Stocks Week: How the Midterms May Influence Wall Street

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Last week was volatile on Wall Street, with stocks falling after Federal Reserve Chairman Jerome Powell dashed dreams of a market pivot and hinted that more rate hikes are on the way. But Wall Street is still pinning its hopes on Washington.

Investors are betting on a big Republican wave in the midterm elections. If Republicans take at least one chamber of Congress in Tuesday’s midterm elections, that will likely lead to more gridlock, which the market typically loves.

According to data from Edelman Financial Engines, the S&P 500 has returned 16.9% since 1948 during the nine years when a Democrat was in the White House and Republicans held majorities in both houses of Congress. That’s 15.1% during the days of full Democratic control and 15.9% during the years of unified GOP government.

Investors are happy when politicians bicker but don’t actually introduce new laws that could hurt corporate profits.

An example is corporate taxes.

“What do midterms mean for markets? If Republicans get the House, tax increases are dead in the water,” said David Wagner, portfolio manager at Aptus Capital Advisors. Republicans are likely to support a tax on oil company profits and are generally not in favor of tax increases on the wealthy.

The market is also betting that some sectors could get a boost, even if Republicans take control of the House or Senate and presumably make it harder for President Biden to pass legislation.

That’s because there are some areas of agreement between the White House and Republican lawmakers.

“A GOP sweep could lead to more defense spending,” Wagner said. “Increasing the defense budget appears to be a bipartisan issue.” The House passed a record defense budget proposal this summer.

Biden and the Republicans also seem to be on the same page when it comes to boosting infrastructure spending. That could give a boost to utilities, construction companies and some real estate stocks. Congress last year passed a more than $1 trillion infrastructure bill championed by President Biden. But it’s still unclear what the appetite for more spending is… even if there is consensus that more is needed.

“Politically, everything is polarized, but there have been agreements on infrastructure. That happened too [Donald] Trump and [Hillary] Clinton in 2016,” said Jim Lydotes, deputy chief investment officer of equities at Newton Investment Management. “As a country we’ve underinvested in infrastructure.

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 when the midterms are in the rearview mirror. Congress and the White House can spend more time bickering than trying to pass legislation.

A divided government could also face some significant drawbacks, especially if fears of a recession materialize next year.

Rob Dent, senior U.S. economist at Nomura Securities International, said there could be less federal government spending on social safety net programs if Republicans control Congress.

“All else being equal, this can lead to a longer recovery from a recession,” Dent said. That would be bad for stocks, as consumer spending generally drives corporate profits.

Dent added that the prospect of further debate over the debt ceiling in Washington is unlikely. The last time it was a major issue was during President Barack Obama’s first term. The US lost its coveted perfect AAA credit rating from Standard & Poor’s in the wake of the debt ceiling drama. The stock market fell more than 5% after the crash in August 2011.

“This election result is less than could be done to help the economy in a downturn,” Dent said. “We are concerned that divided government will bring risks around the debt ceiling and the potential for a government shutdown. We haven’t had to deal with that in a long time.”

But at the end of the day, political headlines are just noise for the markets. Ameriprise chief market strategist Anthony Saglimbene said in a conference call last week that stocks have historically rallied after elections, regardless of which party controls the White House and Congress.

Mid-terms can also take a “back seat” to other macro issues. As Saglimbene notes, “growth, earnings, inflation and interest rates” are more important to investors over the long term. He acknowledged that the election results could lead to more near-term volatility, but the market is already pricing in a high probability of a divided government.

Politically induced market and economic volatility is the last thing consumers, investors, or the Fed need, given that inflation has not been transitory for much of 2021 as Fed Chairman Powell predicted.

It’s clear that higher commodity and other commodity prices, shipping and other transportation costs, and labor costs aren’t going away anytime soon.

Steve Cahillane, CEO of cereal and snack food giant Kellogg ( K ), said on the company’s latest earnings call last week that the idea that “inflation was going to be transitory” was always patently ridiculous.

We will get a better idea of ​​how sustainable inflation is on Thursday after the government releases September’s consumer price index (CPI) figures.

Economists polled by Reuters forecast overall prices rose 0.7% last month, compared with a 0.4% rise in September. That would boost year-on-year prices, which were up 8.2% in the past 12 months to September, even further. Continued labor market strength will put more pressure on prices as well.

“The labor market is resilient and inflation is also spreading to the service sector,” said Troy Gayeski, chief investment strategist at FS Investments.

This could raise further concerns that the economy could be headed for a so-called stagflationary environment, a period of stagnant growth accompanied by high inflation. If that happens, the Fed is likely to keep rates higher for longer.

“We will finally get out of this inflation/stagflation situation,” Gayeski said. “But it’s not like the Fed is going to quickly return rates to zero. It’s going to be very cautious.”

Monday: China trade data; BioNTech (BNTX), Take-Two (TTWO), Ryanair (RYAAY) and Lyft (LYFT) Earnings

tuesday: US midterm elections; DuPont ( DD ), Norwegian Cruise Line ( NCLH ), Lordstown Motors, Disney ( DIS ), Occidental Petroleum ( OXY ), News Corp ( NWS ), IAC ( IAC ), AMC ( AMC ), and Novavax ( NVAX ) earnings

Wednesday: Chinese inflation data; DR Horton (DHI), Weibo (WB), Hanesbrands (HBI), Capri Holdings (CPRI), Roblox, SeaWorld (SEAS), Wendy’s (WEN), Redfin (RDFN), and Beyond Meat (BYND)

Thursday: US CPI; US Weekly Jobless Claims; Earnings for Nio ( NIO ), Ralph Lauren ( RL ), Tapestry ( TPR ), WeWork, Six Flags ( SIX ), Yeti ( YETI ), and Warby Parker

Friday: US bond market closed for Veterans Day; UK GDP; US Michigan Consumer Sentiment; SoftBank Earnings (SFTBF)