AXA IM: Midterm elections - implication for policy and the economy

• Yesterday’s midterm votes are still being counted, but results show Democrats regained control of the House, while Republicans retain a majority in the Senate.

• The first mixed Congress for four years looks set to see political gridlock, which will significantly reduce the prospect of new major legislation, including any hopes for a second tax reform or infrastructure bill.

• Fiscal events are likely to become more fractious with an increased probability of government shutdown, perhaps as early as this December, although we do not expect a delay to extending the debt ceiling next summer.

• These midterms will likely influence the outlook for trade policy. We hold some hope for rapprochement between the US and China over the coming months, but over the medium term we believe a gridlocked Congress will see the President return to protectionism before the 2020 Elections.

• Democrat control of the House also grants control over the impeachment process. Uncertainty surrounds progress of the Mueller investigation and how Democrats might choose to proceed. However, they now have control.

• Modest immediate financial market reaction has been consistent with hopes for a Republican hold being priced out. Future moves will be guided particularly by trade policy developments and the cyclical outlook across 2019.  

At the time of writing, the votes of yesterday’s midterm elections were not fully counted and some counts may be days away with at least one vote likely to need a recount. However, the results were clear enough: Democrats won a majority in the House for the first time since 2010; Republicans look likely to modestly extend their lead in the Senate (polls suggesting a 53/54 Republican versus 46/47 democrat (and independents) split). This was in line with our expectations and most major polls. Early thoughts (some 6-months ago) of a Democrat ‘wave’ election that would have delivered both the House and Senate had faded in recent months, particularly as President Trump’s approval rating rose and Republican voters became more energised in the wake of the contentious Kavanaugh appointment. However, large turnout for young voters (18-29 year olds, 67% voted Democrat) and a strong bias for women voters (59% voted Democrat) provided a significant shift, which left Republicans unable to retain the House. While midterm elections are unlike Presidential elections, many saw this vote as different and a CNN exit poll suggested that two-thirds of voters said their vote was about President Trump, with more stating opposition than support. That said, though this provides some indications for the dynamic for the 2020 Presidential Elections, midterms elections have historically not proven great predictors of future Presidential votes.

The return to a mixed Congress for the first time in four years has a number of implication for policy and the economy over the coming two years.

Major policy initiatives now likely face political gridlock. The Republican direction of a second Tax Reform bill and the prospect of making some of the temporary tax cuts in the first bill permanent is now off the agenda. While progress may be made on issues with regards international sanctions, we now see agreement over immigration issues as much harder to achieve. In terms of policies more directly impacting the economy, we think there is little prospect of legislation that requires significant federal spending. One area of discussion regards an infrastructure bill, which is independently supported by both President Trump and Democrats. However, we believe that the two sides would want to achieve different things from such a bill and any revival of opposition fiscal rectitude from Republican deficit hawks will make funding such a bill difficult. Moreover, Democrats may see an incentive in delaying support for such a bill with hopes that they would have more control over the agenda in two years’ time.

The regular fiscal set pieces are now likely to face more fractious battles for approval. This may begin as early as 7 December, when the current continuing resolution expires. Late-September’s funding bill funded the majority of government spending for the coming financial year (until September 2019), including defence, labour, health and education departments. The small remaining minority faces a 7 December deadline for approval, which could be extended into next year. The fact that most of government is funded for the fiscal year would reduce the economic impact of any government shutdown that occurred over this spending round. However, this might encourage a symbolic battle. Thereafter, spending agreement for financial year 2020 from around the summer of next year could also prove difficult. The debt ceiling is also reinstated from March 2019 and will likely be reached in the summer, although we do not expect a delay in adjusting the debt ceiling.

Trade policy may be affected by the midterm results. We consider the outlook for trade policy uncertain, evens after these midterms, with White House motives for trade policy still unclear. However, with the immediate short-term political focus removed, we see some hopes for a period of reconciliation between the US and China and we hope for some progress in the end-November meeting between Presidents Trump and Xi. As such, while our baseline forecast assumes tariffs are increased to 25% (in January) on the $200 billion of Chinese imports currently covered at 10%, we do not expect the US to fulfil its threat of applying additional tariffs to the remaining $267 billion. This may provide a modest boost for markets. However, looking further into 2019 we see the prospect of the US raising tariffs on autos and auto parts (although excluding Canada, Mexico, Japan and the EU, which should individually be protected by bilateral deals). Moreover, our broader concern is that if political gridlock blocks the passage of legislation, the President may return to a policy that has proven quite successful to date and one that he can carry out, in the main, by Executive Order. Hence, we fear that the White House may return to protectionism later in 2019 or early 2020 in the run up to the Presidential elections, even if there is a modest hiatus in tensions over the coming months.      

Democrats gaining control of the House means they take control of the initiation of impeachment hearings. Much uncertainty still surrounds the outlook for the Mueller investigations and we have been surprised at the relative silence from this quarter in recent months. Perhaps with the political landscape now clear there will be more disclosure of progress. If these investigations find anything, the Democrats, now with control of the House, control the process to initiate impeachment. Besides what Mueller’s investigation discovers, there is also a political calculus involved in pursuing impeachment hearings and it is not obvious that new House Speaker Pelosi will take this path, recognising how divisive it may prove with possible repercussions for the upcoming Presidential elections. However, any such political decision would now sit with Democrats.

With votes not fully counted, financial market reaction has so far been tentative. Moreover, with the results coming in broadly in line with expectations, there should have been little reaction. However, while 2-year yields were stable at 2.91%, 10-year yields fell by 5bps to 3.18% and the dollar was 0.6% lower against a basket of currencies. Insofar as we would have expected yields, the dollar and equities to have moved higher on a Republican surprise, this modest correction lower probably reflects the small probability of this outcome being priced out of markets.

Looking further ahead, we do not expect a more marked reaction to this political news. Future market moves are likely to be governed by policies chosen as a result of this election.  As we believe trade policy will be affected in the short and medium term, we also see the prospect for announcements on this front boosting risk assets over the coming months, but it is still likely to be a long-term headwind. Beyond that, our expectation of ongoing solid expansion in US economic activity in 2019 (forecast 2.3%) should still be supportive of some stabilisation and rebound from a sharp correction in October. However, as we look through 2019, the outlook for the cycle and our outlook for a material deceleration in US economic activity in 2020 are likely to become the dominant drivers of financial market performance.