The three big election scenarios, and the one that scares Wall Street the most

  • A Democratic sweep of Tuesday's elections, in which the party captures both the House and Senate, is Wall Street's biggest negative, according to Cowen strategist Chris Krueger.
  • A rout by either party is considered unlikely, with Democrats expected to take the House and Republicans holding the Senate.
  • "Headline risk [is] exponentially bigger" under the Democratic sweep, while the GOP holding both chambers presents a "VERY different market narrative," Krueger wrote.

A big blue wave is what Democrats are hoping most for, but it spells the only apparent danger scenario for investors coming out of Tuesday's midterms.

If all goes according to forecast, the Democrats will capture the 23 seats and then some that they need to flip the House of Representatives in their favor, while the Republicans will be able to stave off the challenge and hold the Senate, perhaps even building slightly on the current 51-49 GOP margin.

One dark horse looms, though: A Democratic sweep that includes the Senate and sets the party on a collision course with Republican President Donald Trump.

While unlikely — forecaster Nate Silver at FiveThirtyEight gives it just a 19.1 percent chance of happening — the result would be the most likely to upset Wall Street, which is coming off a brutally volatile month.

"Headline risk [is[ exponentially bigger" under the Democrat rout scenario, wrote Chris Krueger, Washington strategist for investment bank Cowen's Washington Research Group. The Republican "deregulatory agenda will come under pressure as the Senate will shut down new Executive Branch confirmations and judges will come to a nuclear freeze." Chances of impeachment in the House also increase, though conviction in the Senate would remain unlikely, he added.

While Krueger concedes that this is "the most most unlikely of the election scenarios," it is also "likely the most market negative in the near-term."

Should the Democrats take full government control since the first two years of former President Barack Obama's first term, the possibility increases that someone like Vermont Sen. Bernie Sanders could become president, he added. A hard-left president would bring "the Herbal Tea Party's greatest hits like Medicare for All, 'Free' College, tax hikes, regulation, trading/bank tax, etc," wrote Kreuger.

The other two scenarios are a little less complicated.

The baseline from pretty much everyone on Wall Street is the aforementioned House-Senate split and the accompanying expectations of at least some level of gridlock.

"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," Krueger said. "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."

One other big area of cooperation could be on trade, where Krueger expects most Democrats to stay in line with Trump's get-tough policy on China.

What if the GOP holds?

Other forecasts are basically consistent with that. Most Wall Street strategists see 2017's tax cuts as staying intact as well, and expectations are that Democrats will not want to shake business confidence by undoing Trump's deregulatory progress.

"In the event the midterms produce divided government, we expect some market-led 'sugar high' optimism over the prospect of further bipartisan impulse. But we think such optimism will be premature," said Ernie Tedeschi, policy economist and head of fiscal analysis for Evercore ISI. "Nevertheless, regardless of midterm outcomes we expect the tax cuts to be preserved and the budget deal to be extended for 2020 and beyond."

The third scenario is that the Republicans defy the pundits and pollsters and hold the Senate and the House.

That presents a "VERY different market narrative as budget reconciliation comes back into play," Krueger said. A laundry list of likely outcomes he lists includes "fiscal sugar high extended, deficit continues to skyrocket, Trump is completely unchecked, Mueller Investigation gets put in a drawer, tariffs galore, deregulation unabated, and Democratic Party begins a circular firing squad."

Again, though, the GOP sweep is considered even less likely than the Democrats running the table. Silver assigns just a 12.1 percent probability of the Republicans hanging on to the House.

One more wild card

There is one other wild card that, while not long lasting presents a chance of near-term volatility. That comes into play if election night is inconclusive, with races so close that recounts are necessary, said Tobias Levkovich, Citigroup's chief U.S. equity strategist.

"Should House control be a function of how these votes go, the investment community may have to deal with such uncertainty for longer than they had expected and that might restrain equity markets for several weeks," Levkovich said in a note.

Bigger picture, though, expectations are that the elections likely will not be disruptive as the headlines start to fade away. After all, the markets have been positive the year after every midterm election since World War II.

"Although we might see some initial volatility due to sentiment, I don't think midterm elections pose a threat to the fundamental value of markets, no matter what the outcome is," said Scott Clemons, chief investment strategist at Brown Brothers Harriman. "Financial markets actually tend to like divided governments because markets don't like change. When a different party controls Congress from the White House, markets tend to do better."

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