Market Outlook

Midterm Elections: Divided Congress Signals Gridlock 

By Jeff Schulze, CFA
07 Nov, 2018
With control of the Senate and House now divided, and the prospects for a recession still muted, the S&P 500 should continue to march higher in 2019 — with areas of potential opportunity for active managers in specific sectors.

Midterm Elections: The Impact on Stocks

ClearBridge Investment Strategist Jeff Schulze examines what the election results may mean for the U.S. equity market in the months ahead.

 

No matter what your political affiliation, it’s important to keep an unbiased lens on market expectations. Historically, regardless of election outcomes, there has been a very strong relationship between market price action and midterm elections. It’s important to note that we’ve experienced every possible congressional combination of Democratic and Republican majority during these periods.

While each period may have experienced different fears, flash points and backdrops, stocks were up in the 12 months following each of the last 17 midterm elections going back to 1950. Stocks have historically performed much better than average in the three-, six- and 12-month periods following midterms, as shown below.

While it may feel like this time is different, history would suggest it rarely is. In fact, the only instance where the S&P 500 Index came close to experiencing a decline was after the 1986 election. This was a direct consequence of Black Monday, the largest single-day loss in stock market history.

Stocks Have Performed Strongly Post Midterm Elections

S&P price performance, pre- and post-midterms, 1950-2016    

Source: FactSet. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. For illustrative purposes only and does not represent the performance of any specific investment product.

Taking a step back, we believe post-midterm election environments are positively skewed due to the presidential cycle. This phenomenon, which closely mirrors the economic cycle, shows that the economy has not seen the start of a recession during the third year of a presidential term in the modern era due to the nature of fiscal stimulus. Specifically, fiscal spending tends to be strongest during the middle of a presidential cycle, typically eroding as a new president enters or a two-term president exits the Oval Office. As such, recessions have historically clustered at the beginning or end of the presidential cycle:

Presidential Cycle and the Economy

Number of Recessions Starting Per Year of the Presidential Cycle, 1948–2016

Source: Strategas Research Partners. For purposes of this analysis, recession is defined as two consecutive quarters of economic contraction. 

We believe the key takeaway from the midterms as it relates to equity markets is straightforward. The S&P 500 should continue to march higher into 2019, with the prospects for a U.S. recession remaining below the horizon, for now. That doesn’t mean, however, that the election won’t create opportunities for active managers within specific sectors or groups of stocks.

In something of a contrast to 2016, the midterm elections largely followed the script with a split in direction of the two chambers of Congress. This scenario has been the consensus narrative for several months now, and investors have had a chance to digest the potential implications. As a result, we believe the market reaction will be more muted than had one party emerged from election night with control of both the House and Senate.

Trade to Remain Policy Centerpiece of Trump Administration

Our base case remains that trade/tariffs will continue to be a focal point for the administration, particularly as it is an area where they can act largely without input from Congress. Importantly, this outcome removes the prospect for additional fiscal stimulus that could help offset any future drags from tariffs. As a result, the economy will be less capable of weathering any storms than it has been this past year. This increases the probability that the administration’s stance softens from current levels. International markets should attract capital at the expense of the U.S. should a détente materialize.

The health care sector has arguably the most to gain or lose based on these elections. A congressional split takes major changes to the Affordable Care Act (ACA) and drug price controls largely out of the near-term discussion. This should be viewed by participants as positive for biopharmaceutical stocks, resulting in a potential rerating higher. Additionally, this could be the catalyst for more merger and acquisition activity within biotechnology, as many larger pharmaceutical companies are flush with repatriated overseas cash.

The administration’s deregulatory efforts will likely slow but not stall, given the specter of investigations into the executive branch and government agencies by various House committees. However, the GOP-led Senate will still be in position to confirm cabinet appointees. This should help keep business confidence high, as company managements will have more certainty of a continued deregulatory operating environment. In turn, this should help to sustain the pickup in capital spending. While the benefits are broad-based, we believe continued deregulation should benefit financials and energy names the most. Additionally, portions of the new communication services sector have the potential to rerate higher, as the threat from a net neutrality reversal is diminished.

The change in congressional leadership could lead to increased volatility for the market broadly, particularly as it relates to government shutdowns and debt ceiling raises. Political grandstanding as we approach 2020 will likely become more common and could lead to volatility spikes. While Democratic leaders may be willing to cut a deal that sees higher domestic spending as well as defense spending in the short term, there is a risk of defense names coming under pressure depending on the outcome of the 2020 election.

  • Important Information 

    All investments involve risk, including possible loss of principal.

    The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

    International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

    Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    Past performance is no guarantee of future results.

    Please note that an investor cannot invest directly in an index.

    Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Important Information:

    The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

    The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

    This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.

    This material is only for distribution in those countries and to those recipients listed.

    All investors in the UK, professional clients and eligible counterparties in EU and EEA countries ex UK and Qualified Investors in Switzerland.

    Issued and approved by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444.

    All Investors in Hong Kong and Singapore:

    This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

    This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

    Distributors and existing investors in Korea and Distributors in Taiwan:

    This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

    This material has not been reviewed by any regulatory authority in Korea or Taiwan.

    All Investors in the Americas:

    This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

    All Investors in Australia:

    This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.