Stock Week Ahead: How the Midterms Could Affect Wall Street

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The past week has been volatile on Wall Street. Stocks fell after Federal Reserve Chair Jerome Powell dashed the market’s dreams of a turnaround and hinted that more big rate hikes were likely ahead. But Wall Street continues to pin its hopes on Washington.

Investors bet on a big wave of Republicans in the midterm elections. If Republicans take over at least one chamber of Congress in Tuesday’s midterm elections, it will likely result in another deadlock, which the market usually loves.

According to data from Edelman Financial Engines, the S&P 500 has had an annualized return of 16.9% since 1948 in the nine years that a Democrat was in the White House and Republicans held the majority in both chambers of Congress. This compares to 15.1% in times of full democratic control and 15.9% in years when there was a unified GOP government.

Investors are more than happy when politicians bicker but don’t enact new legislation that could hurt corporate profits.

One example is corporate taxes.

“What do midterms mean for the markets? If Republicans get the House of Representatives, tax increases are dead,” said David Wagner, portfolio manager at Aptus Capital Advisors. Republicans may be less likely to approve a windfall tax on oil company profits, and they generally do not support tax hikes 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 consensus between the White House and Republican lawmakers.

“A GOP sweep could result in more spending on defense,” Wagner said. “Increasing the defense budget appears to be a bipartisan affair.” The House of Representatives passed a proposal for a record high defense budget this summer.

Biden and Republicans also appear to be on the same page on stimulating infrastructure spending. That could boost utilities, construction companies and some real estate stocks. Congress last year passed a bipartisan infrastructure bill worth more than $1 trillion that was eventually championed by President Biden. But it’s not yet clear what the appetite for more spending is…even if there’s consensus that more is needed.

“Everything is polarized politically, but there were commonalities in terms of infrastructure. That was even with [Donald] trump and [Hillary] Clinton in 2016,” said Jim Lydotes, deputy chief investment officer for equities at Newton Investment Management. “As a country, we have invested too little in infrastructure. That’s an area where there’s a lot of common ground.”

Of course, there is no guarantee that Biden and other Democratic leaders will be able to work effectively with Republicans in Congress. Finally, 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 arguing than trying to pass legislation.

A divided government can also have some significant downsides, especially if fears of a recession next year play out.

Rob Dent, senior US economist at Nomura Securities International, said there could be less federal spending on Social Security programs if Republicans take control of Congress.

“All else being equal, that could lead to a longer recovery from a recession,” Dent said. That would be bad for stocks in general as consumer spending drives corporate earnings.

Dent added that there was also the unwelcome possibility of more bickering in Washington over the debt ceiling. The last time this was a big issue was during President Barack Obama’s first term. The US lost its coveted perfect AAA rating from Standard & Poor’s in the wake of the debt ceiling drama. The stock market fell more than 5% after the August 2011 downgrade.

“This election result is less about what could be done and more about what might not be done to help the economy during a downturn,” Dent said. “We are concerned that a divided government could lead to the debt ceiling and the possibility of government shutdowns becoming reckless. We haven’t had to deal with that for a long time.”

But at the end of the day, political headlines are often just noise for the markets. Ameriprise chief markets strategist Anthony Saglimbene said on a midterm election conference call last week that stocks have historically risen post-election regardless of which party controls the White House and Congress.

The midterms could also fade into the background compared to other macroeconomic topics. Saglimbene noted that “growth, earnings, inflation and interest rates” are more important to investors in the long run. He acknowledged that the election results could lead to near-term volatility but the market is already pricing in a high probability of a split government.

Politically induced market and economic volatility is the last thing consumers, investors or the Fed need as inflation has not proven to be transient as Fed Chair Powell predicted for much of 2021.

It is clear that higher prices for raw materials and other raw materials, shipping and other transport costs and labor costs will not go away anytime soon.

Cereal and snack giant Kellogg (K) CEO Steve Cahillane even said on the company’s latest conference call last week that the idea that “inflation would be temporary was always obviously ridiculous.”

We will get a better sense of just how stubborn inflation is on Thursday after the government released September consumer price index (CPI) figures.

Economists polled by Reuters are forecasting headline prices to have risen 0.7% over the past month, up from a 0.4% rise in September. It would also likely push prices higher year-on-year, which are up 8.2% in the trailing 12 months to September. The sustained strength of the labor market will also continue to put pressure on prices.

“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 lead to further concerns that the economy is headed for what is known as stagflation, a period when sluggish growth coexists with high inflation. In that case, the Fed is likely to keep rates high for longer.

“We’re going to get out of this inflationary/stagflationary situation eventually,” Gayeski said. “But it’s not like the Fed is going to cut rates back to zero anytime soon. It will be very careful.”

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

Tuesday: midterm elections in the US; 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: inflation data for China; 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 CPI; Weekly Unemployment Claims in US; Earnings from 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; consumer sentiment in the United States of America; Earnings from SoftBank (SFTBF)

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