The balance of power
ElectionWatch: 2022 US midterm elections
Midterm elections pose a practical challenge for the political party of incumbent presidents. The adverse impact is more pronounced in the House of Representatives, where the president’s party has lost seats in 17 of the past 19 midterm elections. The exceptions in 1998 and 2002 were attributable to unusual circumstances. Exit polls in 1998 suggested most voters held unfavorable views of President Bill Clinton as an individual but gave him high marks for job performance.¹ Four years later, voters were still inclined to rally around President George W. Bush in the wake of the 9/11 attacks.
These two exceptions may prove the rule. The party in charge of the executive branch generally loses more than two dozen House seats halfway through a presidential term of office. Theories abound as to why that is the case. The incessant media coverage certainly amplifies a president’s occasional gaffes and policy errors. Voter turnout also tends to decline in midterm elections, which suggests that those who do vote tend to be highly motivated. And the average voter affiliated with the opposition party is more likely to show up at the polls on Election Day than the president’s own supporters.²
Voters, particularly those affiliated with the opposition party, tend to view midterm elections as a referendum on the performance of the president. This pattern of behavior appears to be playing out in real time. According to a recent Pew Research Center survey, conducted between 7 and 13 March, 71% of the registered Republicans surveyed said that they plan to cast a vote “against Biden” in November. They also were more likely than Democrats to believe that control of Congress was important. Less than half of registered Democrats plan on treating their vote as an expression of support for the president.³
High job approval ratings can occasionally blunt—if not completely eliminate—the adverse impact of a midterm election cycle. Clinton and Bush both enjoyed high approval ratings, and their respective parties showed small gains in the House of Representatives. Presidents Ronald Reagan and George H.W. Bush also enjoyed high job approval ratings in 1986 and 1990, respectively. Republicans still lost seats in the House in those elections, but the losses were minimal. Conversely, when job approval ratings fall below 50%, the president’s party usually pays a heavy price.
The historical pattern is less consistent in the Senate, where one-third of the members are up for election every two years.⁴ The outcome of these statewide elections often depends upon how many seats one party or the other is defending, and whether the states in play tend to favor one party or the other. The Senate map in 2022 helps Democrats because Republicans must defend more seats, and two GOP incumbents in swing states are retiring. However, four Democratic incumbents are facing tough reelection contests. Prediction markets are showing a greater likelihood of GOP control of the Senate next year, but the outcome is still uncertain.
The generic congressional ballot question is another indicator of the challenges facing Democrats in this midterm election. The survey question typically asks respondents to identify which political party they plan to support in an upcoming election without reference to an individual candidate. Both political parties pay close attention to this question because it is generally regarded as an accurate reflection of voter sentiment.⁵ The spread in support for the two parties began to widen in late January. At current levels, it represents a net positive change of 6.6 points for Republicans versus the 2020 election.
This year’s midterm election will be contested after the decennial census, when the boundaries of House districts are redrawn. The “redistricting” is necessary to account for population changes over the course of a decade and to allocate representation in Congress and in state legislatures more fairly. In practice, whenever either party holds the levers of power in a statehouse, they use the opportunity to draw the boundaries of House districts to their advantage. The ability to draw new boundaries is often subject to judicial review, but legislatures enjoy considerable discretion.
The process is called “gerrymandering”, and it tends to reduce the competitiveness of many elections. This year is no exception. According to one analysis, the number of House seats encompassing areas where the last presidential election was decided by less than five points has been reduced from 50 to just 31.⁶ Ironically, barring a “wave” election in favor of the GOP, this may limit the total number of Democratic seats likely to be lost.
Incumbent Democrats face myriad challenges in the runup to this year’s midterm elections. Inflation is running at a 40-year high, and President Joe Biden’s job approval rating has not recovered from the chaotic US withdrawal from Afghanistan. Thirty-one House Democrats have already chosen to abandon their reelection efforts, which may be as useful an indicator as any of the prospects for a change in control in the House of Representatives.
1 Ronald Brownstein, ìClintonís Pains Aided Democrats Gains, Exit Poll Indicates,î Los Angeles Times, 5 November 1998
² Geoffrey Skelley and Nathaniel Rakich, FiveThirtyEight, 3 January 2022
³ ìRepublicans More Likely Than Democrats to Say Partisan Control of Congress Really Matters,î Pew Research Center, 24 March 2022
⁴ Thirty-five Senate seats will be contested in 2022 because Sen. Jim Inhofe (R-OK) will retire early.
