The stock market wants a Republican wave but expects to see two-party control of Congress

  • With the odds for a blue wave fading, the market is pricing in a split Congress after the mid-term election, and strategists expect stocks to rally no matter the outcome.
  • However, on the outside chance Republicans sweep, the market could actually do better in the year after the election.
  • For the bond market, strategists see slightly higher rates if Republicans win both houses because of the prospect of more tax cuts and more U.S. debt.
Senate Majority Leader Mitch McConnell (R-KY) walks from a vote on Capitol Hill after the senate voted to advance a bill financing the U.S government January 22, 2018 in Washington, DC.
Brendan Smialowski | AFP | Getty Images
Senate Majority Leader Mitch McConnell (R-KY) walks from a vote on Capitol Hill after the senate voted to advance a bill financing the U.S government January 22, 2018 in Washington, DC.

Just ending the uncertainty around the midterm elections is likely to spark a relief rally, and strategists say it could be the start of a very good time for stocks, especially if Republicans hold onto both houses of Congress on Nov. 6.

For weeks, the market has been pricing in a scenario where Republicans keep a lead in the Senate, possibly adding a few seats, but lose control of the House of Representatives to Democrats. That is the scenario that would be most neutral for stocks, according to strategists.

Polls had shown Democrats gaining some traction several weeks ago in Senate races, but those gains have faded away and the Republican Senate lead looks more secure. According to FiveThirtyEight, there are 80 percent odds the GOP holds the Senate, up from 68 percent chance late last month, but there's an 84.5 percent chance that Democrats take the House.

Morgan Stanley policy strategist Micahel Zezas said the case for divided government has become more likely, as Democrats slip in the polls. A split Congress would be mildly bullish for Treasurys, with less of a chance that more tax cuts get passed, and bearish for the dollar. For stocks, it would be neutral

"Democrats standing in the polls have decreased in a few key traditionally red states: Indiana, Missouri, Tennessee and North Dakota, but have improved in purple/blue states: Ohio, Florida, Arizona and New Jersey. On the whole, this means that Democrats can no longer win all of the toss up races to win the majority," Zezas wrote. He said what is not clear is whether the fight over Supreme Court Justice Brett Kavanaugh would affect Senate races and House races differently.

The latest CNBC All-America Survey shows it's unlikely there will be a big blue, or Democratic wave, and recent polling has shown Republicans closing the gap in some key senate races.

"Last month, the Republicans had a 75 percent probability of winning the Senate, but the polls showed a 50-50 Senate. Most notably, open Republican-held seats in [Arizona] and [Tennessee] were not trending in the Republicans' favor and undecided voters usually break against the President's party in midterm elections," wrote Daniel Clifton, head of policy research at Strategas. "The probability of a GOP Senate seemed too high to us. But the recent bounce in enthusiasm for Republicans is now being confirmed in [North Dakota, Tennessee, Arizona Nevada] and [Indiana] polls. We caution there are still six races in the margin of error and how the undecided voters break will be key. They usually move in unison."

Clifton said stocks are not pricing in the surge in betting odds for a Republican sweep. In early October, betting on Predict.it showed a divergence in expectations, with odds for a split congress and a full Democratic sweep falling while the odds of a Republican sweep rose. The odds of s split Congress are still 58 percent, and for a Republican sweep, 36 percent.

One-month chart on odds on which party controls Congress

Source: Predictit.org

"Unanimously everyone believes the Democrats are going to take the House and the Republicans are going to control the Senate," said Julian Emanuel, chief equities and derivatives strategist at BTIG. "From our point of view, when we think about what is a potential surprise to the markets place...the biggest surprise to us would be if the Republicans held the House."

He said no matter who wins, stocks should bounce but with Republicans they could bounce even more.

"The data would show you if the Republicans are successful at holding unified government, the odds are that could spark serious upside," Emanuel said. "…In the event the Democrats take the House, the resolution of uncertainty…could be enough to keep stocks moving forward."

Emanuel notes that stocks have risen moderately in the months leading up to and just after the election in 22 midterm years going back to 1930. In the year following, the market averaged low double digit gains. Of the 13 midterms where there was a unified government, it remained that way after midterm elections only seven times.

All of those were years of Democratic control, but the market thrived in a continued one-party environment, with stocks averaging a 17.6 percent return. In the years when one party went to a divided Congress, the average gain was just 2.8 percent but with very wide variations of a 47 percent decline to a 34 percent gain in annual returns.

If Democrats were to sweep both houses, tax reform could be rolled back and that would be bullish for interest rates, but a Republican sweep would raise the odds for more tax cuts and more Treasury supply, a bearish scenario that would send rates higher, according to Zezas.

Zezas said a Republican sweep would be neutral for stocks but bullish for phamaceuticals, REITs, telecoms and health care services. Democrats would be neutral for stocks in general but bearish for pharma, REITs, telecom and some health care services.

Source: Morgan Stanley