Wall Street's investment banks are advising clients on what to expect from the 2018 midterm elections and how to invest around those outcomes.
While most of the banks still expect the Democrats to take back the House of Representatives and split Congress, some analysts suggest chances are increasing for a Republican or Democratic sweep.
Bank of America Merrill Lynch, for example, told clients "we still think a split Congress is the most likely outcome but the probability of a 'blue wave' election in the House appears to have diminished."
Goldman Sachs suggested investors keep an eye on pharmaceutical stocks, which could rally if Congress ends up divided, the bank speculates. The firm's strategist contends a split Congress reduces the likelihood of an agreement to reduce drug prices.
Others highlighted the importance of trade policy and implications for U.S.-Chinese relations.
Here's what Wall Street is telling clients going into the 2018 midterm elections:
Bank of America Merrill Lynch
- Base case: "We still think a split Congress is the most likely outcome but the probability of a 'blue wave' election in the House appears to have diminished."
- Market reaction: Base case is a boon for equities, as markets historically do well under gridlock. Republican hold could be more near-term bullish with pro-growth measures, but longer-term bearish thanks to stronger dollar, tighter Fed and widening of the deficit.
- Notes: Potential biparisan support for industrials and materials.
"Markets generally do well under gridlock. A modest infrastructure bill might see bipartisan support, which could lift Industrials and Materials. A Republican sweep could be equally positive for the overall market as gridlock, as a coordinated Congress could move to enact pro-growth measures. These could include another round of individual tax cuts, or making select tax cuts permanent. ... Meanwhile, a Democratic sweep could increase the risk of congressional investigations. And while this scenario is currently not on the table, in the event of impeachment proceedings, it could be classified as an exogenous macro 'shock.'"
Goldman Sachs
- Base case: Democrats take control of the House of Representatives, Republicans keep Senate majority by a slim margin.
- Market reaction: Modest reactions, slightly weaker fiscal stimulus and growth, no reason to expect major changes in trade policy. Uncertain implications for U.S. dollar. Both parties have expressed interest in infrastructure, Goldman's economists more doubtful on likelihood of passage due to bickering over implementation, aversion to further spending.
- Notes: Aerospace and Defense stocks suggest the market does not expect major tightening of fiscal policy. Pharmaceutical stocks have tracked the prediction market likelihood of a Democrat victory in the House, suggesting investors believe a split Congress would mitigate chances of major regulatory changes. More major market moves if Republicans or Democrats seize both chambers.
"Our base case implies slightly weaker fiscal stimulus and growth, as well as little reason to expect friendlier trade policy, which translates, in our view, to downside risk to Treasury yields. That said, there has been a lot of focus on how many seats the Democrats can maintain in the Senate, so if Republicans gain more than a slim majority, we could see higher yields even under a divided Congress. Implications for the Dollar appear more ambiguous...
The reaction this year may be different than in the past, particularly given the lower sensitivity of markets to elevated political uncertainty in recent years (based on historically low volatility) and the current fiscal boost likely to fade over the coming years, both of which are unusual around midterm elections. Our equity strategists have also noted that relevant sectors and baskets appear to be pricing few changes to the direction of policy, in line with our expectations." — Karen Reichgott
Cowen
- Base case: Democrats take control of the House of Representatives, Republicans keep Senate majority.
- Market reaction: There will be headline risk with the House moving toward far-left lawmakers. Impeachment of President Trump is more likely, though not a guarantee. De-regulatory agenda should continue anyway.
"Our suspicion is that there will be limited bipartisanship that will extend only to things like the debt ceiling, sequester relief, and other 'must pass' bills. The Venn Diagram of potential areas of compromise includes everything from infrastructure and drug pricing, to a federal minimum wage hike and student debt relief. Keep in mind that many Democrats are in a similar policy place as Trump on trade. Under almost any election scenario, the prospects of another patch in the Budget Control Act (sequester) that will see a modest increase in defense spending seems likely." — Chris Krueger
Deutsche Bank
- Base case: Democrats take control of the House of Representatives, Republicans keep Senate majority.
- Market reaction: Fiscal stimulus and trade policy in the limelight. Republican dominance more bullish, while divided government could de-escalate trade conflict. Fundamental views (bullish equities and bear rates) unlikely to change.
