political parties can agree on that. But we won’t hold our breath.

1. “The Stock Market Typically Rises After Midterm Elections. This Year Is Anything but Typical,” New York Times, November 2, 2018, https://www.nytimes.com/2018/11/02/business/stock-market-rises-midterm-elections.html

2. FactSet Research Systems, period covering January 20, 2009 - January 19, 2017.