US midterm elections: a return to political gridlock?
Current polling suggests the Democratic party could lose its House of Representatives majority in Congress in the November mid-term elections. High inflation is a millstone around the neck of Democrats and could hinger their prospects, especially as incomes have not caught up with price increases.
Financial markets tend to like congressional gridlocks since they mean limited political intervention in the business sphere. However, a gridlocked Congress could complicate policy responses and delay much-needed support in the case of a hard recession (not our main scenario). Political polarisation in the US could mean more battles around debt-ceiling deadlines and federal budget rollovers if the Republicans re-take the House.
The Federal Reserve continues to concentrate on backward-looking data such as high core consumer inflation and resilient monthly job growth numbers. At the same time, it is monitoring surveys like the University of Michigan’s consumer sentiment survey for insight into inflation expectations. These remain stubbornly high, with the preliminary October survey showing respondents expect annual consumer inflation to be 5.1% over the next 12 months.
Bottom line, we think the Fed will deliver another ‘jumbo’ 75bps rate hike at its next meeting on 2 November, six days ahead of the midterms. There are rising risks that the Fed will raise rates by a similar amount again in December, especially given the ongoing inertia in inflation data. In short, we do not think a policy pivot is imminent. Nonetheless, the pace and size of rate hikes already risks depressing demand in the economy more than is needed to contain medium-term inflation. Once one also takes into account the Fed’s quantitative easing, there is also the risk of causing liquidity problems in financial markets. In other words, the danger of a policy mistake should not be underestimated.
Based on 60 years of data, markets tend to better after midterm elections than before. The average price return for the S&P 500 is 19.8% (in USD) in the 12 months after midterm elections, versus +4.4% in the 12 months before. There is, however, an exception worth remembering this time around: statistical analysis suggests that when the Fed is in hiking mode, there is no tangible midterm boost to equity markets, whatever the outcome.
Overall, we do not think the midterms will have a significant impact this time around on the performance of the US equity market. We will continue to watch a host of other factors, including monetary policy, global geopolitics (especially the fragile US-China relationship) and stress in some local energy markets.