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Market View

With control of the U.S. Congress split as the Democrats take the House, what can investors expect? We turned to our experts for their insights.

 

In Brief

  • The American electorate has spoken, and the key word is “gridlock.” In the 2018 U.S. midterm elections on November 6, Democrats took control of the House of Representatives, while Republicans maintained their hold on the Senate.
  • The initial market response to this outcome was positive, with major equity indexes advancing in early trading on November 7.
  • Lord Abbett experts’ key takeaways: Additional tax cuts are less likely, trade and regulatory policies are likely to remain in place, while Democrats may pursue a number of investigations of the Trump administration.
  • What should investors do now? Our outlook for solid growth in the economy, supported by strong fundamentals, remains the same.  We believe this argues for a patient, long term approach to equity and fixed-income portfolios.

 

The wait is finally over. After one of the most contentious campaigns in memory, the results of the U.S. midterm election on November 6 are in. As widely expected, the Democratic Party picked up at least 26 Republican-held seats to gain control of the House of Representatives. In the Senate, the Republican Party added seats to strengthen its majority. At the state level, Republicans continue to hold the majority of governorships despite some high-profile defeats.

The results may usher in a new era of partisan gridlock, as Democratic opposition may block key parts of President Trump’s policy agenda, especially a second round of tax cuts following the 2017 tax-reform legislation. Also, Republican efforts to undo the Affordable Care Act are likely to be blocked by a Democratic House.

Equity markets responded positively to the results in early trading on November 7, as “this middle ground (gridlock) allows for some controls on President Trump but does not undo his policies,” says Lord Abbett equity trader Nestor Melendez, who prepares a daily market analysis for the firm. The U.S. dollar weakened, while U.S. Treasury yields retreated from 7-year highs.

Melendez notes that history has shown that markets typically rallied in the 12 months following midterm elections (even in a divided Congress). But, the potential for trade uncertainties, as well as new rounds of House investigations and subpoenas regarding potential Russian interference in the 2016 elections, as well as other matters, “may limit the post-election rebound this time.”

Potential beneficiaries of the November 6 results, in Melendez’s view, include infrastructure and defense stocks, while the pharmaceutical sector “may feel some pain” as Rep. Nancy Pelosi (D-Calif.), who will likely resume her previous tenure as Speaker of the House, said Democrats may “take real, very strong legislative action” to lower drug prices.

A Bloomberg report surveying prospects for key sectors1 noted that industrials “may continue to languish” under a divided government as a major spending package would be unlikely. The report also noted that technology and internet stocks are likely to face more regulatory scrutiny, with the opposite holding true for banks, “as President Trump’s regulators are firmly in place.”

With the elections in the rear-view mirror, Melendez expects markets will focus once again on geopolitics, with a number of concerns, from Brexit to the Italy-European Union fiscal conflict to additional sanctions on Iran, coming into focus.

Our Experts’ Views
Lord Abbett Partner and Director of Strategic Asset Allocation Giulio Martini says that the midterm elections “delivered no major surprises.” U.S. economic growth remains “dynamic,” he says, with the impact of federal fiscal moves expected to peak in the fourth quarter of 2018 to the first quarter of 2019. However, he believes U.S. trade and monetary policies remain “significant wild cards for global markets.”

Lord Abbett Partner and Portfolio Manager Leah Traub notes that “the most likely outcome is what indeed happened, although I don’t think this outcome was fully priced into the markets.” She observed that “polling was so wrong in [the 2016 U.S. presidential election] that it gave most people pause in positioning too much ahead of time” for the 2018 midterms. In her view, riskier assets—including equities and high-yield bonds—“should have room to rally,” with the U.S. dollar likely to weaken in the near term. 

Given the November 6 results, Traub says it appears unlikely that any new tax bills will get passed, or that previous tax cuts will be repealed. Traub thinks that is “fine, since the economy is doing well and does not need more fiscal stimulus.” After the relief rally, Traub believes markets will go back to focusing on economic news, policy moves by the U.S. Federal Reserve (Fed)—which she thinks will remain on course to hike rates in December 2018 and “probably a couple of times next year”—and trade tensions. 

In a previous Market View, Lord Abbett Partner and Portfolio Manager Kewjin Yuoh noted some factors that investors should consider with split control of Congress. “Tax cuts have certainly been a supportive fiscal policy,” according to Yuoh. “This potential outcome would decrease the likelihood that a second wave of tax cuts would be coming. Economic growth could slow down under this scenario, a consideration that hasn’t necessarily been priced into the market yet,” Yuoh says.  

