US midterm elections — the likely outcome

A shift in the US govt will see a big shift in govt policies which will implicate global economy and financial markets

Fundsupermart Research By SHERMAN TAM CHENG WEI / Pic By BLOOMBERG

Analysts and investors will be closely watching the upcoming midterm election in the US as a shift in the balance of power in Washington could have meaningful implication for global financial markets. 

It is important to formulate a view on the potential makeup of the legislative branch in order to evaluate the possible government policies and the implications for the economy and financial markets.

In the upcoming US midterm election, all 435 members of the House of Representatives, 35 seats in the 100-member Senate along with many state governors and local offices will be up for contest.

For now, Republicans control both chambers of the Congress and the White House (Trump administration).

Some polling suggests that the Democrats will regain control of the House if the party wins 23 seats.

The math suggests it will be more difficult for the Democrats in the Senate where they must defend 26 seats versus nine for the Republicans.

From a historical perspective, the US equity market tends to do well during periods of a split Congress, averaging a 12% annual return.

The reason is that when the government can’t make changes, it can do less harm to the economy and businesses.

Investors know this and tend to flock into stocks when they see a gridlock congress ahead.

A Democratic House will be a boon for US healthcare sector as there will be minimal changes to the Affordable Care Act.

A divided government would put the brakes on higher fiscal spending and tax cuts, which may put downward pressure on US Treasury yields.

The US dollar has been regaining its strength in recent months thanks to higher US interest rates, as well as global trade tensions.

If Democrats regain the control of the House, the greenback will likely be impacted from an increase in perceived political risk. At the same time, a weaker dollar would likely be a positive for emerging markets (EMs).

As Republicans are perceived as the underdog for the House, a “red again” outcome will see them holding both the chamber of House and Senate, and could be mildly positive for US equity markets as a whole, but less so for the bond market.

This would keep the deregulation measures on track with minimal congressional interference and allow the Republicans to pursue additional tax cuts, as well as repealing the Affordable Care Act.

A Republican-controlled congress would simply mean US corporates receive more tax cuts thus driving the US economy stronger moving forward.

This would prompt the US Federal Reserve to hike interest rate faster, leading to a stronger dollar and pare EM assets’ attractiveness in the end.

It is not surprising to increase the odds for further fiscal stimulus which will lead to a bigger deficit.

This would be somewhat bearish for US Treasury yields as the US government would likely be issuing more debt to finance its deficits.

Even though the Democrats are gaining traction in the polls, it remains a less likely outcome for the Opposition party to win the Senate chamber.

A broad-based Democrat victory could be more disruptive if they plan on raising the corporate tax to 25% and reversing tax-cuts for high-income Americans to help pay for the US$1 trillion (RM4.2 trillion) infrastructure investment plan.

We expect this outcome to bring volatility to the US stock market that has done well since Donald Trump’s presidency.

The S&P 500 Index was up about 10.5% in US dollar term (as of end September 2018) and tax reform has been a big driver of that strong performance.

In short, higher corporate taxes would almost certainly be an overall negative for US equities, but good for bond yields if the US Congress raises taxes to pay for it.

What will it mean for trade? Probably not much. Trump will control trade policy no matter who runs the Congress.

The legislature would have to vote on a formal trade deal. But without one, the policy is up to the president’s discretion.