(Bloomberg) — The short-term fate of the stock market hinges on what has been a great boon to stocks for more than 70 years: the U.S. midterm elections.
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Rising interest rates, mounting recession risks and the steepest inflation in four decades could result in a break with past trends. But the fourth quarter and year following the midterm elections has historically been the stock market’s strongest period of the four-year presidential cycle.
With polls showing Democrats could lose control of the US House of Representatives or Senate, stocks could get a further boost from another traditionally friendly factor: a divided government that would derail virtually any major legislation affecting the economic outlook could shake.
“A divided government would be good because nothing would be done and we’re not going to get any more uncertainty for the next two years,” said Kim Forrest, chief investment officer at Bokeh Capital Partners. “Corporations can operate when they know what the rules of the game are, and when Republicans control Congress in the midst of a Democratic president, the US corporation will bring some certainty.”
A Washington-led bout of gains in stock markets would be welcomed by investors battered when the Fed’s most aggressive monetary tightening in decades drove the S&P 500 index down 21% this year.
Losing even one chamber of Congress would reduce Democrats’ ability to take fiscal action to boost the economy when it slows. That would remove a possible reason for Fed Chair Jerome Powell to hike rates even further to curb inflation. Investors will get another crucial hint of rising prices when the CPI is released on Thursday, which will also help determine the pace of central bank rate hikes in the coming months.
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Option prices suggest that Optiver estimates the S&P 500 would rise as much as 0.7% if the Republicans win and fall as much as 3.3% if the Democrats somehow hold onto Congress.
Certainly, the results may not be immediately clear, especially when the candidates refuse to admit or contest the results. And the risk of violence or protests could upset the mood after the vote.
Over the longer term, however, stock bulls take comfort in the fact that US stocks are in the most optimistic time of the 16-quarter US presidential cycle. The fourth quarter of the intermediate-term years and the following two quarters have historically been the strongest, delivering average gains of 6.6%, 7.4%, and 4.8%, respectively, for the S&P 500 since 1950, according to Carson Investment Research.
However, this year’s outlook is complicated by the specter of Fed rate hikes. Last week, Powell dashed all expectations of a change in the central bank’s plans, saying it still has “some way to go” to hike rates and that its benchmark interest rate could peak higher than expected.
“The medium-term seasonality may not hold up this time because the market has still not come to terms with the fact that rates have to stay higher for much longer,” said Liz Young, SoFi’s head of investment strategy.
“Some investors confuse a Fed pause with a Fed pivot,” Young added. “A pivot would mean that the Fed completely changes direction. It is not. The odds of averting a recession are pretty slim, so a Fed pause in 2023 is very likely as it needs to see the impact of what it has already done on the economy. But a pause does not mean that they will move rates decisively lower after a pause ends. They could pause and still bounce back, especially if inflation stays high.”
Such a pause would come at a historically strong time for stocks. The third year of the presidential cycle — next year — has been by far the strongest since World War II, pushing the S&P 500 up an average of 14%, according to data compiled by Bespoke Investment Group. The S&P gained 57% in the second year of the election cycle and 83% in the third year.
Another promising precedent: The S&P 500 has had little weakness in the midterm elections in the past. According to an analysis of data going back as far as 1950 by Willie Delwiche, an investment strategist at All Star Charts, the gauge traded higher on average in the months, three months, six months and a full year following the midterm elections. A year after the midterms, the S&P 500 was up an average of 15%.
For Delwiche, the logic works like this: politicians in power want to be re-elected, so they start more accommodating policies ahead of the general election. But this time there is little certainty about what will happen next, and discontent over inflation could change the typical political scenario.
“This cycle is different in that we haven’t seen more stimulative policies before, we’ve seen the opposite,” Delwiche said. “This cycle is not an anticipation of what is to come, but a reaction to what has already happened. If Republicans win in the medium term, maybe policy would be more market friendly and that could support the S&P.”
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