“Trade policy, tariffs, and potential trade wars have all been significant to spread valuations and market action,” Yuoh says, “but decisions on these policies reside largely in the executive branch, so nothing significant would be expected to change in this regard. Of course, the political rhetoric would continue, contributing to market volatility.”

Yuoh provided an update to Market View on November 7. He thinks that after the midterms, the contentious state of U.S. politics is likely to remain, given widening party divisions. “I do think you will have some risks to headline market volatility, but once again, we’ll live by the tenet that political volatility needs to be looked through when it comes to longer term fundamental economic considerations.”  He believes “the risks to the markets very much revolve around declining global growth and increasing Fed policy uncertainty.”

As Lord Abbett Partner and Chief Investment Risk Officer Alec Crawford and his team assessed the developments on Election Day, their goal was “not to predict whether events will happen or not, but to look at different scenarios,” assess their likelihood, and collaborate with internal and external research units to model the potential impact on the firm’s investment strategies. “In the end, we’re not trying to predict exact performance under these scenarios, we’re just trying to judge, from a risk management standpoint, whether any of these outcomes or events could have a very large impact on our portfolios,” Crawford told Market View ahead of the voting.

“What’s interesting, though, is what’s priced in—not just whether stocks may do well or poorly, but how well or poorly. So the big question is, what’s already built in? My view is that no matter the outcome, we’ll see at least a one-day move.”

Crawford believes that a scenario of a Democratic House and Republican Senate “would be somewhat market positive, because the markets tend to like gridlocked government, even if the electorate doesn’t.” He says that such a split would take moves to impeach President Trump off the table, as “it would be very hard to impeach him on a party line basis” given Republican control of the Senate.

As investors digest the 2018 midterm results, Crawford notes that active managers may be in a better position to take advantage of future bouts of volatility compared to passive strategies. “We don’t have to own things to mirror indexes, so we have flexibility during times of market volatility and uncertainty.”

As for U.S. equities, Lord Abbett Investment Strategist Brian Foerster says that the election results alleviate one of the three risks that the market has been digesting over the past six weeks, namely concern over either a “blue wave” or a “red wall.” In his view, “effectively, the market got both the predicted and most favorable outcome for equities.” He notes that the concern over a big Democratic sweep centered around legitimate concerns of the headline risk of impeachment proceedings and significant regulation around drug prices and Internet privacy, as well as attempts to unwind pro-business legislation over the past two years. Meanwhile, investor concerns over Republicans maintaining their dominance centered around the potential for even more aggressive stimulus with a second tax cut that could lead to accelerated inflation and/or more aggressive Fed tightening.  With the November 6 outcome, Foerster says “it would appear that we are now steeped in gridlock for the next two years,” an outcome that he believes is “ironically, the most benign scenario for equities in the near term.” 

Foerster notes that midterms have tended to be drivers of near-term volatility “going back decades,” but those pullbacks have historically been periods of opportunity for equity investors. He points to a Strategas Research analysis2 of the past 14 mid-term elections (1962-2014), which showed that the average correction during a midterm year was -18.9%, but that the subsequent 12-month return from that low was an average of 31.2%. Moreover, Strategas found that the S&P 500® Index has not declined in the 12 months after midterms going back to 1950, owning partly to the sharp selloff that typically occurs during the midterm election cycle and the relief rally that tends to follow.

Foerster still anticipates more equity market volatility in the near term as political rancor intensifies into 2019, but believes that the simple fact that the midterms are over is a net positive for equities.  “Longer term, we still believe overall market fundamentals are strong and that areas of innovation in secular bull markets continue to be underappreciated by investors, and may provide outsized returns to investors for the next few years, longer than the consensus view,” he says. 

Summing Up
With the midterm results in, investors may have some time to catch their breath and take a fresh look at the current environment. As Yuoh pointed out earlier, it’s important to keep focused on fundamentals. “Historically, event risk, and specifically political event risk, generally provides short-term opportunities in the marketplace” according to Yuoh. “But as far as its impact on long-term fundamentals—that has been a much slower-moving phenomenon. And so in the current environment, with fundamentals being as strong as they are, we expect the midterm elections to potentially provide some volatility and some risk-taking opportunities in the short term. But our outlook for U.S. growth and the domestic economy continues to support our position to take risk.”

Coming soon: Our experts will present their views on what’s ahead for the global economy and markets in 2019 in our Year-end Investment Roundtable. Don’t miss it!

 

1Felice Maranz, “Stock Investors Are Watching These Six Sectors Ahead of Midterms,” Bloomberg, November 5, 2018.
2Strategas Research Partners, “3Q in Review in Charts: Markets Catch Up to the Economy”, October 1, 2018.

 

 

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