A version of this story originally appeared in CNN Business’ Bell the Bell newsletter. Not a subscriber? You can register here.
It was a volatile week on Wall Street last week, with stocks falling after Federal Reserve Chairman Jerome Powell dashed hopes of a market turnaround and said bigger rate hikes were on the way. 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 result in more of the gridlock that 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 that a Democrat was in the White House and Republicans held majorities in both houses of Congress. That’s 15.1% during periods of full Democratic control and 15.9% during years of unified GOP government.
Investors are very happy when politicians argue but don’t actually pass new laws that could hurt corporate profits.
An example of this is taxes from enterprises.
“What do interim assessments mean for markets? If Republicans take over the House, the tax hikes are dead in the water,” said David Wagner, portfolio manager at Aptus Capital Advisors. Republicans may be less likely to approve a windfall tax on oil company profits and generally do not favor 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, possibly making it harder for President Biden to pass legislation.
That’s because there are some areas of consensus for the White House and Republican lawmakers.
“The GOP sweep could lead to more defense spending,” Wagner said. “Increasing the defense budget seems to be a bipartisan issue.” The House passed a record defense budget proposal this summer.
Biden and Republicans appear to be on the same page when it comes to increasing infrastructure spending. That could boost utilities, construction companies and some real estate stocks. Congress last year passed a more than $1 trillion bipartisan infrastructure bill sponsored by President Biden. But it is not yet clear what the appetite for more spending is… even if there is a consensus that more is needed.
“From a political point of view, everything is polarized, but there are common views on infrastructure. Even so it was [Donald] Trump and [Hillary] Clinton in 2016,” said Jim Lydotes, deputy chief investment officer for equities at Newton Investment Management. “As a country, we have underinvested in infrastructure. This is an 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, with the midterms in the rearview mirror, the political narrative will quickly shift to the 2024 presidential race. Congress and the White House can spend more time arguing than trying to pass legislation.
There could be some significant downsides to a divided government, especially if fears of a recession materialize next year.
Rob Dent, chief U.S. economist at Nomura Securities International, said the federal government could spend less on social safety net programs if Republicans take control of Congress.
“All things being equal, this can 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 an unwelcome possibility of more debate in Washington over the debt ceiling. The last time it was a big issue was during President Barack Obama’s first term. The US lost its perfect AAA credit rating from Standard & Poor’s as a result of the debt ceiling drama. After the crash in August 2011, the stock market fell more than 5%.
“The outcome of this election is less about what won’t be done than what can be done to help the economy during a recession,” Dent said. “We are concerned about a divided government leading to a cliff on the debt limit and the potential for a government shutdown. We haven’t dealt with it for a while.”
But at the end of the day, political headlines are often just noise for the markets. Anthony Saglimbene, chief market strategist at Ameriprise, said on a conference call last week that stocks historically rise after elections, regardless of which party controls the White House and Congress.
Midterm exams can take a backseat to other macro issues. Saglimbene noted that “growth, earnings, inflation and interest rates” matter more to investors over the long term. He acknowledged that the election results could cause more near-term volatility, but the market is already pricing in a high probability of a split government.
Given that inflation is not transitory, as Fed Chairman Powell has predicted for most of 2021, politically motivated market and economic volatility is the last thing consumers, investors or the Fed need.
Clearly, high prices for commodities and other raw materials, shipping and other transportation costs, and labor costs are not going away anytime soon.
Cereal and snack food giant Kellogg ( K ) CEO Steve Cahillane even said on the company’s most recent earnings call last week that “the idea that inflation is going to be temporary is always patently ridiculous.”
We’ll get a better idea of how sustainable inflation is on Thursday after the government reports September’s consumer price index (CPI) figures.
Economists polled by Reuters forecast that overall prices rose 0.7% last month, compared with a 0.4% increase in September. This is likely to further push up annual prices, which rose 8.2% in the last 12 months to September. Continued strength in the job market will also put more pressure on prices.
“The labor market is resilient and inflation is spilling over into the services sector,” said Troy Gayeski, chief investment strategist at FS Investments.
This could lead to further concern that the economy could be headed for a so-called stagflationary environment, a period of stagnant growth alongside high inflation. If that happens, the Fed will keep interest rates higher for longer.
“We will eventually get out of this inflation/stagflation situation,” Gayeski said. “But it’s not like the Fed is going to cut rates to zero anytime soon. It will be really prudent.”
Monday: China trade data; Profits 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; US weekly jobless claims; Gains from Nio ( NIO ), Ralph Lauren ( RL ), Tapestry ( TPR ), WeWork, Six Flags ( SIX ), Yeti ( YETI ), and Warby Parker
Friday: US bond market closed for Veterans Day; UK GDP; Consumer sentiment from Michigan, USA; Earnings from SoftBank (SFTBF).