Midterm mayhem?

Bottom line

The summer is winding down and soon the Labor Day holiday will be upon us. This year, the new school year is joined by the start of the midterm election season. For investors, the consideration is how they could impact US economy and financial markets.

As has been the case for years, Republicans and Democrats are offering starkly different visions of the future. That legendary political strategist Yogi Berra once opined that “When you come to a fork in the road, take it.” This election, the tines of that proverbial fork are bent far apart. 

Will the political pendulum swing? Since Franklin D. Roosevelt served in 1934, the party out of power has regained an average of 27 seats in midterm elections. In only two instances during the post-war era (President Clinton in 1998 and President George W. Bush in 2002) did the White House manage to buck that trend to add seats to their majority. 

President Trump’s poll numbers are significantly underwater, particularly on key issues such as the direction of the country, the economy, immigration, inflation and military action. It would seem an opportune time for the Democrats to make gains. In particular, they have the opportunity to regain control of the House of Representatives, as the Republicans have a historically narrow lead of just five seats. Strategas Research Partners’ midterm election model suggests Republicans could lose 35-40 seats. 

Gerrymandering increases But many states are conducting midcycle gerrymandering, redrawing legislative districts in partisan fashion to gain House seats. When the dust settles, the GOP might pick up an additional 7-8 seats, which would mitigate their expected loss.

What about the DSA? Democrats are the more energized party this cycle, and many progressive voters have embraced some tenets of Democratic socialism. While the political organization Democratic Socialists of America (DSA) does not represent the plurality of these voters’ positions, it serves as a good proxy. The DSA’s surge in popularity has long coalesced around Sen. Bernie Sanders (I-Vt.) and Rep. Alexandria Ocasio-Cortez (D-NY). But the charismatic and articulate New York mayor Zohran Mamdani has risen in the ranks, and other new faces have won primaries, often upsetting moderate Democrats. But how will they play to swing voters in the general election come November? One prominent race already shows the potential limits. In the primary for Wisconsin governor, DSA-endorsed Francesca Hong lost to centrist Dem David Crowley.

Independents’ Day Voter affiliations have shifted dramatically over the past two decades. According to Gallup, in 2008, 49% of voters registered as Democrats, 25% as Republicans and the remaining 26% either independents or in smaller parties. Today, the percentage of Democrats has plummeted to 27%, with that of Republicans rising to 27% and independents soaring to 45%. 

Why has this happened? In our view, the average middle-of-the-road voter is disgusted with how partisan Washington has become over the past two decades, with “compromise” now a dirty word. Our elected Congressional representatives should reach across the aisle to pass bipartisan legislation both fiscally prudent and socially responsible. There are precious few instances these days. 

The Senate could stay in Republican hands Similar to the lower chamber, since 1934 the party out of power in the US Senate has historically regained seats in midterm elections by an average of three seats. Today, Republicans now have a comfortable six-seat lead, though they are defending more seats this cycle (20 versus 13 for the Democrats). The result could very well be another 50-50 tie, in which case Vice President Vance can break all ties, effectively keeping the Senate in Republican hands.

Several key states will have competitive Senate races. It appears that North Carolina will flip to Democratic control. Races in Alaska, Ohio and Texas are close. Maine presented an opportunity for a Democratic flip, but candidate Graham Platner's withdrawal may allow Republican incumbent Susan Collins to win re-election. Michigan could shift to Republicans, as candidate Abdul El-Sayed narrowly defeated his moderate opponent, Haley Stevens, in the primary. The Republican candidate, Mike Rogers, had been trailing Stevens in the polls, but is currently ahead of El-Sayed. 

Not as simple as ‘eat your spinach’ versus ‘free lunch’ Candidates deviate from party positions, of course, but there are popular planks: 

• Republicans, generally speaking, embrace capitalism and a smaller federal debt; want a strong defense and secure borders; increased domestic energy production; military support of Israel; and, of course, favor lower tax rates.
• Democrats historically have a wider range of concerns. But the platform generally includes expanding health care; subsidizing education and childcare; establishing rent control for lower-income residents; promoting a 32-hour workweek; reforming prisons, policing and immigration enforcement; exiting military involvement in the Middle East; and, of course, higher taxes. 

‘Back to the future’ wildcard Lawmakers have limited time to pass spending legislation to avert a federal government shutdown on September 30. The debate is further complicated by a political fight over including the SAVE Act, which mandates voter identification. We’ve seen this movie before and know how it ends. Congress shut down the federal government for six weeks last October and November, inconveniencing Americans and impairing fourth-quarter GDP growth. Will lawmakers do it again, knowing that political blowback from voters a month before the midterms could redirect some career paths in Washington?

How might stocks respond to midterm results? The stock markets generally like a politically divided government. That situation creates checks and balances, particularly with fiscal policy. While President Trump is a Republican, but if the GOP loses the House but retains the Senate, the S&P 500 may follow its historical trend over the past 93 years of rallying to nearly 14% annual returns on average. But if Democrats run the table in November, the combination of a consolidated Democratic Congress with a Republican president has been the least productive combination for stocks, with the S&P returning an historical average of less than 5% annually.

With the broad middle swath of the political spectrum seemingly wide open, and with President Trump's poor poll numbers, Democrats have a golden opportunity in the midterms to make political hay in the House of Representatives — and maybe the Senate — by positioning themselves slightly left of center. But the DSA wing of their party could impair that, potentially snatching defeat from the jaws of victory. For voters and investors alike, choose wisely. 

Read more about our views and positioning at Capital Markets.