Investors are getting ready for government gridlock because Republicans are expected to win in the U.S. midterms.

Asian Trade TVNovember 9, 2022

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NEW YORK – The U.S.Investors expect the Republicans to do well in the U.S. midterm elections. This will likely mean less spending and regulation by Democrats, but it will set up a rough fight next year over raising the U.S. debt ceiling.

Polls and betting markets show that Republicans are likely to take control of the House of Representatives. The Senate, on the other hand, is a closer call, and some states still have polls open. If that happened, Democrat Joe Biden would be president, and the government would be split. In the past, a split government has been good for the stock market in the long run.

Related: Investors are not happy with European stores this Christmas.

Early results from Tuesday’s midterm elections showed that Republicans were likely to take control of the House of Representatives. However, the chances of a “red wave” seem to have gone down. The Senate, which is currently run by Democrats, was still too close to call.

This year, the main things that have moved markets have been macroeconomic worries and the Federal Reserve’s monetary policy. However, politics on Capitol Hill could also have an effect on asset prices.

Analysts at Morgan Stanley (NYSE: MS) wrote this week that if the GOP did well in the midterm elections, it would likely ease investor fears that higher government spending would make inflation worse and increase the chances that the party would freeze spending by raising the debt ceiling. They said that could help 10-year Treasury bonds go up and help stocks keep going up after their recent gains.

“Gridlock does remove a little bit of uncertainty,” said Edward Jones’ top investment strategist, Mona Mahajan.”Some investors were worried about some of the trends in fiscal spending and tax reforms, especially in this inflationary environment.

“More generally, it gives companies a chance to prepare, plan, and budget knowing that new laws, rules, tax reforms, etc. may not be passed in this environment,” Mahajan said.

In the past, stocks have done better when the government is split and a Democrat is in the White House. Investors think this is because political gridlock keeps major policy changes from happening.

RBC Capital Markets looked at data going back to 1932 and found that the average annual return on the S&P 500 was 14% when there was a split Congress and 13% when there was a Republican Congress and a Democratic president. When Democrats ran the White House and Congress, that number was 10%.

A Republican Congress could stop fiscal stimulus and make “the Fed’s job to stop inflation a little bit easier,” said Troy Gayeski, chief market strategist at FS Investments.

On Tuesday, before the election results came out, the S&P 500 closed up 0.6%. The benchmark index has gone up about 5% in the last month, which has cut the 20% loss it has had so far this year.

Still, a split government could make it harder to raise the federal debt ceiling in 2023. This could lead to the kind of long-lasting fight that caused Standard & Poor’s to lower the U.S. credit rating for the first time in 2011, sending the financial markets into a tailspin.

Tim Ghriskey, a senior portfolio strategist at Ingalls & Snyder in New York, said, “If the Republicans really gain some power here in the House and Senate, they could make it very hard to raise the debt ceiling.”

U.S. Treasury yields, which move in the opposite direction of bond prices, have gone up a lot this year. However, a government shutdown could help keep yields and the dollar in check by easing worries that higher government spending could cause inflation. Analysts at Morgan Stanley say that, on the other hand, a surprise from the Democrats could lead to a stronger dollar and higher yields because a possible increase in government spending could require more rate hikes.

The U.S. equity options market is set up for relative calm, but if Democrats do better than expected, it could shake things up.

Tom Borgen-Davis, head of equity research at options market-making firm Optiver, said that the way options were positioned on Monday pointed to a 1.5% drop in the S&P 500 the day after the vote if Democrats did better than expected.

Some parts of the stock market could do better if the Republicans win, like pharmaceutical and biotech stocks, because there would be less chance of stricter rules on how much prescription drugs cost. Meanwhile, big tech stocks could do better because there would be less chance of regulatory pressure and more spending on defence.

On the other hand, if Democrats were in charge, shares of clean energy and cannabis companies could go up.

In the meantime, cryptocurrency spent millions of dollars on the U.S. midterm elections and may hope to change laws as lawmakers move forward with digital asset legislation.

The perfect record

Many strategists are quick to point out that the stock market has always gone up after midterm elections. According to Deutsche Bank, the S&P 500 has gone up every year after midterm elections since World War II (ETR:DBKGn).

(Graphic: U.S. stocks are doing great after the midterm elections, https://graphics.reuters.com/USA-STOCKS/MIDTERMS/gdpzqrdoqvw/chart.png)

But some investors said they didn’t think it would happen again this time because they didn’t know how quickly the Fed would be able to stop inflation and stop its market-damaging monetary tightening.

Even though the election result could end some uncertainty, investors are still worried about the future of stocks. This is shown by the fact that volatility futures tied to the CBOE Volatility Index will continue to trade at historically high levels well into next year.