The period following the US midterm elections is often a buoyant period for stock markets. Oxford Economics reports that over the past 18 political cycles, the S&P 500 has risen by an average of just 5% in the 12 months prior to the mid-terms, but over 15% in the year following the vote. But with recession looming, an unpopular president and rising extremism, can US markets repeat the trick this time round?
The midterms are likely to reflect an increasingly divided society in the US. Both congress and the senate may switch to the Republicans, leaving just the presidency in Democratic hands. This is likely to put a halt on Biden’s legislative agenda, but it is unlikely that the Republications will be able to enact significant change either.
This may look like an unpromising backdrop for financial markets, but as Oxford Economics points out, US equities typically do better when there is gridlock in Washington. It suggests that financial markets often do well after midterm elections because the division of political power makes significant change less likely. In other words, markets like the certainty that gridlock provides.
However, this time, there is less uncertainty on fiscal policy going into the midterms. The uncertainty all rests on monetary policy, which the midterms will do little to influence. Oxford Economics says: “This limits the scope for gains and we do not expect a sustained equity recovery while the Fed remains fully focused on fighting inflation and equity fundamentals continue to deteriorate.”
Equally, recession appears to be just round the corner. The majority of economists believe that the US will fall into recession next year. Even if inflation starts to moderate – and there are signs of slowing growth in the labour market and weakness in the housing market – it seems unlikely that interest rates will start to drop in the near term. Investors are likely to want a notable change in positioning from the Federal Reserve before a sustainable recovery starts.
Joshua White, portfolio manager, US large cap equities at Boston Partners, says: “There are some soft signs that inflation is rolling over, but there are also things to keep us concerned. The inflation data itself is pretty hot. When we talk to companies in our portfolio, wage inflation is still running quite high, for example. Inflation could still be sitting at around 4% next year. As such, we don’t believe the Federal Reserve can lower interest rates in the near term. It will continue to err on the side of caution.”
There is a chance that a Republican victory in the midterms may ease the pressure on inflation. In stalling any further fiscal measures from the Biden administration, it reduces the amount of money in the system. However, the impact is marginal – the president’s major legislative programme is already behind him, having passed the Inflation Reduction Act in August this year and the Infrastructure Investment & Jobs Act in 2021, so any further initiatives were likely to be smaller.
Oxford Economics says: “With equity valuations now at much more compelling levels and investor sentiment already very depressed, there is a good chance that US equities are higher in a year’s time and the midterm effect’s record is maintained, but we think there could be further downside to come in the near-term, with volatility likely to remain high.”
The market still has a lot to digest on earnings. For the time being, earnings have been relatively robust, but this is before the effect of higher interest rates and tighter household budgets have been felt. The market may be cheaper than it was a year ago, but – as the recent experience of Amazon and Meta shows – it can still go cheaper if earnings disappoint.
As such, investors have to be careful on valuations and outlook, targeting those areas where there is some room for manoeuvre. White says that some growth parts of the market still look highly valued: “Growth stocks are still broadly unattractive. They continue to trade at a premium to their historic averages. There has been a lot of froth in the market and it is not completely washed out.” This has been seen in the recent share price falls from a number of the technology giants, where weak earnings have dented investor confidence.
Having been positioned very defensively over the past 12 months, White has tentatively started to look at more cyclical companies: “We are just starting to turn the ship. It is a six-to-nine-month process and it will be very data dependent.” He says there are signs that economic weakness is now largely priced into a lot of cyclical companies: “In the semi-conductor companies, for example, there has been some poor guidance, but the market has largely shrugged it off.”
The US midterms are likely to have only a marginal, short-term effect on US stock markets. The world is still paying far closer attention to inflation statistics to try and judge the Federal Reserve’s next move. Investors shouldn’t expect the usual post-midterm bounce, but there are opportunities emerging as US equities get cheaper.