What a split congress could mean for markets

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November 2022
 

As Republicans take control of the House after two years of Democrats holding both chambers of Congress, managers and economists from BNY Mellon Investment Management outline what the future may hold with the shifting balance of power.

Highlights:

  • Market volatility typically declines after a major election
  • A split government will likely lead to greater political gridlock
  • Risk assets have potential to fare well
  • Municipal bonds are likely to be unaffected and the short end of the Treasury curve is unlikely to move

Republicans have won the House, but Democrats have retained their Senate majority. The new makeup of Congress raises questions as to how markets will respond after a period of volatility and rising inflation. BNY Mellon Investment Management portfolio managers and economists have varying opinions on what a divided Congress will result in.

What does a divided Congress mean?
Merely having the midterms in the rear-view mirror is a good thing for the markets because the uncertainty surrounding potential new regulation and taxes is alleviated, says Insight Investment, head of US multi-sector fixed income Gautam Khanna. “Risks assets have traditionally been volatile and trended sideways just before midterm elections, but generally calmed down and rallied in the aftermath1.”

Khanna thinks a split government will likely lead to greater political gridlock with Republicans thwarting Democrat’s policy implementation.

“Although the Democrats passed key legislation in their first two years, such as its infrastructure bill, CHIPS Act and Inflation Reduction Act, they were not quite able to meet all their ambitions including further tax hikes on corporations and the wealthy, healthcare expansion, drug pricing caps, childcare tax credits, student loans and education spending and climate change,” says Khanna. “All tax related policy must originate from the House of Representatives, meaning any such initiative will fail before moving on to the Senate to be passed into law.”

BNY Mellon Investment Management GEIA team head of US macroeconomics, Sonia Meskin, concurs that a split Congress is less likely to produce meaningful economic changes because any large-scale spending or tax reductions could risk further fueling inflation.

She shares a similar outlook when it comes to potential market implications. “The short end of the Treasury curve is unlikely to move as it reflects near-term monetary policy expectations, which are not likely to change,” says Meskin. “Equity indices may rise modestly on the passage of a risk event (the midterm elections) and the US dollar could see a very modest weakening.” She notes historically, equities have performed well following midterm elections as political uncertainty declines, all else equal.

Potential market-friendly outcomes
Despite the predicted gridlock in Washington, a divided house could result in markets edging upwards. “The market has already priced in the Democrats holding the Senate while the Republicans hold the House so we wouldn’t expect much movement in the market,” says John Bailer, deputy head of equity income, portfolio manager, Newton. “A split government is a welcome result for the US equity market as big fiscal spending will likely be off the table. However, defense spending will likely be a priority for the Republicans, which could increase by 8%. Furthermore, I expect the trades that have been working continue to work.”

Bailer also believes the midterm election results will keep hot button issues – inflation and interest rates – elevated. “Inflation and interest rates will likely stay higher than they have over the previous decade due to deglobalization, limited oil supply and the fiscal stimulus already passed,” says Bailer. “This additional fiscal stimulus will benefit capex spending in the United States which will lead to a manufacturing renaissance.”

Khanna agrees that markets could be poised to improve. “Risk assets have historically performed better after midterms when control of Congress and the White House is split,” says Khanna. “The Republicans gaining a foothold in Congress by winning a majority in the House of Representatives is potentially the most market-friendly outcome.”

Economic management may shift while concerns of inflation may be mitigated. “I expect the prospect of curtailed fiscal spending to ease market concerns around inflation. This will leave the management of inflation and growth entirely in the hands of the Federal Reserve,” says Khanna. “The central bank is focused on bringing down inflation by reducing demand.”

Insight Investment head of municipal bonds Dan Rabasco foresees the municipal bond market keeping its foothold. “Market sentiment would view gridlock as non-expansionary and provide a more stable backdrop to rates,” says Rabasco. “There will likely be little or no impact on municipal bond fundamental credit conditions, nor any change to supply/demand picture for municipal bonds.”

Newton head of specialist investment research Raphael Lewis says the Real Return team is agnostic to the outcome to the midterm elections because Republicans and Democrats are largely in accord when it comes to policies that may immediately impact corporate strategy and business outcomes.

“Whether antagonism to the technological rise of China, the desire to ramp up military and cyber security, discomfort with the power and reach of Big Tech, populist policies favoring the reshoring of industry, and unease with new large-scale stimulus spending that could further exacerbate inflation, the argument is not over whether to act, but rather over whether the Republicans or Democrats can claim the mantle of savior,” says Lewis.

However, in light of the divided government, Lewis notes geopolitical instability will likely remain and possibly accelerate. “US aid to Ukraine in its defensive war against Russia could decrease materially if the isolationists prevail.”

1Goldman Sachs, October 2022, based on US equity performance from past 90 years.

Disclosures

All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks.

BNY Mellon Investment Management is one of the world’s leading investment management organizations, encompassing BNY Mellon’s affiliated investment management firms and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the corporation as a whole or its various subsidiaries generally.

Investment advisory services in North America are provided by Insight North America LLC, a registered investment adviser and regulated by the U.S. Securities and Exchange Commission (SEC). Insight North America LLC is associated with other global investment managers that also (individually and collectively) use the corporate brand Insight Investment and may be referred to as “Insight” or “Insight Investment.”

“Newton” and/or the “Newton Investment Management” brand refers to the following group of affiliated companies: Newton Investment Management Limited (NIM) and Newton Investment Management North America LLC (NIMNA). NIM is incorporated in the United Kingdom (Registered in England no. 1371973) and is authorized and regulated by the Financial Conduct Authority in the conduct of investment business. Both Newton firms are registered with the Securities and Exchange Commission (SEC) in the United States of America as an investment adviser under the Investment Advisers Act of 1940. Newton is a subsidiary of The Bank of New York Mellon Corporation. Newton’s investment advisory businesses are described in their Form ADVs, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request.

Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.

This material has been provided for informational purposes only and should not be construed as tax advice, investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change.

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