Will the US midterms affect markets?

The upcoming US midterm elections could have the biggest impact on financial markets in years.

US flag at Wall Street
Source: Bloomberg

The 2018 US midterm elections will be one of the most watched in history - by politicians and investors. The midterm elections could have lasting repercussions for the US stock market for many reasons.

How Democrats could change Wall Street

The US stock market has been on a mulit-year bull run, but markets have been volatile for the last few weeks. The results of the midterm elections could complicate the markets more.

Historically, the party opposing the current president gains more seats in Congress at the midterms. This year, there's an additional reason for optimism from the opposition Democrats because a record 39 Republicans are retiring. A 'blue wave' of Democrats being elected to the House of Representatives and Senate could create a check to Republican President Donald Trump’s power and shift America’s financial priorities. Instead of Republican-friendly tax cuts to corporations that boost the stock market, Democrats could enact legislation to crack down on Dow Jones and boost spending to social programmes that could make investors extra-cautious.

'Markets will be closely watching the midterms as shifts in the balance of power in Washington could have meaningful implications for fiscal policy and foreign relations,' according to Niladri Mukherjee, a Merrill Lynch analyst.

'The president’s party has historically not fared well during midterm elections, and the results could affect the likelihood of certain pro-growth measures such as the so-called Tax Reform 2.0, which could include making individual tax cuts permanent and create new incentives for retirement savings and research and development,' added Mukherjee.

Democrats may also change stock market performance with political actions as well. A majority of Democrats in the House of Representatives could lead to a repeal of corporate tax cuts and implementation of regulations that could hurt the bottom line of major corporations and upset shareholders.

Markets are typically jittery before midterms

In the months before a midterm election, there is usually increased volatility. Portfolio manager, Mitch Zacks, notes that stocks tend to drop 19% in the months preceding the midterms. Investors can become anxious about a Washington leadership in flux, causing them to panic sell. October 2018 was no exception, with the Dow dropping by hundreds of points one day and rallying the next. October is often an unsettling month for stocks, but the midterms can add to the instability of the markets.

Markets calm down after midterms

While there is lot of unpredictability in stocks before the elections, they historically have settled down following the midterms. Once investors adjust to the new leadership, stocks tend to rise. The S&P 500 has grown by at least 12% in the year after a midterm election. The S&P 500 has never declined in the last 20 midterm cycles.

The uptick in stocks happens no matter which party is in control of Congress, but there is a slight difference. Despite the assumption that Democrats aren’t friendly to stockholders of large corporations, there is evidence that the S&P rises slightly more when Democrats take over Congress. In the year following the 2006 midterms when Republican George W. Bush was president and Democrats took over the House, the US 500 rose 24%. After Republicans took over Congress during 2010, stocks increased 31% under Democratic President Barack Obama.

Ironically, political gridlock between the two parties could help investors as well. If the Democrats take back the House and battle with a Senate still controlled by Republicans, there could be fewer laws passed that will affect investors.

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