Potential Market Reaction to Midterm Elections

Political disclaimer: Polls aren't that far removed from the Op-Ed section of your favorite paper. Unless there is a terrific attempt to remain unbiased (which is rare), opinion polls can be skewed to generate any outcome or conclusion that conveniently supports your point. I honestly don't know enough about election polling to draw any firm conclusions about the methods, though I do know that in the last cycle the Republicans own polls were laughably and alarmingly misleading. That being said, there does seem to be a breath of a consensus that the Republicans are likely to win a slim majority in the Senate. Other polls claim its all still too close to call. FWIW.

Republicans increasingly likely to take control of the Senate: New polls out over the weekend project a 70% chance that Republicans will take control of the Senate (for a majority of 51 seats) as a result of Tuesday's midterm elections. The current party breakdown in the Senate is:

• Democrats  - 53
• Republicans - 45
• Independents - 2 (both of whom caucus with the Democrats)

Given that both independents caucus with the Democrats, the Republicans need to pick up 6 seats to win unequivocal control of the chamber. Political analysis and election modeling on FiveThirtyEight now projects that Republicans have about a 40% chance of ultimately winning 8 seats in the Senate, (giving them 53 seats) though analysts there expect two seats to require run-off elections.

It's worth noting that even if Republicans take a 53 seat majority, that is far from 60 required to prevent a filibuster, so there is no expectation that a majority Republican Senate would have a carte blanche - or a "mandate" - to pass legislation.

Republicans almost certain to increase their majority in the House: Polls suggest that Republicans are also likely to modestly increase their majority in the House of Representatives by 10 to 12 seats, which they currently hold 234 to 199 (with two seats vacant).

Bullish for equities: There is an interesting Barron's interview with Bob Doll of Nuveen (formerly of BlackRock) which provides his analysis of the equity market's potential reaction to Tuesday's midterm elections,  Midterm Elections: If GOP Wins These Stocks Should Gain. Doll says,

"The midterm elections are huge for the market. During the six-month period that followed each of the past 16 midterm elections, the stock market has gained 16% on average. It isn’t all about which political party wins. Granted, it isn’t unimportant. What’s more important is to actually have the midterm elections and remove uncertainty from the financial markets. The markets don’t like uncertainty, and the midterm elections determine who can craft legislation, spend money and who is best positioned for the presidential election in two years’ time."

He expects that if Republicans do take control of the Senate, the corporate sectors that are likely to gain the most are conventional energy companies (oil), defense contractors and big banks. If Democrats hang onto their majority, the beneficiaries could be alternative energy, hospitals and infrastructure.

Unclear for bonds: Presidential elections have tended to have a stronger impact on the bond market than midterms, though the prospect of a Republican Congress that would lean towards lower spending and tax reform could be supportive of bond prices and keep yields low. From an article titled How Do Elections Affect Bond Market Returns?,

"A 2006 study in the Financial Services Review titled, “Tactical Asset Allocation and Presidential Elections” reported that from 1961 through 2004, long-term government bonds produced an average annual return of 4.14% when a Democrat was in the White House and 10.80% when a Republican was in control. The average annual return for the full period was 7.77%. This gap has since closed, however, as long-term government bonds have performed very well since President Obama was elected in 2008."

Given that midterms are unlikely to provide either party with enough traction to dramatically shift policy, the biggest driver of the bond market will probably continue to be the Fed and economic data.