The final countdown

The state of the economy takes center stage in voters’ minds as they head to the polls every November. This year is no exception. In a survey conducted by the Pew Research Center in August, more than 75% of the respondents identified the economy as the preeminent policy issue in their decision to support a particular candidate. Nine out of 10 registered Republicans and voters who “leaned Republican” rated the issue as most important. Two-thirds of registered Democrats and Democrat-leaning voters agreed, which goes to show how pocketbook issues continue to resonate with voters regardless of party affiliation.²

Crime and public safety have also risen in importance among prospective voters. In a recent Politico/Morning Consult poll, more than 75% of respondents cited violent crime as a major problem.³ Not surprisingly, GOP candidates are focusing on inflation and public safety, along with immigration, in their campaigns for Congress.

The Supreme Court decision in Dobbs v Jackson Women’s Health Organization, which eliminated the constitutional right to an abortion, altered the electoral landscape by rousing an apathetic Democratic base weighed down by the performance of an unpopular president. The Pew Research survey, conducted in the wake of the high court decision, showed that registered Democrats remain focused on healthcare and abortion rights—some even more so than on the economy—as touchstone issues. Participation in primary elections increased after the SCOTUS decision, with Democratic candidates outperforming expectations.

Voter turnout in midterm elections is generally higher for the party in opposition to the incumbent president, so the outcome this year may depend upon whether Democrats can motivate their base to participate in this election in greater numbers than history would suggest.

Foreign policy considerations and geopolitical risks can influence voter behavior, but the impact is more pronounced in presidential elections than in the midterms. The 2004 presidential election, pitting incumbent president George W. Bush against senator John Kerry, is a good example. In that election, Bush and Kerry frequently sparred over questions of national security in the wake of the 9/11 attacks.

US support for Ukraine in its war with Russia remains popular among the public, as does the adoption of a more adversarial posture toward China.⁴ In this midterm election, we believe voters are more likely to view geopolitics through the prism of the US economy instead. Inflation remains high and is proving to be more persistent than initially anticipated by the Federal Reserve. The decision by the OPEC and allied oil producers (OPEC+) to reduce production has already triggered a rebound in fuel prices, which may undermine President Joe Biden’s ability to convince voters that inflation is subsiding.

The size and scope of the federal deficit has been a recurring political issue for decades, but its rhetorical potency had diminished until very recently. Extremely low interest rates had prevailed for more than a decade, which made financing the budget deficit inexpensive. However, Congress added another USD 3.4 trillion of borrowing for pandemic relief, pushing the accumulated deficit to unprecedented levels.

The Fed’s belated but aggressive response to persistent inflation has also begun to alter the narrative. Rising yields make the cost of servicing the federal debt more expensive. The gross national debt of the US now exceeds USD 31 trillion only nine months after surpassing USD 30 trillion in January.⁵ In May, the Congressional Budget Office projected that interest payments will exceed USD 8 trillion over the next decade absent corrective budgetary action. If interest rates are 1% higher than the CBO projected earlier this year—and they are—interest on the national debt will rise by another USD 2.4 trillion through 2032.⁶

Congress has pursued a variety of initiatives to restrain the growth in spending. By and large, these have been unsuccessful because the political will to raise tax revenue or reduce spending has been absent. Bipartisan compromise is necessary for any successful effort at deficit reduction, and prospects for that type of agreement in the near term are limited. The status of the US dollar as the global reserve currency has insulated the US from the need to exercise strict fiscal discipline, but larger deficits will still place a greater financial burden on future generations and narrow the options available when the next crisis occurs.

Skepticism over the accuracy of public opinion polls has increased. According to the American Association of Public Opinion Research (AAPOR), polls conducted in advance of the 2020 presidential election were the least accurate in 40 years for the national popular vote.⁷ The polling error was too favorable for Biden by 3.9 percentage points in national polls and by 4.3 percentage points in statewide polls. The AAPOR study rejected a host of explanations for the discrepancy, ranging from the shy Donald Trump voter who might be reluctant to respond candidly to a pollster, to ambivalent voters choosing a GOP candidate in the final days of the campaign.⁸

Instead, sampling error may be to blame. There may have been too many Democratic respondents, for example. It is also possible that individuals who did choose to identify themselves as registered Republicans were the ones more likely to support a Democratic candidate. Pollsters face recurring challenges in an era where fewer individuals respond to unknown callers. It is also important to remember that poll results are accompanied by a margin of error and therefore should never be treated as highly precise predictions. The last presidential election was decided by fewer than 50,000 votes in three states, so the margin of error will always be a factor.

No. The Fed has exhibited a consistent willingness to adjust short-term interest rates either to restrain the rate of inflation or to stimulate economic growth without regard to impending elections.⁹ While Fed chairs are occasionally subjected to withering criticism over monetary policy, as was the case under presidents Lyndon B. Johnson, Ronald Reagan, and Trump, the US central bank has managed to navigate the rocky shoals of partisan politics for decades.

