A version of this story first appeared in CNN Business’ Before the Bell newsletter. Not a subscriber? You can register here. New York CNN Business —
Last week was volatile on Wall Street, with stocks falling after Federal Reserve Chairman Jerome Powell dashed market dreams of a turnaround and suggested more big rate hikes were likely to come. But Wall Street is still pinning its hopes on Washington.
Investors are betting on a big Republican wave in the midterm elections. If Republicans pick up at least one house of Congress in Tuesday’s midterm elections, that would likely lead to a longer deadlock, which the market usually loves.
According to data from Edelman Financial Engines, the S&P 500 has returned 16.9% annually since 1948 during the nine years when a Democrat was in the White House and Republicans held majorities in both houses of Congress. That compares to 15.1% in periods of full Democratic control and 15.9% in years when there was a unified GOP government.
Investors are more than happy when politicians disagree but don’t actually enact new laws that might hurt corporate profits.
An example is business taxes.
“What do intermediate terms mean for markets? If the Republicans take the House, tax increases are dead,” said David Wagner, portfolio manager at Aptus Capital Advisors. Republicans may be less likely to approve a windfall tax on oil company profits and are also generally not in favor of tax increases on the wealthy.
The market is also betting that some sectors could get a boost — even if Republicans take control of the House or Senate and possibly make it harder for President Biden to pass laws.
That’s because there are some areas of consensus for the White House and Republican lawmakers.
“A GOP sweep could lead to more defense spending,” Wagner said. “Increasing the defense budget appears to be a bipartisan issue.” The House passed a record-high defense budget proposal this summer.
Biden and Republicans also appear to be on the same page when it comes to boosting infrastructure spending. That could boost utilities, construction companies and some real estate stocks. Congress passed a more than $1 trillion bipartisan infrastructure bill last year, which President Biden ultimately sponsored. But it’s not yet clear what the appetite is for more spending…even if there’s a consensus that more is needed.
“Everything is polarized politically, but there is common ground on infrastructure. This was happening even with [Donald] Trump and [Hillary] Clinton in 2016,” said Jim Lydotes, deputy head of equity investments at Newton Investment Management. “As a country we have underinvested in infrastructure. This is one area where there is a lot of agreement.”
Of course, there is no guarantee that Biden and other Democratic leaders will be able to work effectively with Republicans in Congress. After all, the political narrative will quickly shift to the 2024 presidential race when the midterm elections are in the rearview mirror. Congress and the White House may spend more time bickering than trying to pass legislation.
There could also be some significant downsides to a divided government, especially if recession fears come to fruition next year.
Rob Dent, senior US economist at Nomura Securities International, said there could be less federal government spending on social safety net programs if Republicans take control of Congress.
“All else being equal, that could lead to a longer recovery than a recession,” Dent said. That would be bad for stocks in general, as consumer spending drives corporate profits.
Dent added that there is also the unwelcome possibility of more controversy in Washington over the debt ceiling. The last time it was a major issue was during President Barack Obama’s first term. The US lost its AAA-awarded perfect credit rating from Standard & Poor’s as a result of the debt ceiling drama. The stock market plunged more than 5% after the downgrade in August 2011.
“This election result is less about what might be done than what might not be done to help the economy in a recession,” Dent said. “We are concerned that divided government will lead to an impasse over the debt limit and the possibility of a government shutdown. We haven’t had to deal with that in quite some time.”
But at the end of the day, political headlines are often just noise for the markets. Ameriprise chief market strategist Anthony Saglimbene said on a conference call last week about the midterms that stocks historically rise after elections, regardless of which party controls the White House and Congress.
Midterm elections may also take a backseat to other macroeconomic issues. Saglimbene noted that “growth, earnings, inflation and interest rates” matter more to investors over the long term. He admitted that the election results could lead to more near-term volatility, but that the market is already pricing in a strong possibility of a divided government.
Political market and economic instability is the last thing consumers, investors or the Fed need as inflation turns out not to be transitory as Fed Chairman Powell predicted for much of 2021.
It’s clear that higher prices for commodities and other raw materials, shipping and other transportation costs, and labor costs aren’t going away anytime soon.
Steve Cahillane, CEO of cereal and snack giant Kellogg ( K ), even said on the company’s most recent earnings call last week that the thought that “inflation would be transitory was always patently ridiculous.”
We’ll get a better sense of how persistent inflation is on Thursday, after the government reports September consumer price index (CPI) data.
Economists polled by Reuters forecast overall prices rose 0.7 percent last month, up from 0.4 percent in September. That would likely push year-on-year prices, which rose 8.2% in the past 12 months to September, even higher as well. Continued labor market strength will put more pressure on prices as well.
“The labor market is resilient and inflation is spreading to the services sector,” said Troy Gayeski, chief investment strategist at FS Investments.
This may lead to more concerns that the economy may be headed for a so-called stagnation environment, a period where stagnant growth occurs alongside high inflation. If that happens, the Fed is likely to keep interest rates higher for longer.
“We will get out of this inflationary/stagflationary situation eventually,” Gayeski said. “But it’s not like the Fed is going to quickly cut rates back to zero. It will be very careful.”
Monday: China trade data. gains from BioNTech (BNTX), Take-Two (TTWO), Ryanair (RYAAY) and Lyft (LYFT)
Tuesday: US midterm elections. gains from DuPont ( DD ), Norwegian Cruise Line ( NCLH ), Lordstown Motors, Disney ( DIS ), Occidental Petroleum ( OXY ), News Corp ( NWS ), IAC ( IAC ), AMC ( AMC ), and Novavax ( NVAX )
Wednesday: China inflation data. gains from DR Horton (DHI), Weibo (WB), Hanesbrands (HBI), Capri Holdings (CPRI), Roblox, SeaWorld (SEAS), Wendy’s (WEN), Redfin (RDFN), and Beyond Meat (BYND)
Thursday: US CPI? Weekly US jobless claims. gains from Nio (NIO), Ralph Lauren (RL), Tapestry (TPR), WeWork, Six Flags (SIX), Yeti (YETI) and Warby Parker
Friday: The US bond market is closed for Veterans Day. UK GDP? US U. of Michigan consumer sentiment? earnings from SoftBank (SFTBF)
