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Investors face unclear outcome in midterms, with questions over spending, regulation

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NEW YORK, Nov 9 (Reuters) –

Investors on Wednesday are weighing a less clear outcome in the U.S. midterm election, as a better-than-expected showing by Democrats muddies the outlook for issues such as fiscal spending and regulation.

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Control of Congress was still up for grabs early on Wednesday with many of the most competitive races uncalled, leaving it unclear whether Republicans would crack Democrats’ tenuous hold on power. The prospects of a “red wave” had evaporated although in the House of Representatives, Republicans remained favored to win a majority.

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S&P futures were off about 0.5% on Wednesday morning, while the dollar rose against a basket of currencies. Yields on the benchmark U.S. 10-year Treasury, which move inversely to prices, were higher.

“You’re in a slightly different situation and it does look like the Biden Presidency has not been dealt a massive blow by these midterm elections, so the markets are in a wait-and-see mode,” said Danni Hewson, financial analyst at AJ Bell in London.

While macroeconomic concerns and Federal Reserve monetary policy have been the dominant forces behind market moves this year, Capitol Hill politics could exert influence on asset prices.

If Republicans are able to take control of the House of Representatives, it means split government with Democrat Joe Biden in the White House, an outcome that historically has been accompanied by positive long-term stock market performance.

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A strong performance by Republicans had been seen as likely to allay investor concerns about higher fiscal spending exacerbating inflation and raise the chances of the party freezing spending via the debt ceiling, analysts at Morgan Stanley wrote this week. That could support a rally in 10-year Treasury bonds and help stocks extend their recent gains, they said.

Historically, stocks have tended to do better under a split government when a Democrat is in the White House, with investors attributing some of that performance to political gridlock that prevents major policy changes.

Average annual S&P 500 returns have been 14% in a split Congress and 13% in a Republican-held Congress under a Democratic president, according to data since 1932 analyzed by RBC Capital Markets. That compares with 10% when Democrats controlled the presidency and Congress.

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Analysts have forecast that equities would react negatively if Democrats manage to maintain House and Senate majorities, with Goldman Sachs analysts saying that there would be risk of additional corporate tax increases weighing on earnings and risk of higher interest rates to counter probable additional spending.

A gridlock situation would be more positive, analysts have said.

“For the markets, a gridlocked administration should be positive for equities, given that it makes the Fed’s task that little bit easier,” said Stuart Cole, head macro economist at Equiti Capital.

Ahead of the election results, the S&P 500 finished up 0.6% on Tuesday. The benchmark index has risen about 5% over the last month, cutting its year-to-date decline to about 20%.

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Still, a split government could lead to heightened tensions over raising the federal debt ceiling in 2023, setting up the kind of protracted battle that led Standard & Poor’s to downgrade the U.S. credit rating for the first time in 2011, sending financial markets reeling.

“This will almost certainly be the end of the tax rises the Biden administration had been talking about imposing on U.S. corporations and the well-off,” said Cole.

“It also means the end of the loose fiscal policy Biden had been pursuing. This is particularly important, as it removes a source of stimulus from the economy and makes the job of the Fed in getting inflation back under control that little bit easier, to the extent that it may allow for a lower terminal rate.”

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U.S. Treasury yields, which move opposite to bond prices, have soared this year, but government gridlock could help contain them – and the dollar – as it relieves concerns about heightened fiscal spending that could drive inflation.

Conversely, a Democrat surprise could mean a stronger dollar and higher yields as possible fiscal expansion could require more rate increases, analysts at Morgan Stanley said.

With the U.S. equity options market positioned for relative calm, Democrats retaining control could upend markets.

Options positioning on Monday implied a decline of 1.5% in the S&P 500 on the day after the vote should Democrats pull off a stronger-than-expected showing, according to Tom Borgen-Davis, head of equity research at options market making firm Optiver.

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Republican gains, meanwhile, could boost several areas of the stock market such as pharmaceutical and biotech shares, on diminished prospects for tougher prescription drug pricing rules. Big tech stocks could benefit from less likelihood of regulatory pressure and defense on expectations of more significant spending.

Conversely, Democrats holding power could support shares of clean energy and cannabis companies.

Cryptocurrency, meanwhile, spent millions on U.S. midterm races and may hope to influence laws as policymakers push forward digital asset legislation.

PERFECT TRACK RECORD

Many strategists are quick to cite the stock market’s perfect post-midterms track record: The S&P 500 has posted a gain in each 12-month period after the midterm vote since World War Two, according to Deutsche Bank.

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But some investors cautioned against expecting a repeat this time, given uncertainty over how quickly the Fed will be able to tame inflation and end its market-bruising monetary tightening.

Indeed, while the election outcome could put some uncertainty to rest, investors remain on edge about the outlook for stocks, as shown by volatility futures tied to the Cboe Volatility Index trading at historically elevated levels well into next year.

One potential catalyst for volatility comes Thursday with the U.S. consumer price report, a data point that has spurred sharp market moves throughout 2022.

“Next year’s earnings estimates are still too high, Fed policy is still tight and tightening, inflation is still too high,” said James Athey, investment director at Abrdn.

“This is all bad news for equities.”

(Reporting by Bansari Mayur Kamdar, Saqib Iqbal Ahmed, Carolina Mandl, Laura Matthews and Lewis Krauskopf; Editing by Ira Iosebashvili, Megan Davies, Jonathan Oatis, Claudia Parsons and Chizu Nomiyama)

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