A version of this story first appeared in CNN Business’s Before the Bell newsletter. Don’t have a customer? you can sign up right here,
Last week was a volatile one on Wall Street, with shares falling after Federal Reserve Chairman Jerome Powell dashed market dreams and suggested more big rate hikes are likely. But Wall Street is still turning its hopes toward Washington.
Investors are betting on a big Republican wave in the midterm election. If Republicans take at least one House of Congress in Tuesday’s midterm election, it will result in more stalemate, which the market generally prefers.
According to data from the Edelman Financial Engine, the S&P 500 had an annual return of 16.9% during the nine years since 1948 when a Democrat was in the White House and Republicans had a majority in both chambers of Congress. This compares to 15.1% during periods of full democratic control and 15.9% in years when there was a unified GOP government.
Investors are happier when politicians chime in, but don’t actually enact any new laws that could hurt corporate profits.
One example is taxes on businesses.
“What does the medium term mean for the markets? If Republicans get the House, the tax hike is dead in the water,” said David Wagner, portfolio manager at Aptus Capital Advisors. Republicans may be less likely to approve an unexpected tax on oil company profits and are generally not in favor of tax increases on the wealthy.
The market is also betting that some areas may get a boost — even if Republicans take control of the House or Senate and possibly make it more difficult for President Biden to pass legislation.
That’s because there are few areas of consensus for the White House and Republican lawmakers.
“A GOP sweep could cost more on defense,” Wagner said. “Raising the budget for defense seems to be a bipartisan issue.” The House passed a record high defense budget resolution this summer.
Biden and Republicans also seem to be on the same page when it comes to increasing spending on infrastructure. It can boost utilities, construction companies and some real estate stocks. Congress last year passed the more than $1 trillion bipartisan infrastructure bill that President Biden ultimately championed. But it is not yet clear what drives the appetite to spend more… even though there is general consensus that more is needed.
“Politically everything is polarised, but there has been common ground on infrastructure. it was the same with [Donald] Trump and [Hillary] Clinton in 2016, said Jim Lidots, deputy chief investment officer for equities at Newton Investment Management. “As a country we have underinvested in infrastructure. This is an area where there is considerable consensus.”
Of course, there is no guarantee that Biden and other Democratic leaders will be able to work effectively with Republicans in Congress. After all, the political narrative will quickly shift to the presidential race of 2024, when the midterms will be in the rear view mirror. Congress and the White House may spend more time than just trying to get legislation passed.
There could also be some significant drawbacks to a divided government, especially if fears of a recession emerge next year.
Rob Dent, senior US economist at Nomura Securities International, said the federal government’s spending on social safety net programs could be cut if Republicans took control of Congress.
“All else being equal, that could lead to a longer recovery from the recession,” Dent said. This would generally be bad for stocks because consumer spending outweighs corporate profits.
Dent said there is also the unwanted potential for further bickering in Washington about debt limits. The last time that was a major issue was during President Barack Obama’s first term. The debt ceiling drama resulted in America losing its prized overall AAA credit rating from Standard & Poor’s. The stock market fell more than 5% after being downgraded in August 2011.
“This election result is less about what can’t be done to help the economy during a recession,” Dent said. “We are concerned about a divided government that is on the verge of debt ceiling and the possibility of a government shutdown. We haven’t had to deal with it for a long time.”
But at the end of the day, political headlines are often just noise for the markets. Ameriprise chief market strategist Anthony Saglimbene said on a conference call last week about the mid-term that stocks have historically gone up after the election, no matter which party controls the White House and Congress.
The medium term could also take a “back seat” to other macro issues. Saglimbene noted that “growth, profit, inflation and interest rates” matter more to investors over the long term. He acknowledged that the election results could create more volatility in the near term, but the market is already pricing in the strong possibility of a divided government.
Politically motivated market and economic volatility is the last thing consumers, investors or the Fed need to see that inflation has not become as fleeting as Fed Chairman Powell predicted for 2021.
It is clear that higher prices for commodities and other raw materials, shipping and other transportation expenses, and labor costs are not going to go away anytime soon.
Steve Kahlen, CEO of cereal and snack food giant Kellogg’s (K), also said on the company’s most recent earnings call last week that “inflation was going to be fleeting, it was always frankly ridiculous.”
We will have a better idea of how stable inflation is on Thursday after the government reports its September Consumer Price Index (CPI) data.
Economists polled by Reuters are forecasting that overall prices rose 0.7% last month, up from 0.4% in September. This is likely to drive up the year-on-year prices, which rose 8.2% during the past 12 months to September, even more. The continued strengthening of the job market will put further pressure on prices.
“The labor market is resilient and inflation is spreading to the services sector as well,” said Troy Gesky, chief investment strategist at FS Investments.
This could further raise concerns that the economy could be headed for a so-called stagflationary recession, a period where high inflation is accompanied by stagnant growth. If that happens, the Fed is likely to keep rates higher for a longer period of time.
“We will eventually get out of this inflationary/inflationary situation,” Gesky said. “But it’s not like the Fed will quickly return rates to zero. It’s going to be really cautious.”
monday: China trade data; Earnings from BioNTech (BNTX), Take-Two (TTWO), Ryanair (RYAY) and Lyft (LYFT)
Tuesday: US midterm elections; Revenue from DuPont (DD), Norwegian Cruise Line (NCLH), Lordstown Motors, Disney (DIS), Occidental Petroleum (OXY), News Corp (NWS), IAC (IAC), AMC (AMC) and Novavax (NVX)
Wednesday: China inflation data; Revenue from DR Horton (DHI), Weibo (WB), Hansbrands (HBI), Capri Holdings (CPRI), Roblox, SeaWorld (SEAS), Wendy’s (WEN), Redfin (RDFN) and Beyond Meat (BYND)
Thursday: US CPI; US weekly jobless claims; Earnings from Nio (NIO), Ralph Lauren (RL), Tapestry (TPR), WeWork, Six Flags (SIX), Yeti (YETI) and Warby Parker
Friday: US bond markets closed for Veterans Day; UK GDP; US U of Michigan Consumer Sentiment; Income from SoftBank (SFTBF)