A version of this story first appeared in CNN Business’ Before the Bell newsletter. Not a subscriber? You can register over here.
Last week was volatile on Wall Street, as stocks tumbled after Federal Reserve Chairman Jerome Powell dashed market dreams of turning into a pivotal point and signaled the potential for more big rate hikes. But Wall Street still turned its hopes to Washington.
Investors are betting on a big Republican wave in the midterm elections. If Republicans take at least one room in Congress in Tuesday’s midterm elections, it will likely lead to more gridlock, which the market usually likes.
According to data from Edelman Financial Engines, the S&P 500 has had an annual return of 16.9% since 1948 during the nine years when the Democrat was in the White House and the Republicans had a majority in both houses of Congress. That compares to 15.1% during periods of full democratic control and 15.9% in years when there was a unitary republican government.
Investors are more than happy when politicians squabble but don’t actually enact any new laws that might hurt corporate profits.
One example is corporate taxes.
“What do the midterm elections mean for the markets? If the Republicans get the House, the tax increases are dead in the water,” said David Wagner, portfolio manager at Aptos Capital Advisors. Republicans may be less likely to agree to a windfall tax on oil company profits. Nor do they generally favor tax increases over the wealthy.
The market is also betting that some sectors can get a boost — even if Republicans take control of the House or Senate, presumably making it difficult for President Biden to pass laws.
That’s because there are some areas of agreement between the White House and Republican lawmakers.
“A sweep of the Republican Party could lead to more defense spending,” Wagner said. “Increasing the defense budget appears to be a bipartisan issue.” The House passed a record-high defense budget proposal this summer.
Biden and Republicans seem to be on the same page when it comes to increasing infrastructure spending. This could give a boost to utilities, construction companies and some real estate stocks. Congress passed a bipartisan infrastructure bill of more than $1 trillion last year, which President Biden endorsed after all. But it is not yet clear what the desire for more spending is…even if there is consensus that more is needed.
“Everything is politically polarized, but there was common ground about infrastructure. That was the case even with [Donald] Trump and [Hillary] “Clinton in 2016,” said Jim Lidots, vice president of equity investment at Newton Investment Management. “As a country, we have reduced investment in infrastructure. This is an area where there is a lot of agreement.”
Of course, there is no guarantee that Biden and other Democratic leaders will be able to work effectively with Republicans in Congress. After all, the political narrative will quickly shift to the 2024 presidential race once the midterms are in the rearview mirror. Congress and the White House may spend more time bickering than trying to pass legislation.
There could also be some big snags in a divided government, especially if fears of a recession emerge next year.
Rob Dent, chief US economist at Nomura Securities International, said there could be less federal government spending on social safety net programs if Republicans took control of Congress.
“All other things being equal, this could lead to a longer recovery period from the recession,” Dent said. That would be bad for stocks in general because consumer spending drives corporate profits.
There is also the unwelcome prospect of more bickering in Washington over the debt ceiling, Dent added. The last time it was a major issue was during President Barack Obama’s first term. The US lost its AAA perfect credit rating from Standard & Poor’s as a result of the debt ceiling drama. The stock market fell more than 5% after the rating downgrade occurred in August 2011.
“This election result is the least that can be done versus what may not be done to help the economy through the downturn,” Dent said. “We are concerned about the divided government leading to brinkmanship over the debt limit and the possibility of a government shutdown. We haven’t had to deal with that in some time.”
But at the end of the day, political headlines are often just noise for the markets. Ameriprise’s chief market strategist, Anthony Saglimpin, said on a midterm conference call last week that stocks have historically risen after elections, regardless of which party controls the White House and Congress.
Mid-term courses can also take a “back seat” to other macro issues. Saglimpin noted that “growth, earnings, inflation and interest rates” matter most to investors in the long run. He acknowledged that the election results could lead to more volatility in the near term, but the market is already pricing in a strong possibility of a government split.
Market and economic volatility caused by politics is the last thing consumers, investors or the Fed need since inflation hasn’t been as temporary as Fed Chair Powell had predicted for most of 2021.
It is clear that the high prices of goods and other raw materials, and other shipping and transportation expenses and labor costs are not going away any time soon.
Even Steve Cahillan, CEO of cereal and snack giant Kellogg (K) said in the company’s latest earnings call last week that the idea that “inflation would be temporary has always been downright absurd.”
We’ll get a better idea of how much inflation will continue on Thursday after the government released CPI numbers for September.
Economists polled by Reuters expect overall prices to rise 0.7% last month, up from 0.4% in September. That is likely to push year-on-year prices, which are up 8.2% over the past 12 months to September, even higher. The continued strength of the labor market will put more pressure on prices as well.
“The labor market is resilient and inflation is spreading to the services sector as well,” said Troy Gaysky, senior investment analyst at FS Investments.
This may lead to further fears that the economy may be heading towards a so-called stagflationary environment, a period in which stagnant growth occurs alongside rising inflation. If that happens, the Fed will likely keep interest rates higher for a longer period.
“We’re going to get out of this inflationary/stagflationary situation eventually,” Gaske said. But it’s not as if the Fed will quickly cut interest rates to zero. He’d be really careful.”
Monday: Chinese trade data. Earnings from BioNTech (BNTX), Take-Two (TTWO), Ryanair (RYAAY), and Lyft (LYFT)
Tuesday: US midterm elections; Earnings from DuPont (DD), Norwegian Cruise Line (NCLH), Lordstown Motors, Disney (DIS), Occidental Petroleum (OXY), News Corp (NWS), IAC (IAC), AMC (AMC), and Novavax (NVAX)
Wednesday: China inflation data; Earnings from DR Horton (DHI), Weibo (WB), Hanesbrands (HBI), Capri Holdings (CPRI), Roblox, SeaWorld (SEAS), Wendy’s (WEN), Redfin (RDFN) and Beyond Meat (BYND)
Thursday: US consumer price index; US weekly unemployment claims; Earnings of Nio (NIO), Ralph Lauren (RL), Tapestry (TPR), WeWork, Six Flags (SIX), Yeti (YETI), and Warby Parker
Friday: US bond market closed on Veterans Day; UK GDP; US Consumer Confidence from Michigan; SoftBank Earnings (SFTBF)
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