⁵ Harry Enten, ìHereís the Best Tool We have for Understanding How the Midterms Are Shaping Up,î FiveThirtyEight, 5 June 2017. See also Pew Research Center, ìWhy the Generic Ballot Test,î 1 October 2002, and Amy Sherman, The Poynter Institute, Poltifact, 3 November 2013
⁶ Ally Mutnick, ìThe new midterm match: how redistricting, Biden, and Trump shaped the battle for the House,î Politico, 21 March 2022
Equity markets are off to a volatile start in 2022. If history is a guide, volatility could remain higher than normal ahead of the midterm elections. Economic policy uncertainty tends to rise in the runup to elections, and the US equity market tends to trade sideways as it waits for clarity. Post-election, the market typically rallies regardless of who wins a majority in Congress. Today’s environment is unique in many ways, making it difficult to know if the historical pattern will repeat. Ultimately, economic fundamentals drive markets, though that can be influenced by fiscal and regulatory policies. In our base case, we don’t see any major policy shifts on the horizon, and therefore we see the midterm election as largely a nonevent for the broader equity market. Admittedly, some sectors such as healthcare and financials may be more sensitive to elections given the potential for regulatory reform.
This year, we believe economic growth and monetary policy will be the key near-term drivers of the market. With economic growth set to moderate, the Federal Reserve expected to tighten at the fastest pace since at least 1994, and a war in Ukraine, we look for somewhat of a range-bound market in the coming months.
Divided government offers clarity
In our base case scenario, the House of Representatives will flip to Republican control. This would mean legislative gridlock—making it more difficult to implement major policy changes. Typically, equity investors prefer policy clarity. Any parts of the Biden administration’s legislative agenda—including increased spending on social and climate initiatives and higher taxes—that aren’t passed by year-end will likely face stiff headwinds afterwards and won’t be enacted. Under that scenario, the market could react favorably as it would mean no further increase in fiscal spending that could add impetus to already elevated inflation, and no tax increases that could be a drag on corporate profits.
Market returns tend to be subdued and volatility rises in midterm election years
The market tends to be range-bound in the months leading up to Election Day before breaking out to the upside. Average returns tend to dip in the second and third quarter before rebounding in the fourth. Some of this can be attributed to policy uncertainty regarding which party will control Congress and what it might mean for market-related legislation. The elimination of uncertainty allows markets to resume focusing on fundamentals. That said, the data does show that much of the large negative preelection returns occurred in the 1960s and 1970s—a period of sluggish economic growth and high energy prices, inflation, and unemployment. When this period is stripped out, calendar year returns are 8.5%óroughly in line with average annual returns for the market.
Equity market volatility has also tended to increase in the months preceding midterm elections. This year has already diverged from the historical pattern, with volatility rising sharply in January and February. We attribute this to the war in Ukraine and a more hawkish Fed.
Strong returns in the year after midterm elections
Regardless of how midterm elections turn out, the market typically rallies shortly thereafter. Since 1928, the average 12-month return is 13%, compared with 5.5% for other years. Only in two instances did the market have negative 12-month returns after a midterm election: in 1930–31 and in 1938–39. The first period occurred during the Great Depression, and the latter during heightened geopolitical tensions as World War II began in Europe.
Less than a month before the midterm elections of 1974, President Gerald Ford stood before a joint session of Congress to propose an economic recovery plan. Inflation had exceeded 11% in the wake of an OPEC oil embargo, and Ford was making a fervent effort to convince America’s legislators to exercise greater fiscal discipline and adopt an array of measures to slow the rise in consumer prices. It’s unusual for a US president to make a peacetime appearance in the House of Representatives and deliver a speech devoted entirely to one topic. Ford’s focus on inflation as a national crisis is worth remembering; he even sported a “WIN” pin on his lapel—a reference to his pledge to “whip inflation now.” The sentiment was sincere but failed to alter the outcome. Republicans lost 48 seats in the House and five in the Senate that November.
President Ford’s successor, Jimmy Carter, fared little better four years later. Inflation was running at an annualized rate of 7.5% when he delivered a televised speech in October 1978 calling for a program of national austerity. That didn’t go over so well, either. Democrats lost 15 seats in the House and three in the Senate. Ever since, it has been axiomatic that inflation is bad politics. To paraphrase William Galston and Elaine Kamarck of the Brookings Institution, voters will overlook many shortcomings in their elected representatives, but rarely do they forgive a president who remains indifferent to their top concerns.¹
President Biden referred to rising inflation as a “real bump in the road” in December. Recent polling data suggests that his assessment understates the degree of concern among the electorate. A recent national poll found the president’s job approval rating had declined to just 40%.²
The nexus between rising inflation and Biden’s declining popularity is illustrated by the fact that almost two-thirds of the respondents cited family incomes failing to keep pace with a higher cost of living as their biggest concern. A plurality of those polled blamed the president.³ The criticism may be a bit unfair given the Federal Reserve’s belated acknowledgment of inflation’s tenacious hold on the economy amid a pandemic and a war in Europe. Whether or not one believes the criticism is warranted, inflation now poses an existential challenge to Democratic control of Congress.
