John Lynch Chief Investment Strategist, LPL Financial
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Will midterm elections drive mayhem in the markets? The upcoming midterm elections promise to be among the more interesting in recent decades. The Republicans can take comfort in elections generally being about “…the economy, stupid!” Unemployment is at multidecade lows and wages are trending higher.
On the other side, Democrats can point to the administration’s lack of progress on trade, President Trump’s below-average approval ratings, and the number of House of Representatives seats historically lost in a president’s first midterm election (~29 based on the past 13 such elections over 100-plus years, according to Strategas Research Partners).
While historical patterns, recent polling data, and betting sites suggest odds slightly favor that the House flips, what does that potentially mean for policy, and how might markets react? We take a look here.
POLITICAL TAILWIND?
As stock investors, we have mixed emotions about the upcoming midterm elections. On the one hand, historically, stock market volatility increased ahead of the elections due to policy uncertainty. However, stocks also tended to rebound strongly coming out of midterm election-year lows, as we wrote about here. The S&P 500 has been higher one year after the midterm election than it was on midterm election day every time since 1946. We are now entering the most favorable part of the four-year presidential cycle.
Figure 1 breaks up the four-year cycle by quarter, so the first period is the first quarter of a new president’s term (year one) and the last period is the fourth and last quarter of a president’s term (year four). We are about to enter the fourth quarter of year two. As the chart shows, the period from the fourth quarter of year two through the second quarter of year three has historically been the best nine-month period of the entire cycle (going back 120 years on the Dow Jones Industrials). Note that some of this seasonal boost may have been pulled forward into years one and two, so it may be prudent to temper expectations some.
The upcoming year (post midterms, pre-election) has historically been the best of the four-year cycle, in part because of presidents’ efforts to boost the economy with pro-growth policies ahead of the election in year four. While we are not ready to make any market predictions for 2019, the political calendar is encouraging and we would look at any volatility driven by policy uncertainty ahead of the midterm elections as an opportunity. This historical pattern is hard to ignore, while the economic backdrop is favorable and corporate fundamentals are quite healthy.
IS GRIDLOCK GOOD?
We often get the question: What political leadership combination in Washington, D.C., is best for the stock market? This is an easy question to answer by looking at historical returns, which we have done in Figure 2. A Democratic president and Republicancontrolled Congress has been the best combination for the S&P 500, followed closely by a Democratic president and split Congress. A divided Congress under a Republican president, a reasonable prediction for the outcome this November, has also been a good environment for stocks historically. On the other end of the spectrum, a Republican president and Democratic-controlled Congress (possible but unlikely in November) has produced the weakest average returns.
It is difficult to say whether we can we apply this history to the upcoming elections. Regardless of which side of the political aisle you land on, the stock market has performed well since President Trump took office with Republican majorities in the House and Senate (the S&P 500 has risen 29% since the start of 2017 through September 17, 2018). Stocks seemed to like tax reform. So perhaps the status quo wouldn’t be so bad.