A Market Guide to the Midterms

(Bloomberg) -- The U.S. midterm elections are upon us, and the results will have implications for everything from bond yields to equity volatility. Here’s a sampling of what strategists are saying about the outlook for markets.

Taxes and Fiscal Policy

Republicans adding to their Senate majority would offer an extra layer of protection for Donald Trump’s tax cuts beyond the next presidential cycle in 2020, while a Democratic House and a 50-50 Senate may not, Evercore ISI strategist Terry Haines wrote in a note Tuesday.

See: Google, Groceries, and Gaming: 10 Election Night Tax Issues to Watch

Republicans controlling both houses would boost expectations for tax-cut extensions and could drive forecasts for higher interest rates, according to Morgan Stanley.

If Democrats sweep, “they won’t be able to change fiscal policy before 2020, but it would change expectations about the trajectory beyond it,” Morgan Stanley strategists Michael Zezas and Meredith Pickett wrote in a note Monday. “This shifts the narrative away from rising rates and, in the near term, alleviates the pressure stocks have felt in recent weeks.”

A divided Congress “would have little effect on our baseline fiscal policy view that tax policy goes from growth-positive to growth-neutral by late 2019,” Goldman Sachs Group Inc. strategists led by Jan Hatzius and Alec Phillips wrote Monday. It would set the stage for no new tax cuts, roughly flat government spending and the potential for turmoil around fiscal deadlines, they said.

Equities

U.S. equities typically perform well following midterm elections, though typical drivers -- declining political uncertainty and easing fiscal policy -- may be less likely in the current political environment, Goldman strategists Ben Snider, Ian Wright and Christian Mueller-Glissmann wrote in a note Tuesday.

“We strategically continue to see a base case of low risk-adjusted equity returns in the medium term,” they said.

A Market Guide to the Midterms

Nobel Prize-winning economist Robert Shiller took a more dire view, citing the potential for “fear and chaos” in comments on Tuesday. He said that the market is vulnerable to further declines as midterm elections challenge the U.S. president’s pro-growth posture.

Financials could do well regardless of the outcome. Cowen’s Jaret Seiberg wrote that gridlock in Congress would mean bank regulators continue “to advance proposals to moderate the existing regime.” That’s why Cowen is still positive on the sector from a policy perspective, especially for regional banks.

Infrastructure-related stocks may not benefit at all, as the likelihood of a major program coming to fruition isn’t very high, according to Goldman strategists.

Pharmaceutical and biotechnology stocks may gain if the expected stalemate in Congress takes the threat of drug pricing restrictions off the table, according to analysts.

Energy stock investors are more focused on local outcomes, including a statewide drilling referendum in Colorado and a push for renewables in Arizona.

Cannabis stocks may be the same way, with marijuana legalization on the ballot in four states, including recreational pot use in North Dakota and Michigan.

Rates

Treasury yields should fall if Democrats take both houses, due to reduced prospects for fiscal stimulus, and rise if Republicans sweep because of both greater chances of fiscal stimulus and reduced regulatory uncertainty, the Goldman strategists led by Snider wrote.

Treasuries should continue to trade with a bearish bias once midterms are out of the way, especially if there’s a divided result, Societe Generale strategists wrote.

“After the 2016 Presidential elections we did see a sharp rise in equities and bond yields as risk-on sentiment took hold of the markets. We could see a reverse reaction in the markets, albeit to a much smaller magnitude” in a Democratic House/Republican Senate scenario, SocGen wrote. A Democratic sweep “could see a more prolonged impact on risky assets and tighter financial conditions, bringing investors to the safety of bonds,” while a Republican sweep should see bond yields rise amid “renewed risk-taking.”

Currencies

The impact on the U.S. dollar might be ambiguous, the Goldman strategists led by Snider wrote: If taxes come into play, the administration might delay further tariffs to keep the votes of Republican Senators in the Midwest.

Societe Generale sees a divided Congress supporting its call for a gradually weaker dollar in 2019, with a Democratic wave accelerating the pace of the decline. A Republican sweep could actually lead to a rally by the greenback amid expectations of further fiscal stimulus, the firm wrote.

The most volatile emerging-market currencies like the Brazilian real, the South African rand, the Turkish lira and the Indonesian rupiah should outperform if the Democrats retake the House, Morgan Stanley strategists led by James Lord wrote in a note. If Republicans sweep, emerging markets would probably suffer as additional rate hikes and fiscal stimulus would likely be priced in, they said.

Corporate Credit

Morgan Stanley recommends remaining cautious in corporate credit, because the asset class has outperformed and hasn’t really absorbed many of the non-policy concerns that have infected markets in recent months.

“Even if election night drives a constructive near-term narrative for credit, perhaps on tax policy, we would use any rally to continue moving up in quality,” Zezas and Pickett wrote.

A split result might make the U.S. high-yield markets look vulnerable, Societe Generale strategists wrote, in which case would recommend going long European credit risk and short U.S. risk.

Volatility

Being long equity volatility makes sense -- and even more so, go long developed-market FX volatility “to reflect idiosyncratic political risk of various stripes,” Zezas and Pickett wrote, citing Morgan Stanley’s cross-asset strategists.

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