The Fed is currently engaged in a restrictive monetary policy, providing further evidence that it will pursue its twin mandates of price stability and maximum employment deliberately despite the potential for political consequences. For the time being, Chair Jerome Powell has made it clear that price stability is the paramount consideration. We expect the Fed to raise the policy rate again on 2 November, less than a week before Election Day.

Midterm elections are notoriously challenging for the party in control of the White House. The incumbent president’s popularity is a critical factor in midterm election campaigns. President Biden’s job approval rating has improved marginally in recent months but is still mired at levels that should present a drag on the reelection campaigns of House Democrats in competitive districts.

Democrats were disheartened six months ago when polls suggested that they would lose dozens of seats in the House and surrender control of the Senate. The Supreme Court decision in Dobbs boosted their confidence by providing a platform to counter Republican criticism that the Biden administration has been an ineffective manager of the national economy. As we approach the final weeks of the campaign, our colleagues in the UBS US Office of Public Policy have refined their election outcome probabilities. The GOP is expected to capture the House of Representatives, but control of the Senate remains highly competitive.

Midterm elections have had little immediate impact on market performance in the past, and we expect that pattern of behavior to continue. As we discussed in a prior edition of ElectionWatch, bond yields have exhibited only modest movements around the dates of prior elections. The midterm elections should not be the immediate cause of any fixed income market volatility.

We also do not expect midterm election results to affect the broader stock market. Historically, the market tends to trade sideways in the months preceding Election Day and then rallies in subsequent months. However, that historical pattern has already been challenged this year, as tighter monetary policy has been a major headwind to the market and is likely to persist. We expect equity and fixed income markets to remain volatile and be driven by the Fed’s actions, inflation, and economic growth rather than a shifting political landscape.

In a divided Congress, which is our base case, domestic legislation will require a degree of compromise. We expect a Republican House to exercise more rigorous oversight of executive agencies and to advocate for a more lenient regulatory regime, but the GOP’s ability to advance formal legislation will be constrained. We believe foreign policy and geopolitics will preoccupy the latter half of President Biden’s term of office.

We expect that the Senate will remain in the hands of Democrats, but the margin of control should remain exceptionally narrow. Even in the event the GOP does recapture control of the Senate, enactment of most legislation will require some votes from each side of the aisle and the signature of the president. Along those lines, we do expect Congress to enact a major agriculture bill in 2023, which ultimately will receive the support of both parties after lengthy negotiations.

Congress has an unenviable record in terms of enacting budgets on a timely basis. According to the National Conference of State Legislatures, Congress relied on continuing resolutions (CRs) 43 times between 1977 and 2019.¹⁰ They did so again three weeks ago. CRs typically extend existing funding from a previous fiscal year for a defined period while budget negotiations are underway. On occasion, the absence of a budget or a CR has triggered a partial government shutdown. The probability of this happening in 2023 is rising, but investors have become a bit desensitized to shutdowns, so the market impact should be limited.

The bigger risk is a failure to raise the debt ceiling. As concern over the deficit grows, recalcitrant members of Congress may demand political concessions in return for a vote to raise the debt ceiling. We expect that Congress will have to act again by the third quarter of 2023.¹¹ Any failure to raise the debt ceiling constitutes a default, even if the Treasury chooses to prioritize the payment of government debt over other expenditures. Rating downgrades and an abrupt increase in market volatility would necessarily follow. Congress conceivably could raise the ceiling in the lame-duck session of Congress, but the vote is more likely to occur next year. The potential for partisan brinksmanship and a political stalemate in 2023 is worth monitoring.

We do recommend a defensive investment strategy, but we do so because the Fed’s exceptionally tight monetary policy has contributed to greater economic uncertainty. We expect inflation to remain higher than normal over the next several quarters, which is likely to reinforce the Fed’s commitment to higher interest rates. The risk of recession is rising, so the construction of a resilient portfolio is more important than ever.

Value stocks tend to outperform growth stocks when inflation exceeds 3%, so a focus on positive cash flow and profitability is appropriate. We expect consumer staples and healthcare stocks to outperform other equity sectors. Energy is not inherently defensive, but the war in Ukraine has interrupted commodity flows, raised prices, and made the sector more attractive.

Within fixed income, a cross-asset barbell is appropriate for private clients in the US. An inverted yield curve has made the front end of the Treasury curve very attractive. On the longer end, the yield on high grade tax-exempt municipal bonds can exceed the yield on corresponding US government securities. The probability of default is low, and there is minimal correlation with equities. Finally, we recommend an allocation to hedge funds, particularly discretionary macro strategies, and private markets for their diversification benefits and historical lack of correlation to other asset classes.