How Do the Midterm Elections Impact the Outlook for Markets and the Economy?
Politics will always be a source of uncertainty for markets, but it’s policy, not politics, that is more influential for the economy and markets in the long run.
Markets often rally after elections, and the 2022 midterms were no exception with markets up 5.9% during election week. In the future, market prognosticators will point to this as another data point confirming the pattern of post-election rallies.
However, the rally had little to do with the midterms and more to do with a softer Consumer Price Index (CPI) print that offered hope that the data-dependent Federal Reserve may not have to increase rates as high as investors thought. This dynamic is very instructive for how we should think about the rest of this quarter: The Fed is the signal; the midterms are the noise. Historically, Q4 returns during midterm election years have been strong, averaging 7% over the last 80 years, and overwhelmingly positive. However, there are two notable recent exceptions to this. Negative returns in Q4 of 2018 and 1994 likely had more to do with the Fed hiking rates than the midterms, which could very well be the case this year depending on incoming data and how the Fed responds.
Over the next two years, divided government should lead to political gridlock which can help contain the deficit. This is particularly important in the current environment because tighter monetary policy works most effectively in concert with tighter fiscal policy, which we’ve seen in 2022. While this is an effective combination to combat inflation, if the economy does enter recession next year, the flipside is that the monetary and fiscal response could be muted, allowing the recession to linger. In addition, political gridlock could lead to government shutdowns over the budget over the next two years which could lead to short-lived market volatility. We may also approach the debt ceiling in 2023, which, unless resolved during the lame duck session of Congress, could also cause market jitters.
Politics will always be a source of uncertainty for markets, but it’s policy, not politics, that is more influential for the economy and markets in the long run. Policy is likely to play a considerably smaller role under divided government, reducing its impact to markets over the next two years.
Federal surplus/deficit as a % of GDP
Source: S&P, J.P. Morgan Asset Management. Data are as of November 17, 2022.