Market Perspectives Highlights:
- The midterm elections produced a definitive victory for the Republican party. But gridlock is likely to carry into 2015.
- Contrary to conventional wisdom, divided government has not historically resulted in better stock market returns.
- History does show stronger than normal returns in the third year of a president’s term, arguably a result of more economic stimulus in that year, something unlikely next year.
- One area we could see progress is trade. And the election could have an impact on certain sectors, including health care, defense and energy.
While many pundits expected a long night and close call, the midterm elections produced a definitive victory for the Republican Party. Not only did the Republicans recapture the Senate, but they increased their majority in the House of Representatives and won several governorships in states that typically lean Democrat. Still, the Republicans did not capture a "veto-proof" majority in the Senate and President Obama still has two more years in office. This begs the question: How much will policy actually change?
Movie buffs may recall Bill Murray's classic speech in the 1979 film "Meatballs" exhorting the campers "It just doesn't matter!" in their efforts to beat a rival camp in a race. For investors, this moment comes to mind as we face the prospect of a new U.S. Senate and House of Representatives: While the midterm election represents a significant shift in Washington's balance of power, it is not clear how large an impact the election results will have on financial markets.
Despite persistent and often creative efforts to identify market biases based on political configurations, there is little evidence to suggest a clear relationship. While policy matters a great deal, historically, no one party or configuration of parties has been consistently better or worse for financial markets. There is also little evidence to support the popular view that financial markets perform better during periods of divided government.
This leaves the Bill Murray question: Does Washington matter at all? Our view is that there are instances when both politics and the political cycle may have, at the margin, some impact. First, there is some evidence to suggest that equity markets do better during the third year of a presidential cycle. This phenomenon may be driven by a tendency to increase both fiscal and monetary stimulus in the run-up to a presidential election. However, while this has been a fairly reliable pattern in the past, it may not prove as meaningful next year. Given where we are in the monetary cycle, further monetary easing is unlikely. On the fiscal side, a combination of budgetary and political constraints make any further stimulus, to say the least, difficult to imagine.
Where the election is likely to have an impact is at the sector level. A Republican Senate nominally raises the likelihood for further trade liberalization. We are also more likely to see policy movement relating to health care, defense and energy specific issues. For example, it is conceivable that Republicans will use upcoming budgetary negotiations as an opportunity to pair legislation raising the debt ceiling with unrelated items, such as extension of the Keystone Pipeline or repeal of the medical device tax. That said, outside of a few niche areas, or another crisis requiring a policy response, we believe that for the next two years the markets will be driven by fundamentals, not by Washington's machinations.