- The stock market could take an initial hit if Democrats pull off a surprise victory in Georgia's runoff election.
- But market strategists expect the market could then respond to the prospect of more stimulus spending by Democrats, and that would cause a sell-off in bonds and drive a rotation into cyclical and value stocks.
If Georgia voters surprise the market by electing two Democratic senators in Tuesday's runoff election, bond yields could immediately go higher and stocks could sell off.
The stock market, however, could seesaw as investors weigh the risk of tax increases against the prospect for more government spending to boost the economy. Some strategists say it may not prove negative for the market for long and there could be another big rotation toward the stocks that would do well with more fiscal stimulus and infrastructure spending.
"I'm kind of negative on it if it turns totally Democrat. I think the market has a bad reaction to that initially," said James Paulsen, chief investment strategist at Leuthold Group. "I don't think it's going to end the bull. ... Eventually, we're going to get a catalyst to create a correction anyway, and that could be it. There's a lot of people out there that think it's a positive because it could bring more fiscal juice."
Paulsen said if the market does react positively to the potential of more stimulus, growth stocks could lag. "You move toward value, cyclicals, small caps, and international for that matter. ... It would also probably weaken the dollar," he said.
Tuesday's races pit Republican David Perdue, whose Senate term expired Sunday, against Democrat Jon Ossoff and Republican Sen. Kelly Loeffler against Democrat Raphael Warnock. The election is critical since it will determine which party controls the Senate, and how easy it will be for President-elect Joe Biden to push through his policies. It was widely expected that Republicans would continue to hold the majority, with a win of at least one of the two Senate seats.
But polls are close, betting market odds have been narrowing, and the market is getting nervous. If both Democrats win, each party will have 50 Senate seats and Vice President-elect Kamala Harris would then act as tie-breaker in any vote.
"[Historically] stocks go down for a few days if there's a Democratic sweep," said Michael Schumacher, director of rates at Wells Fargo. "I think the stock call is tougher but the bond call is easy in a way. ... The bond people figure more spending, bigger deficits, more [Treasury] supply."
That should push interest rates higher, with the 10-year Treasury yield rising above the psychological ceiling of 1%. Schumacher expects the benchmark Treasury yield to hit a near-term high of 1.05% if Democrats win.
Treasury yields were higher Tuesday with the 10-year edging up to 0.96%. Yields move opposite to price. After Monday's big sell-off, the S&P 500 was up nearly 1%.
"Democrat control of the Senate is still a long shot and even with a 50-seat majority (with Harris' tie break vote) Democrats are unlikely to change taxes much given how many Dems face difficult elections in the 2022 mid-terms," wrote Evercore ISI strategists in a note. "One thing is pretty obvious though, if Democrats win GA, more stimulus is coming and 10yr yields and value stocks will move higher."
The Georgia runoff was required since none of the candidates had more than 50% of the vote in the Nov. 3 election.
Regardless of which party wins, stimulus spending is expected, but Democrats would approve a much bigger plan. But there is debate about how much and when Democrats would press for higher taxes, if they did have control.
"I think the likely outcome would be a watered-down Biden agenda, if they have a sweep," said Andy Laperriere, head of policy at Cornerstone Macro. Laperriere said he expects tax increases could be on the agenda this year, and they would likely pass the Senate and squeak by the House.
Laperriere said he expects the corporate tax rate would likely go to 25% from 21% and the tax rate for the wealthiest Americans would go from 37% back to the prior 39.6% level. He also expects a slight boost to capital gains taxes and taxes on dividends.
If Democrats win, Laperriere expects Biden to push through a $2 trillion spending plan, but if the GOP continues to hold the majority, there would be no tax hikes and the spending plan would be much smaller.
"I think alternative energy and infrastructure are the winners if the Democrats win," said Laperriere. "Tech companies that play low tax rates and drug companies are the losers. It's more likely the Democrats would reduce reimbursement rates."
Besides the Georgia election this week, politics will be in the headlines as some Republicans in Congress challenge the Electoral College vote Wednesday. Strategists expect the joint meeting of Congress will hold debates and then a majority will affirm the Electoral College vote for Biden.
Depending on the outcome in Georgia, that could add more tension to a potentially nervous market.
— CNBC's Michael Bloom contributed to this report.