Democrats are expected to retain the Senate, but Republicans have won the majority in the House of Representatives. Here’s what that means for policy, taxes, and markets.

Democrats broke the historic trend of midterm elections going against parties in power by retaining its slim majority in the Senate. Both Arizona and Nevada have been called in their favor, giving them 50 seats in the Senate and the Republicans 49. The final outstanding Senate race for Georgia will be decided in a runoff election on December 6. But even if Republicans win, Vice President Kamala Harris will continue to be the deciding vote in the event of a tie.

 

Republicans won the majority in the House of Representatives, but the number of seats that the party gained fell short of the dozens that the GOP, polls and markets first predicted. Democrats’ better-than-expected performance has reinvigorated the Biden Administration, and the outcome of the Georgia vote will determine how much leverage it will have in the upper house.

 

That said, neither party has a resounding mandate in Congress and gridlock will continue in Washington for the remaining two years of the Biden administration. Here’s what that means for markets, policy, and the economy.

 

What Happens Next?

 

An aggressive lame duck session now begins, as Democrats race to get as much of its policy agenda finalized in the remaining weeks of 2022, before Republicans assume power of the House on January 3. Top of mind will be passing the Appropriations Budget before year-end, as well as the 2023 National Defense Authorization Act, which has bipartisan support.

 

Biden may also push for an increase in the child tax credit, and Republicans may trade that for an extension to expiring tax cuts enacted by the Trump administration.

 

But the most critical issue Democrats may pursue before year-end is approval to raise the government’s debt ceiling. Normally increases in debt ceilings aren’t tackled until they are needed, which in this case is in the summer of next year. But leaving it until then would provide the Republicans with a powerful negotiating tool for 2023, at a time when the Democrats could be dealing with the economic fallout from the Federal Reserve’s rate hikes to fight inflation.

 

With Congress in gridlock, major changes to tax policy are also unlikely over the next two years. As for monetary policy, it is unlikely that politicians will influence the Fed to ease up on its most aggressive tightening cycle in a generation, even if mass layoffs are needed to bring inflation down to its 2% target.

 

How Will Midterms Affect Markets?

 

Markets priced in a Republican sweep leading into the election, but then gave back some of that rally on Wednesday when that didn’t emerge. Stocks quickly looked past election results following the release of a better-than-expected October inflation report, underscoring the greater importance of corporate earnings and economic fundamentals.

 

Nonetheless, gridlock should work well for markets, because it lessens the risk of unexpected changes to tax laws and other legislation for the next two years.

 

History shows that stocks tend to have positive returns in the 12 months following a midterm election, and that a recession almost never occurs in a President’s third year in office.

 

Exhibit 1: Q4 Seasonality and Midterms Reasons to be Positive

 

Yet, while we expect stocks and bonds to be delivering positive returns this time next year, the journey will be volatile and could include a recession. Much will depend on the Fed’s ability to bring inflation down and how deeply that will hurt the economy.

 

We think there’s a 70% probability of a recession next year, and while the markets tend to find a bottom before the economy does, we remain cautious in the near term until earnings estimates drop to more realistic levels and the Fed indicates it has finished raising rates.

 

Bottom Line

 

The midterm elections coincide with a seasonally positive time for the markets, and once the dust settles, we could enjoy a year-end rally. But investors should remember that economic and corporate fundamentals, rather than politics, will ultimately drive the markets in 2023. Our forecast is for stocks to finish in positive territory by the end of next year, with the markets pricing in better earnings expectations for 2024. We also believe bonds have the potential to provide positive returns in the year ahead. But we are unlikely to experience a smooth V-shaped recovery, as we no longer have the luxury of low rates and quantitative easing to turbo-charge the economy.

 

More important than the balance of power in Congress is having an investment plan in place which aligns with your goals. Staying invested is the best way to ensure you can benefit from the inevitable turnaround that is likely to occur in the latter part of 2023.

 

 

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