Upcoming US midterm elections may see the Republican party lose its majority in one or both houses of Congress which could make passing policy changes more difficult for the government. But, policy already passed (including tax reform) will be difficult to reverse.
Impeachment investigations against Trump are likely if Democrats gain a majority in the House, which would lead to uncertainty and higher market volatility.
Numerous legislation (including things like trade policy) are done outside of Congress and are not impacted by changes to government majorities. Expect Trump’s protectionist stance on trade to continue.
The US economy remains strong, but growth will slow in 2019. The Federal Reserve is still on track to lift rates in December and three more times next year.
There may be more downside for shares given midterm risks and worries about trade and higher bond yields. But, a major bear market is unlikely. US share valuations are stretched and we see better value in non-US markets.
Over the past year, the easing in US fiscal policy (tax reform and higher government spending) have been an important factor in lifting US economic growth and US sharemarkets. The upcoming US midterm elections (on 6 November) could change the makeup of the US government and impact fiscal policy decisions and growth as a result. We review the various issues that surround the midterms in this report.
A background to the midterms
The US presidential election occurs every four years (the next one is due in 2020), with midterm congressional elections held in between, with all seats in the House of Representatives (lower house) and a third of the Senate (upper house) up for re-election. As things currently stand, the Republican party has a decent majority in the House and a slim majority in the Senate which has helped the government to pass some of its key policies (e.g. tax reform in 2017). Midterm elections can result in changes to the seats held by parties in the lower and upper houses and any majorities held by the governing party. A change in the Republican’s majority has implications for fiscal policy because it usually means that policy becomes harder to pass because of the need to negotiate and gather support from the opposition.
What result is likely from the midterms?
Based on current polling (see chart below), approval rates for President Trump, seats up for re-election and historical trends, we outline the probabilities of four potential outcomes from the midterms:
1) Democrats win a majority in the House of Representatives and Republicans maintain Senate (55% chance)
The biggest change under a Democrat-led lower house may be the push to start impeachment proceedings against President Trump. But, impeachment challenges take time and would still need to pass the Senate with a two-thirds majority (where the Republicans could still maintain their majority). So, impeachment and removal from office is not necessarily a done deal under a Democratic house.
A protectionist trade tilt is still likely to continue from Trump under a Democrat-led lower house because trade legislation (things like tariffs) do not have to pass through Congress. The tough stance on China is expected to be maintained but there may be more negotiations between the US and China around the recently imposed tariffs after the midterms pass. However, the new NAFTA agreement does need to pass through Congress to be ratified and this may take longer to achieve under a Democratic lower house.
It is unlikely that already legislated tax changes (corporate and individual tax cuts passed in late 2017) would be rolled back as this policy would still need to pass the Senate (where the Republicans would have a majority) and it would be difficult to achieve politically given that households and firms have already felt the benefits of lower taxation.
2) Republicans maintain control of the House and Senate (30% chance)
While there is a decent chance that the Republican party will maintain their majority in Congress, this majority is likely to slim down which would still make passing legislation harder, especially given the apparent disorder in the Republican party. A Republican Congress would mean that “Tax Reform 2.0” (which we detail below) would be pursued. Trump would also continue with a focus on deregulation (particularly in the financial sector) and protectionist-type trade policies.
3) Democrats win House and Senate (10% chance)
There is a small chance that Democrats will be able to gain a majority in both chambers of Congress but the Senate will be harder to win based on the seats that are up for re-election (i.e. they are mostly Democratic seats).
In this outcome, there is also less of a chance that the Republican’s “Tax Reform 2.0” is legislated. This legislation was recently passed by the House of Representatives and includes making the individual tax cuts in last year’s tax reform program permanent, encouraging retirement savings and providing tax breaks for start up firms.
4) Democrats win Senate and Republicans maintain House (5% chance)
This outcome is least likely based on the seats up for re-election. If the Democrats win the Senate, then it is likely that they would also win the House of Representatives.
Impact of the midterms on the economy
The economic impact of the election outcomes is small, even if Republicans lose their majority. Tax reform for households and businesses has already had a significant positive boost to the economy and is very unlikely to be wound back. We still expect US GDP growth to be around 3% this year and as business investment lifts and consumer spending remains high. Growth in 2019 is likely to slow, to around 2.5%, as the positive boost from tax cuts wears off and higher interest rates eventually slow consumer and business spending. There will also be negative impacts on the economy from the introduction of tariffs. Corporate earnings growth is also expected to slow in 2019.
The impact of the midterms on infrastructure decisions is difficult to assign because both Republicans and Democrats have spoken about the need to lift government infrastructure spending. Some lift in infrastructure spending is likely to occur over the next two years which would provide a boost to economic growth and jobs, dependent on how it is funded (for example if spending is funded by higher budget deficits, this has negative impacts on the economy in the medium-long run).
A change in Republican majority will have minimal impacts on passing continuing resolutions for government funding (to avoid government shutdowns) and on the debt ceiling because shutdowns have occurred despite the government controlling Congress (in January for example). And, as we have seen from history, long government shutdowns have minimal impact on the economy and markets as services eventually resume.
How is the US economy currently tracking?
The US economy still remains in a solid position, despite the US Federal Reserve (Fed) raising interest rates. US financial conditions are accommodative (see chart below) even with higher interest rates which is positive for economic activity.
US jobs growth is strong, the unemployment rate is very low, wages are rising, businesses remain optimistic and inflation is lifting. The US Fed will continue to lift interest rates and we see another rate hike in December and then another three hikes in 2019, which would take US interest rates into a range of 3 to 3¼% at the end of 2019, which is similar to the Fed’s own forecasts.
Financial markets continue to expect fewer interest rate hikes than the Fed is indicating (see chart below) which has been a consistent trend over the past few years.
Tax cuts and fiscal spending have been offsetting some of the tightening impacts of higher interest rates. As already noted, we expect slower US GDP growth in 2019. The key vulnerabilities of the US economy to watch as risks to growth are high corporate leverage and some lift in household debt across areas like credit cards and car loans.
Implications for investors
The US midterm elections are expected to have a slightly negative impact on US sharemarkets, which may then flow through to other global markets. The Republicans are likely to lose some of their seats in Congress which means more policy uncertainty and ongoing market volatility as a result. Impeachment challenges will add further to market volatility and could put downward pressure on the US dollar because of concern around the negative impact on the economy.
Sharemarkets have had a rough ride over recent weeks and there may be more downside around the time of the midterms as well as due to concerns around trade, higher bond yields and emerging market contagion. But without a significant slowing in the global economy, a major bear market is unlikely to occur for now. We see further upside in equities, but prefer markets outside the US (especially Japanese shares) given very high valuations in US equities.
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