"Our equity strategists believe that the environment is ripe for an equity rally into year end. Markets have historically rallied around midterm elections, though this is equally due to historic coincidence (growth has tended to be strong around elections) as the actual elections. Still, we expect this scenario to repeat, as growth looks strong, positioning is light, and Democratic gains could act as a check on the president's trade war policies. On the other hand, some Democratic politicians have expressed support for President Trump's trade war, so they may actually support an escalation against China." — Quinn Brody
BlackRock
- Base case,: Democrats take control of the House of Representatives, Republicans keep Senate majority.
- Market reaction: There are few market implications if Congress is divided. Low risk of rollback to President Donald Trump's tax cuts and regulatory polices. Some disruptors could include growing support for crackdown on China's trade and intellectual property practices and increased risk of investigations into the president.
"We see few sustained market implications if the midterms result in a divided Congress. Our base case sees strong U.S. growth underpinning the global expansion, yet the range of possible economic outcomes is widening with a skew to the downside. We remain pro-risk, but advocate building greater resilience into portfolios. We favor quality companies, especially those with strong balance sheets, and find those predominantly in the U.S." — Richard Turnill
Strategas
- Base case: We are a 50/50 country and both the House and Senate races are closer than the consensus anticipates. With so many House and Senate races in the margin of error and no enthusiasm gap between the two parties, there is a chance of a surprise in either direction. Republicans are likely to keep the Senate, Democrats are likely to capture the House.
- Market reaction:Â Health care, ex pharma, should benefit from divided government and a new surge of Democratic governors. The market is likely underpricing a deal for Defense, National Institute of Health, and infrastructure spending towards the end of 2019. Should Republicans sweep we would favor financials and energy. Should Democrats sweep we would favor infrastructure, healthcare, and consumer staples.
"We don't believe in the view that divided government leads to status quo events. Midterm elections are inflection points for stocks. ... A China trade deal and indexing capital gains to inflation could be done without an act of Congress. De-regulation, which is helping productivity, will continue. Our concern is that there will be a debt ceiling fight in mid-2019 with House Democrats pushing for an increase in corporate tax rates as a condition of a debt ceiling increase. It is likely Trump will try to cut a deal with Democrats on infrastructure, drug pricing, and/or the minimum wage to avoid a major debt ceiling fight and to avoid tax increases." - Dan Clifton
Bernstein
- Base case: Democrats take control of the House of Representatives, Republicans keep Senate majority.
- Market reaction: Terms with a Republican White House and Senate see an average market gain of almost 12 percent, sparked by multiple expansion. When Democrats control the White House and the Senate, market returns are a bit stronger.
"While parsing out the likely election outcomes and looking back for historical precedents does not lead to particularly clear conclusions (in part because of small sample sizes), the most robust result we have found is that economic, fundamental and market outcomes tend to improve in the two years following a mid-term election, without regard to President or party."
Morgan Stanley
- Base case: Democrats take control of the House of Representatives, Republicans keep Senate majority.
- Market reaction: Trade risk remains a constant regardless of the outcome. Fiscal outcomes key for stocks, with wages, trade and interest rates; a Republican or Democratic sweep could impact models.
- Notes: Should the GOP hold both houses, could see added fiscal stimulus through extended tax cuts, but likely drive rates higher with more hawkish Fed. If Democrats sweep, they can't affect fiscal policy before 2020, but impacts trajectory beyond it. Reasonable to conclude fiscal contractions, less hawkish Fed, diminished worries about rising input costs. Stay long volatility, stay cautious on corporate credit.
"As a relative outperformer, the market hasn't onboarded many of the nonpolicy concerns that have been key to this year's 'rolling bear market' across asset classes. Hence, 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." — Michael Zezas
Fundstrat Global Advisors
- Base case:: Democrats narrowly win House, Republicans keep Senate with 52 to 48 majority.
- Market reaction: Rally into year-end; longer midterm rallies depend on no change in House majority. Democrat takeover in the House could suggest a more disappointing 2019.
- Notes: Overweight industrials, technology, energy, materials, financials, communication services. Neutral on so-called FANG stocks. Expect higher interest rates.
"While a House majority switch suggests markets returns could disappoint in 2019, we do not see this as pointing to a more protracted economic or equity market downturn. In fact, these midterms switches have not preceded major turning points for markets ever. We still look for a rally into year-end, driven by strong seasonals and midterm seasonals as well as performance chasing." — Tom Lee
— With reporting by CNBC's Patti Domm and Michael Bloom.
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