Midterm Elections: Gridlock

The potential outcomes of the midterm elections have been dominating the news cycle lately - with more than 60,000 news stories1 between September 30th and today referring to U.S. midterm elections - and we know from history that the markets typically do not like uncertainty. With the Democrats taking control of the House of Representatives, and Republicans maintaining their majority in the Senate, this clarity may bring some reassurance for investors (and with political ads disappearing, we can all rejoice!)

Throughout the course of 2018, Legacy has been communicating our expectations for a return to more normal levels of market volatility (after experiencing very little in late 2016 and 2017), driven by forces such as economic growth, inflation concerns, rising interest rates, trade tensions, and political uncertainty. And in fact, the S&P 500 Index has slipped into "correction territory," defined as a 10% decline from a recent high, on three separate occasions this year. While potential tariffs and Federal Reserve policy may have garnered most of the headlines, the underlying uncertainty around the U.S. midterm elections has probably also been pressuring markets.

Historically, midterm election years are the most volatile of the four-year presidential cycle. The equity markets are typically unable to sustain any lasting momentum because investors are awaiting the outcome and considering how it may influence policy, the economy, and in turn, the markets. Sometimes, market participants conclude that the potential for political "gridlock" - a divided Congress - is a favorable outcome, as that suggests any extreme political or economic measures are unlikely. Either way, since 1950 the U.S. stock market has displayed a sort of "relief rally" after the midterm elections; so if history repeats itself, we may see strong performance through the rest of 2018 and into the first half of 2019.

Although clarity may be all that the stock market is looking for, there are several important policy implications for investors to consider in light of this year's results. With the Democrats taking control of the House, "gridlock" may in fact mean a better sense of political balance for many market participants, as it limits the potential for the policy pendulum to swing too far in any one direction. We may also see an infrastructure spending deal and progress on trade, which could provide further support for the markets. On the other hand, the debt ceiling debate may create renewed uncertainty if the Democrats attempt to roll back some of the recent tax cuts in order to reach a deal on the federal budget, and increased scrutiny of the administration may periodically weigh on market sentiment2.

Overall, the traditional post-midterm election rally may ensue, as investors attempt to identify asset classes, sectors, and industries positioned to benefit from the election results.Although considering the deep domestic political divide, as well as the ever-present global challenges, it would be prudent for investors to prepare for further bouts of market volatility in the year ahead. At the same time, it's also important to stay focused on those factors that traditionally drive markets in the long run: not political headlines, but rather the solid fundamentals supporting economic growth, the direction of interest rates, and the impact of corporate profits on the financial markets.

While initially concerning, periods of volatility can be beneficial for patient investors. Market stress provides occasions to rebalance into areas of opportunity, providing capital to areas where capital is scarce and return potential is most significant. Legacy believes investors are best served by avoiding reactionary-decisions to short-term market moves, adhering to their investment plans, and maintaining diversified portfolios.

As always, Legacy will remain vigilant in monitoring the market situation and will take appropriate future actions for each client's unique situation.

1.    Rusty Guinn, "ET in the News: Midterm Elections Edition," Epsilon Theory, November 5, 2018. epsilontheory.com 
2.    John Lynch, Midterm Elections, LPL Financial LLC.

Jonathan Darabos