Apprehension about Georgia's Senate runoff election Tuesday helped fuel a sharp New Year's sell-off, and politics could continue to unhinge the stock market even after the outcome is known.
Policy strategists said the results could take several days, if the vote is as close as expected. The runoff for two Senate seats is the final determinant of the 2020 election, and at stake is control of the U.S. Senate. Wall Street has widely expected at least one Republican will win, keeping the GOP in control by the narrowest margin.
Stocks traded sharply lower on the first trading day of the year, with the S&P 500 and Dow hitting a new record high in early trading before falling sharply. Futures prices on Tuesday were slightly in the green.
Traders said there were multiple causes for Monday's selling, including concerns about the pandemic, with new shutdowns in the U.K. and the slow distribution of the vaccine in the U.S., as well as political risk and a growing concern Democrats could win in Georgia.
Republican Sen. David Perdue is being challenged by Democrat Jon Ossoff, while GOP Sen. Kelly Loeffler is being challenged by Democrat Raphael Warnock. None of the candidates had more than 50% of the vote in the Nov. 3 election, so Georgia law required a runoff election between the two leading candidates for each seat.
Another unusual political event is also overhanging the market.
"It's not surprising at all that you're having this pullback," said Julian Emanuel, head of equity and derivatives strategy at BTIG. "The question is when you look at the next two or three days, is it a catalyst for further pullback? ... The market is concerned that Democratic control of the Senate would manifest itself as risk off. Given the fact that the market is so overbought, ... it wouldn't surprise us to see a 10% to 15% down move in the near term."
The worry for the stock market is that if the Democrats win both Senate seats, each party would have 50 seats but Vice President-elect Kamala Harris would cast the tie-breaking vote after she takes office. President-elect Joe Biden would then be able to press more of his agenda, including capital gains and corporate tax increases.
"I think the market has priced in the fact that at least one of these two seats is going to a Republican," Cowen CEO Jeffrey Solomon said on CNBC's "Squawk on the Street." "The market definitely likes it where the executive branch and legislative branch are not in the same camp. If it turns out we get two Democrats elected, we're likely to see some reaction to that. ... Irrespective of who controls the House and Senate, I think we're going to see significant fiscal spend, and there's going to be an infrastructure bill."
Solomon said he expects a stock sell-off would create a buying opportunity.
Emanuel agrees, and he expects the S&P 500 to go to 4,000 this year after an early sell-off.
"We knew all these things as risks on Dec. 31, and we knew them all for the most part of December, but basically people felt as if they wanted to be fully invested coming into year-end," he said. "The market tends not to respond until it's staring right in the face. And that's today."
Quincy Krosby, chief market strategist at Prudential Financial, said investors became more concerned about the Georgia races Monday, as betting markets started to show improved odds for Democrats. "That's part of the sell-off," she said.
Analysts say there may be a bigger sell-off if Democrats win, but there could also be an opportunity for a bigger and faster spending package. That would boost the economy and also the stock market.
JPMorgan strategists said the Georgia runoff has been a wild card for the market, and the ripple would be felt across financial markets if Democrats win.
"If there is a surprise, the knee-jerk reaction is likely to be a fall in [the dollar] and a bounce in bond yields. This might weigh on the overall market in the very short term, but it could also catalyze the next leg up in Value rotation," the strategists said in a note.
Tom Block, Washington policy analyst at Fundstrat, said even if the Democrats win, there's little chance many of Biden's policies are acted on. He said some Democrats, like conservative Democrat Sen. Joe Manchin of West Virginia, may side with Republicans on some issues.
"I don't see capital gains rates going up, even if the Democrats get control. It will make the confirmation process of the Cabinet and judges easier. I think it makes things like Covid relief much easier," he said.
The key to the election will be voter turnout. "Moderate Republicans appear to have gone and voted for Biden, but then came home and voted for Republicans," Block said.
Evercore strategists said that traditionally, the party that loses the White House is more motivated to vote in January runoffs. They note, however, that Democrats may have turned out to vote early, and Republicans could be hurt by President Donald Trump's attacks on state leaders for certifying Biden's win.
"In the event of a Democrat sweep, we would expect a powerful internal market rotation as investors reprice for a high fiscal/some taxes/more green/more regulation outcome than Biden with divided government, with the market likely down on net overall on the day," the Evercore analysts wrote.
While not expected to be a big market event, political strategists say the unprecedented challenge of the Electoral College vote by Republican congressmen and senators on Wednesday could cause more problems down the road.
Block contended that it could start a spiral, where Democrats may challenge the next election won by a Republican. If the parties continue to try to impair each other's ability to govern there could be longer term issues for the U.S.
"It's creating a question that has never existed about the stability of the transition from one government to another in the U.S., which has been a pillar to the dollar as a reserve currency," he said.
Brian Gardner, Stifel chief Washington policy analyst, said he believes the challenges will just be "noise" and added that there are bigger worries if the antagonism continues and escalates.
"I don't think there's any short- or even medium-term market risk," Gardner said.
"I think this is generally political noise. The bigger question is, did this signal another turning point in U.S. politics that makes governing impossible? Or at least more difficult than what we're used to," Gardner said. "If the answer to that is yes, then there is market risk that longer term the federal government, the U.S. becomes ungovernable."
Gardner said there would be significant risk if that were the outcome, but he expects the event will be a passing occurrence.
Correction: Congress' counting of the Electoral College vote is scheduled for Wednesday. An earlier version had the wrong day.
--Michael Bloom contributed to this report