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Morgan Stanley says investors should ignore the midterms and watch profits and the Fed instead

Key Points
  • This year's midterms will decide whether one party will control Congress or if divided government prevails.
  • Morgan Stanley analysts expect some impact to the dollar and Treasury rates but little on stocks regardless of the outcome.
  • Current expectations are for the Republicans to hold the Senate and lose the House to Democrats.
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The trade war is Trump's negotiating tactic for the midterms: Strategist

The upcoming midterm congressional elections could matter to some asset classes, though a big market impact would come only with a major surprise, analysts at Morgan Stanley said.

With control of the House and Senate up for grabs, Wall Street will be watching how the battle for power shapes up. Current expectations are that Republicans likely will maintain control of the House while ceding the Senate to the Democrats.

That divided-government scenario, while fueling partisan rancor inside the Capitol, could yield to lesser legislative action that would force attention elsewhere particularly when it comes to stocks, a team at Morgan Stanley said in a lengthy analysis for clients.

"In 2016 and 2017, investors were well served to ignore the political volatility and focus on the fundamentals," the analysts wrote. "We think the same will be true of 2018 midterms."

Among the key areas the markets should be watching are a likely deceleration of corporate profit gains and the Federal Reserve's continuation of interest rate increases.

"Outside of trade policy, we suspect that most of the policy changes in the realm of possibility will actually not alter the course of these fundamental variables all that much, and so we will prefer to spend our time reviewing incoming data and earnings reports instead of parsing polls and sentiment on Sunday morning news shows," the note said.

That doesn't mean there won't be market changes.

Infrastructure likely to get derailed

Morgan Stanley expects a weaker dollar and a positive scenario for Treasury yields. Congressional support is likely to continue for President Donald Trump's tariffs, particularly against China, though the bank expects a tough time for Trump to get through his proposal to increase infrastructure spending.

Beefing up America's ailing roads, bridges and other public works is a cornerstone of Trump's three-pronged economic revitalization plan — the other two being tax cuts and deregulation.

However, Morgan Stanley expects that fiscal stimulus is "as good as it gets" and unlikely to get much of a lift in the face of debt and deficit concerns.

"Infrastructure spending proposals get a lot of attention, but an unfunded version of this is unlikely under all outcomes, in our view," the analysts said. "The most likely candidate for fiscal deficit expansion is Tax 2.0, an extension of expiring provisions in the tax code. Yet this is only possible if Republicans retain control of Congress."

The analysis looks at the two other possible but unlikely outcomes, namely either party holding both chambers following the election. Neither, however, produces any major changes as far as stocks go. A Republican sweep is more positive for the dollar and pharma and telecom stocks, while a Democratic win would be more positive for rates and less so for the dollar and pharma.

The election comes ahead of the third year of the presidential election cycle in markets, which is typically the best of the four years. Stocks have been positive 88 percent of the time during year three, with an average return of 16.4 percent, according to Charles Schwab data.

"A lack of realistic high stakes policy outcomes that are material for equity markets means there is not a lot priced in that could change based on election outcomes in November," Morgan Stanley said. "We think investors will fare better focusing on underlying fundamentals and the Fed instead of the ballot box."