October 05, 2018
In 2018, US investors have enjoyed the strongest economy in years, but have simultaneously faced highly impulsive politics. Reconciling these two phenomena within an investment strategy has been a challenge and though equity indices have hit successive new highs, it hasn’t been an easy ride for investors. As we enter the last quarter, it doesn’t look set to get much easier. October will see the race towards the US midterm elections (scheduled for November 6th) intensify. Whether the Republicans retain their majority in both houses, or whether they lose one or both to the Democrats, the outcome is likely to have meaningful policy implications.
Until now, politics have taken a backseat with investors focusing on the solid economic backdrop and stellar corporate earnings. However, as the midterms approach, uncertainty as to the next chapter in Trump’s presidency will surely manifest in the form of market volatility.
Considering the often diametric views of the running parties, the midterms could have a wide spectrum of meanings for various aspects of fiscal policy…
For example, if Republicans maintain control of both chambers, they would likely pursue “tax reform 2.0“. This would make individual tax cuts passed in December 2017 permanent (they are currently intended to sunset in 2026). Another initiative floated by Trump, is the indexing of capital gains tax to inflation. Individuals would no longer be taxed on what Trump’s top economic adviser – Larry Kudlow – calls “phantom income.” Should the Democrats win one or both chambers, they could use the historically high deficit as justification to raise taxes. This is unlikely, but not impossible.
Trump’s highly anticipated infrastructure package, which was supposed to have been worth $1.5T, has been put on the backburner until beyond 2018. Gary Cohn, Trump’s former top economic advisor recently stated that “If the Democrats win the House I will be shocked if the first thing they don’t do [in collaboration with Trump] is infrastructure” – but financed through federal borrowing rather than the public-private partnerships as was floated by Republicans. However, given that national debt is already at a staggering $28.7T, the Democrats could potentially look to repeal a portion of the corporate tax cuts to fund spending.
And after the Republicans attempted to dismantle Obamacare, the Democrats are focusing much of their campaign on healthcare and are promising to protect Medicare.
In the past 3 midterms, the party in power suffered heavy losses. If the Democrats do gain a majority, we can assume a degree of political gridlock when it comes to Trump’s legislative agenda. This may compel Trump to narrow his focus upon trade and external affairs, which of course would have global implications.
These are just some examples of how the political makeup of Congress could have an effect. If we consider the unpredictability of the 2016 election, results could swing either way. Thus, investors have a lot of uncertainty to grapple with, which is likely to foster volatility throughout October. Albeit, on a positive note, the S&P 500 has bounced back strongly after midterm election year (MEY) corrections in the past. In fact, LPL research finds that between 1950 and 2017, on average, the decline in MEYs (-16%) has been followed by a +32% rebound over the following 12 months… Of course history doesn’t repeat itself but it often rhymes.
Until we have clear results, we continue to anchor our strategy on the fact that the US economy is performing excellently, which in turn is allowing corporates to flourish. Risks remain – whether it be trade tensions, impeachment threats, the scope for a Fed misstep… – but beyond the headwinds that midterms may bring, we still expect US equities to rise further in the fourth quarter.
Author: Group Investment Office