That challenge is compounded by the expressed willingness of the Fed to aggressively raise short-term rates and unwind its balance sheet in an election year. The central bank’s willingness to do so is not unusual—it has adjusted policy in one direction or the other in 11 of the past 12 election cycles—but a tighter monetary policy does run the risk of slowing the rate of economic growth as voters prepare to go to the polls in November.
In a recent public statement, the president cited the historic decline in the number of Americans filing new unemployment claims as evidence that his policies have been effective in strengthening the economy. However, in a tacit acknowledgment that inflation poses the bigger political challenge, he also said that “we will continue the fight to lower costs with every tool at our disposal.”⁴ That bump in the road just got bigger.
¹ William A. Galston and Elaine Kamarck, ìInflation politics is clearer than inflation economicsî, Brookings Institution, 14 January 2022
² Mark Murray, ìCost of living jumps to top issue,î NBC News, 27 March 2022
⁴ ìStatement from President Joe Biden on Unemployment Insurance Claims,î The White House, 24 March 2022. https://www.whitehouse.gov/briefing-room/statements-releases/
While the midterms will eventually enter the headlines, key market drivers over the next 12 months will likely remain geopolitical uncertainty and tighter monetary policy from the Federal Reserve. The Russian invasion of Ukraine has shattered the postwar consensus that international borders are static. The resulting geopolitical uncertainty is likely to persist for months and could be more important than the outcome in November, given the likely limited policy implications of the election.
With these considerations in mind, we think investors wondering how to navigate an election year should stay focused on the Fed and fundamentals, consider winners of the policy environment despite gridlock, and be prepared to manage through volatility.
Stay focused on the fundamentals
The war in Ukraine has further stoked inflationary pressures, but we believe most companies will be able to pass on higher costs to their customers. The war has also shaken US consumer confidence, but Europe is more directly affected by the higher energy prices due to its reliance on Russian energy. Still, an economic slowdown in Europe should not derail US profit growth in the aggregate because only 14% of S&P 500 sales are sourced from Europe, as outlined in our report, “S&P 500 earnings: resilient” (13 April 2022).
The Fed remains the primary driver of markets as it pursues an exceptionally aggressive series of rate hikes in a belated attempt to reduce inflation. Overall, we expect equity markets to be range-bound until investors have more clarity about how much the Fed will tighten policy and how this will impact economic growth. Given where we are in the economic cycle, we currently advise equity investors to hold a balanced exposure between defensives, such as healthcare, and cyclicals, like the energy sector.
Fixed income assets have also suffered as the pace of future rate hikes becomes more apparent. After months of relatively poor performance, we believe preferred securities now offer an attractive entry point, as discussed in our latest Fixed Income Strategist (7 April 2022).
Similarly, after three months of poor performance, tax-exempt municipal bonds are now trading at more attractive ratios relative to US Treasuries. Mutual fund outflows are likely to continue for another few weeks, which are a headwind to performance. However, we expect market technicals, including seasonal redemptions and cheaper valuations relative to taxable paper, to increase investor appetite and provide a good entry point for investors by early summer. For more, please refer to the Municipal Market Guide (14 April 2022).
Consider policy winners
The likely scenario of gridlock means that specific policy beneficiaries in the context of the midterms will be limited. That said, we do see a few pockets of opportunities that should benefit from the policy environment.
While the total amount of defense spending authorized by Congress may vary a bit depending on the composition, we believe we have entered a new age of security following the Russian invasion of Ukraine. An emphasis on security for both public and private decision-makers should lead to greater spending on conventional defense, cyber, energy, food, and semiconductor supplies. As detailed in the our report “Security takes center stage,” select companies will be poised to benefit.
We also highlight that the already passed bipartisan infrastructure bill has still not been fully priced into certain areas of the equity market, and select companies within our “Business spending rebound” theme should still stand to benefit.
The midterm elections are just another factor that will add to an already uncertain environment in 2022. With markets likely choppy at least for the remainder of the year, we think it is a critical time for investors to review their broader needs and objectives in the context of our Liquidity. Longevity. Legacy. framework. Specifically, by setting aside a Liquidity strategy to fund the next 3–5 years of spending from the portfolio, investors can have confidence about meeting spending needs in the short term even if markets sell off, which can help you avoid making any panicked decisions that can destroy wealth and disrupt your ability to stay on track to meet your financial goals. The Liquidity strategy should be composed of resources that are likely to preserve capital for spending needs during bear markets, such as cash, bonds with limited credit risks, and reserved borrowing capacity.