US mid-terms: The impact of an unpredictable election on investment outlook

by | Oct 26, 2018

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Scott Osborne, Investment Analyst at Brown Shipley, has written an exclusive for IFA Magazine, looking ahead to the mid-term elections in the US.

With the 2018 primary season complete and candidates for the two major parties decided, attention has shifted to the upcoming mid-term elections in the US.

As with all political events of this scale, the outcome will have a major macroeconomic impact so it is important that advisers keep their wits about them irrespective of the result.

Given that preliminary reporting ranges from “fact-based” to full on “fake news”, the below provides a quick snap shot of the current state of play.

  1. The Senate – Republicans currently have 51 seats in comparison to the Democrats’ 49, meaning a two-seat gain would be sufficient for the latter to take control. With the Democrats comfortably ahead in the polls this seems achievable – at least at first glance.

The reality might be different, as out of the 33 seats up for election only eight are Republican. Of the remaining 25 Democrat seats, ten are in states won by Trump in 2016, of which six had double digit winning margins.

The electoral map for this election is not on the Democrats’ side. A substantial lead in the polls could feasibly flip two Red states, but not losing any others seems pretty unlikely.

Base Case: Republicans retain the Senate

  1. The House – Unlike the Senate, all 435 seats in the House of Representatives are up for election. With the map the same every year, this is where the overall polls indicate an expected win for the Democrats.

What will be more interesting, however, is what the dynamic between more left wing and traditional centrist Democratic candidates will be like. This relationship could have implications for Democrat policy post-election and perhaps go as far as to inform the direction of travel for the next Presidential election.

Base Case: Democrats win the house

  1. The Margin of Error – How many pollsters does it take to change a lightbulb? Just one (plus or minus five). So goes the joke regarding how forecasters of all types caveat their predictions with a wide margin of error.

 A perfect example of this was Trump’s election in 2016 as it demonstrated a fundamental shift in voting patterns that was surprising to many, but not outside the realm of possibility defined by models.

Local issues and a greater focus on candidates provide more detail for mid-term data models, but as usual any and all predictions should be taken with a large pinch of salt.

Base Case: Unpredictability means Volatility

Known unknowns

While it is difficult to speculate on any potential market impact given the above, there are some outcomes which look more likely than not.

Base case expectations show a return to gridlock, with Democrats expected to block White House policy and slow processes down. This would not necessarily be a bad outcome from an investment perspective.

With the potential ramifications of a “Blue Wave” or an against all odds Republican triumph, maintaining the status quo for a few years could be something of a relief given heightened risk around debt ceilings and Government shutdowns.

Another likely short term outcome is a shift in Trump’s rhetoric towards the more domestic ‘wins’, particularly regarding tax reforms.  A trade war plays well to general populist sentiment, but the pain felt by some of the core farming states in the “Red Middle” makes it a tricky local issue that’s probably best avoided in what is fundamentally a local election.

How will markets react?

But what does this mean for investment portfolios? History tells us that the market performs best when Republic Presidents have the backing of both the House and the Senate.

Since 1901, the Dow Jones Industrial index has gained on average 7.3% in real terms (after deducting inflation) when both the White House and Congress were in Republican hands. In years when the US had a Republican President, but both the House and the Senate controlled by Democrats, the Dow Jones lost on average 2.0%.

A divided house – the most likely outcome we will see this November – comes with expectations of a poorly performing market at average annual loss of 7.3% for the Dow Jones.

Investor response

With all this in mind, our view is that if everything comes to pass as expected, advisers should take a cautious stance.

From a stock selection perspective, the binary event risk that comes with US elections is difficult to manage and with the heightened uncertainty across markets of late, this is not an election investors should look to get ahead of.

Diversification remains the best defence against unexpected outcomes and volatility post-event is often the most fertile ground for opportunistic moves.

Retaining a balanced mix of investments across different sectors and geographies is the best way to reduce broad market risk. This can feel like an inherently defensive move, but the value in active management around market moving events like this, such as Brexit and the Italian elections, is recognising and responding quickly to change – not predicting it.

Investing is a long term decision and it takes a manager with a cool head to keep this in mind when short term sentiment can lurch one way or another.

A good example of this are biotech stocks which would likely come under pressure from Democrat strength, who campaigned for lower drug prices and healthcare reform.

But initial volatility here still probably wouldn’t change the long term structural tailwinds of an aging demographic or derail the current golden period of innovation across the biotechnology industry.

While we would not necessarily look to position ahead of the event by reducing exposure to the sector, any opportunities that are thrown up in the wake of a surprise result would be well worth considering.

 

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