This week’s midterm election can only be characterized as another significant midterm defeat for President Obama and the Democratic Party. Though some votes are still being counted as of this writing, overall the results are striking: Congressional Democrats lost almost every vulnerable incumbent seat in the Senate, failed to pick up any competitive Republican Senate seats and lost nearly every swing district in the House of Representatives. Of the 36 governor races, Republicans managed to hang onto most of their vulnerable seats, while also picking up some surprise seats in blue states such as Massachusetts, Illinois and Maryland.
While the gains for Republicans were compelling, they are directionally consistent with historical election outcomes: In the sixth year of a president’s term, the president’s party typically loses – and often loses big. In fact, over the past 80 years, the party of the president has lost an average of 35 House seats and six Senate seats.
Republicans gain a majority in the Senate …
The Louisiana race is headed to a runoff, but at this point it can be assumed that Republicans will have gained a total of nine Democratic seats while fending off competitive Democratic challengers in Republican states, giving Republicans a likely majority of 54–46 seats in the next Senate. With a majority in the Senate comes control of the “floor schedule” (what is voted on and what is not) as well as control of the Senate committee chairman positions and agendas. Importantly, however, despite the large wins for Republicans, they will head into the new Congress without a filibuster-proof majority (60 votes), implying that in order to pass most legislation, Republicans will need at least a handful (and possibly more) of Democratic votes to get legislation passed.
… and a greater majority in the House
Not all districts have been called, but Republicans look poised to add up to 15 additional House Republican seats, likely giving Republicans a 30-seat (and potentially larger) majority. This will represent the largest Republican House majority since the Depression era. Republicans picked up almost all of the competitive seats as well as defended some seats that had seemed like a lost cause. The composition of the new Republicans will be more centrist (i.e., less Tea Party), providing Speaker John Boehner (who will almost surely run again and win) more wiggle room on key votes.
Expect a (slightly) more productive Congress next year
What are the possible policy implications for investors over the next two years? Our view is that next year’s Congress will likely be incrementally more productive than that of recent years, though with the caveat that we are finishing the least productive sessions of Congress ever, so the proverbial bar is set quite low. We will almost surely see progress on issues that have enjoyed bipartisan support in previous sessions of Congress but for political reasons have not seen a vote, including expedited approval of the Keystone XL pipeline, a repeal of the medical device tax and greater latitude for the President to negotiate free trade agreements (known as Trade Promotion Authority). We will also surely see efforts by Republicans to repeal parts of the Affordable Care Act and the Dodd-Frank Act. Some of these efforts may be successful if they are “tweaks” versus substantive changes, although it remains to be seen whether President Obama supports any changes – regardless of how small – that undermine his signature (and potentially only) legislative achievements. We should not expect a significant change on the fiscal side, with discretionary spending likely to stay roughly flat year-over-year, but we may see a slight increase in defense spending, especially if tensions in the Middle East continue to escalate.
The Congressional changes may also lead to a return of policy uncertainty related to fiscal issues such as the upcoming spring deadline to increase the debt ceiling. This will largely depend on what concessions Republicans try to extract from the President in exchange for a debt ceiling increase and whether the President decides he wants to negotiate over the debt ceiling (which would be a departure from his stance over the past two years).
What about the large, ambitious legislative reforms that have been discussed in Washington ad nauseam over the past few years but have seen little movement, such as entitlement reform, a tax overhaul and government-sponsored-enterprise (GSE) reform? We believe the chances of any larger, meatier legislation remain slim. Not only do the parties continue to have vast policy disagreements on these issues, but it is unclear whether President Obama and the Republicans will really want to strike a deal on these more controversial issues. Democrats will be eyeing 2016, when their chances to win back the Senate and keep the White House look decent, while Republicans may continue to distrust the President as a negotiating partner, especially if he moves forward with executive action on immigration reform (which he is expected to do).
Equities and other risk assets may get a post-midterm boost
From a market perspective, we believe Tuesday’s election outcomes are marginally supportive for both equities and the U.S. dollar, but they also increase, to some degree, the prospect for market volatility and tail outcomes (both right and left tail).
Historically speaking, the period following a midterm election has been generally favorable for equities and other risk assets. Since 1950, the S&P 500 index has returned 15.8% on average in the year following midterm elections, with no instances of negative performance (see Figure 1).
We caution against unabated euphoria, as Washington will still be plagued by a deep partisan divide. However, our expectation for a marginally more productive Congress, while far short of a united Congress capable of breakthroughs on tax and entitlement reform, still represents movement in the right direction, as the last Congress accomplished virtually nothing of substance. Furthermore, the more Republican-leaning initiatives that are likely to be addressed, such as “tweaks” to the Dodd-Frank Act, are on the margin more friendly to risk assets.
Similar to historical equity markets, the U.S. dollar also tends to do quite well following midterm elections. Given the possibility of improvement in trade negotiations and legislation to improve energy exports, coupled with relatively strong U.S. economic growth in a global context, we expect the U.S. dollar to retain its strength.
Our base case is for a marginal improvement in Congressional productivity, but uncertainty around the base case has also increased. While we became accustomed to very little bipartisan agreement under the previous Congressional makeup, we also learned to expect ultimate resolution to the recurring fiscal deadlines pertaining to the debt ceiling and budget resolutions (albeit at the eleventh hour). Increased uncertainty regarding potential changes to the negotiating tactics of emboldened Republicans in Congress and a President in his final two years of office may lead to an increase in market volatility surrounding next year’s debt ceiling extension.
Additionally, some in the market expect the Republican gains may lead to increased scrutiny and political pressure on the Federal Reserve. We are not especially concerned on this front because we believe that, ultimately, “Fed bashing” is more of a political ploy than a legislative agenda; any posturing and threat to the Federal Reserve’s independence would lead to significantly higher market volatility.
On one final cynical, yet constructive, note, the probability of favorable right tail outcomes has likely increased along with the probability of unfavorable left tail outcomes. After the election cycle of 2012, we could have predicted with near precision that the subsequent two years would yield virtually no substantive legislative reform. While it is not our base case, at least now there is some non-zero probability that a more centrist and emboldened Republican Party, coupled with a president who has no more elections (but yet a legacy) to worry about, could achieve breakthrough reform that lifts long-term growth – and market – prospects.