The U.S. midterms are less than a month away and there has been considerable anxiety, amongst voters and investors, as to what may ultimately transpire during this event. Such anxiety is somewhat understandable given that markets dislike uncertainty, and the feeling of ambiguity is amplified by a cycle that many worry has become unsustainably long in the tooth. I would also go as far as to say that this anxiety fed into the ~7.5% market correction we have seen so far in October.

 

Investors’ focus should remain on the health of the U.S. economy, alongside the outlook for earnings growth. On the former, we do not expect changes to U.S. Congress to shift the course of economic growth in the U.S. which is expected to be ~3% in 2018 and 2.5% in 2019 (modestly above the average pace of growth over the last decade). With respect to earnings growth, RBC forecasts 19% and 9% in 2018 and 2019 respectively – both above the average earnings growth since 2011. Further, based on what we have seen of market performance in previous midterm election years, we would use periods of market volatility leading into this event to add to high-quality stocks that have been out of reach due to elevated valuations.

 

Likely Outcomes: Midterm Elections:

On November 6, U.S. voters will decide the fate of 35 out of 100 Senate seats, 36 out of 50 Governorships, and all 435 seats in the House of Representatives.

 

Currently, in the House, the Republicans hold 237 seats, while the Democrats have 193 seats (there are also five vacancies). Thus, the Democrats would need a net gain of 23 seats to gain control of that chamber. In this regard, the consensus seems to be that the House has a high likelihood of switching to Democratic control. Predictions see about a 75% chance that the Democrats gain control of the House.

 

The situation in the Senate is a bit different. Republicans currently hold a slim 51-49 majority in the Senate, yet it should be easier for the GOP to defend its control. That’s because, of the 100 Senate seats, only 35 seats are up for election, 26 of which are held by the Democrats. So really, the Democrats are under more pressure to maintain the 26 seats already held, but also flip the nine Republican held-seats that are up for grabs at the ballot box. This is no small feat, especially given that 10 of the 26 Democratic seats at stake are in states that President Trump carried in 2016.

 

Another useful predictor that has been used in the past has been the “party of the president”. Since WWII, the president’s party has lost an average of 25 seats in midterm elections. In this regard, investors should take some comfort in the fact that such a change across Congress is not unusual. Further, the popularity of the president is also relevant. Based on research, when the presidential approval rating is below 50% that number is 37 seats; above 50% it is 14 seats. President Trump’s approval numbers have recently floated around 40% giving hope to Democrats up for election on November 6th.

 

Of the three possible election outcomes - the GOP maintains control over both legislative chambers, Democrats gain control over both chambers, or the consensus/base case that the Dems take the House while the GOP wins the Senate - the one that typically gives investors the greatest concern is the second. This may be because the Dems are generally thought to be less business friendly than Republicans.

 

Setting aside the low likelihood that Congress goes Blue, and irrespective of whether the Dems control one or both chambers, we (RBC) still believe either outcome is unlikely to have any meaningful economic impact. This is because any new legislation would have to be passed by both the House and Senate, and not be vetoed by the President, who happens to be a Republican. Similarly, in the more likely event that the GOP and Dems control the Senate and House respectively, the former would face an uphill battle with respect to passing new legislation given the latter holds veto power.

 

Midterms and the Market:

Based on previous election cycles, we know that the U.S. market typically corrects in the 12 months leading into the midterm election. Based on S&P 500 returns surrounding midterm elections between 1934 to 2014, the S&P 500 corrected by an average of -20.6% over the 21 instances.

 

2018 has been no exception. The ~10% correction in late January to early February of this year remains fresh in investors’ minds. More recently, we saw a ~7% correction in early October. And, while it’s not clear what the primary driver of that volatility was, I would wager that the uncertainty around mid-terms contributed to the negative sentiment.

 

While the equity market performance leading into midterms is less than ideal, importantly it is what happens after the midterms that matters. In this regard, the U.S. market demonstrates better performance after the midterm election year low has been established. In fact, the S&P 500 rallied 47.3% on average, as measured from the low point reached during the midterm election year to the high in the following year. In all of the 21 instances since 1934, the market traded higher.

 

Directional changes in performance have not always occurred immediately after the midterms, and so we could see more market volatility before we see a rebound later, often weeks or months later. That being said, it would seem that based on historical precedent, one should look beyond the noise related to the midterms and use such volatility to add to high-quality stocks that have been out of reach due to a run-up in valuations.

 

Tim