What the Midterms Could Mean for Markets

With the US midterm elections now just over a month away, politics are starting to become an increasingly important consideration for investors. On November 3, Americans will vote on all 435 seats in the House of Representatives and 35 seats in the Senate, with the results determining who controls Congress for the final two years of President Trump's term.

The outcome matters because control of Congress can influence fiscal policy, government spending, regulation, and the administration's ability to advance its agenda. Those decisions ultimately have consequences for the economy and financial markets.

And the timing is particularly interesting.

The US economy is already navigating a complicated environment. Inflation remains above the Federal Reserve's target, oil prices have been elevated, and the 10-year Treasury yield has climbed above 5%, its highest level since 2007. That last point is worth paying attention to.

Long-term interest rates are influenced not only by inflation and expectations for Federal Reserve policy, but also by government borrowing and the amount of debt investors are being asked to absorb. If the election results in a different approach to government spending or fiscal policy, the bond market will be watching closely.

But this is where I think investors need to separate the political implications from the market implications.

J.P. Morgan recently made a similar observation, noting that while elections can influence the policy environment, the broader economic cycle and corporate earnings have historically been more important drivers of markets over time.

At the same time, markets do respond to changes in the policy environment. A change in congressional control could be interpreted by investors as a potential check on the administration's ability to pursue some of its more ambitious policy objectives. Depending on the outcome, investors may see a change in congressional control as either reducing or increasing uncertainty around fiscal policy, trade, and regulation.

That is an important distinction.

Markets don't ultimately invest in political parties. They invest in businesses, earnings, and cash flows, while interest rates and economic growth determine how those future earnings are valued. But politics can influence those fundamentals when it changes the policy environment in which businesses and investors operate.

There may be more volatility as we get closer to the election, particularly as investors assess what a change in congressional control could mean. But I think the bigger question is whether the election actually changes the fundamentals we have been watching all year.

The midterms will tell us something important about the direction of US policy. For investors, the more important question is what that means for economic growth, government borrowing, inflation, interest rates, and corporate earnings.

The election may change Washington. The question for investors is whether it changes the economy.

‍