The notion of congressional gridlock has become almost a mantra of the election season, amid hopes that divided government leads to inaction and an easing of Washington's onslaught against Wall Street.
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Those wishes are predicated on Republicans almost certainly taking back the House and possibly the Senate after two years of Democratic rule that produced the most prolific flurry of legislation since Lyndon B. Johnsonsat in the Oval Office.
But what would a Republican-led Congress look like, and how would that impact investors? The answer may not be so obvious as it seems.
"If the changes do come to fruition and the Republicans do gain the House and maybe even control of the Senate, the market will react positively toward that," says Peter Cardillo, chief economist at Avalon Partners in New York.
"It'll be positive in the short term but in the long term it could have a negative effect. The Republicans will do everything in their power to stop excessive spending and that means more austerity on the way. That could mean the market will have to take a different approach."
What that approach entails could take a variety of forms. Here are three possible outcomes:
1. Health Care Repeal
At the top of the Republicans' list to enact its own version of hope and change is likely to be scrapping of the public health insurance packageCongress passed earlier this year.
Critics say the far-reaching plan will come at a prohibitive cost to taxpayers and could inhibit rather than enhance medical care.
But Wall Street's concerns will be mainly financial—how much increased premiums will cost and whether a bevy of questions will be removed regarding investment choices.
"The uncertainties there are now regarding health care probably will begin to ease because obviously there will be some form of repeal of the Obama health care plan, which has basically held back corporate America from making a lot of decisions," Cardillo says. "The big decision of course is rehiring of people."
Surveys have shown business owners reticent to rehire until they know how much health care will cost, so the election should help resolve lingering questions that have kept the nation's unemployment rate elevated.
"Overall, the job creation picture is still bleak. Weak sales and uncertainty about the future continue to hold back any commitments to growth, hiring or capital spending," William C. Dunkelberg, chief economist at the National Federation of Independent Business, said in a statement earlier this month. He added that, among business owners, "few believe the healthcare bill will actually help them."
2. The Fed Digs In, Commodities Keep Rising
If gridlock does set in and the White House and Congress are locked in a perpetual stalemate, who will set policy?
That could well be the Federal Reserve, which has been at the core of efforts to revive the economy after the financial system collapsed. Jeffrey Nichols, senior economic advisor at Rosland Capital in New York, said the central bank could take an even more prominent role should divided government occur.
"There is only one policy-setting group that can function in that environment, and that is the Federal Reserve," Nichols says. "The Federal Reserve really only has one tool at its disposal these days, which is quantitative easing—essentially printing more money. They can do that ad infinitum until spending picks up."
A recent CNBC opinion survey of market prossuggested that the Fed is likely to implement another round of easing in November that would total $500 billion.
The Fed's easing efforts thus far have totaled about $1.8 trillion and have been accompanied by sharp rises in commodities, particularly metals and most specifically gold. Nichols sees that trend continuing and ultimately leading to higher levels of price inflation.
"Commodity prices are rising rapidly now pretty much across the board," he says. "Industrial commodities, agricultural commodities, food—you name it, and it's a worldwide inflation."
The Fed would be better off using its QE programs to buy bonds associated with infrastructure projects rather than Treasurys and mortgage-backed issues, Nichols says.
"We've been buying things we don't need with money we don't have, effectively just borrowing it from foreign banks like China," he adds. "That's just gotten us nowhere."
What Could Stop the Stocks Rally?
3. The Stock Rally Could Fade
Markets tend to price in major events—meaning that they often anticipate changes such as elections and policy shifts and don't wait for them to actually happen before deciding what impact they will have.
As such, the Fed's QE measures as well as the Republican takeover of Washington may be the main driver behind the September-October rallyand could generate a reversal after the central bank's November meeting and the election, both of which happen Nov. 2.
"One of the factors that has revived irrational hope is this idea that midterm elections will fix everything," says Walter Zimmerman, chief strategist at United-ICAP in New York. "Talk about a triumph of hope over reason."
While Zimmerman thinks the market can last over the short term, he has doubts about the longer-term outcome.
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"After the election people realize elections don't change anything and never have," he says. "This is a problem that goes beyond the composition of the House of Representatives and the Senate. This goes so far beyond partisan politics."
Indeed, Bob Janjuah, strategist at Nomura Securities International in New York, believes that once reality sets in after the election that current policies aren't working and the Fed is running out of ammunition, the snapback in the market could be pronounced.
"Surely it must be clear by now that if policy...does not succeed in creating sustainable growth and sustainable real estate price appreciation, then all it is likely to do is result in financial market asset price distortions and valuations that are not sustainable," Janjuah wrote in an analysis for clients. "As a result we would again be faced with elevated levels of systemic risk."
Nomura is advising clients to "pre-position" for a result that, like Zimmerman's projections, includes a market downturn perhaps six months out.
"On a six-month basis our major concern is that market sentiment will abruptly and completely flip," Janjuah wrote. "Why? Because by then we think it should become clear that current policy settings are not working...that more of the same policy will be seen as non-credible, and because we will likely be pretty much out of any other policy options."
