Investment implications of US mid-terms

US congressional elections rarely move financial markets.

Our analysis of how stocks, bonds, currencies and commodities behave in the three months immediately after US mid-terms shows no obvious pattern compared to non-election years (see Fig. 1).Energy stocks do stand out in some years but did so for factors that were not associated with global developments such as the Russian invasion of Ukraine.

Still, there are ways in which these elections could go against the grain. While the results might not alter the policy trajectory in the near term, an unexpectedly strong showing for either political extreme could upend investors' perceptions of the 2028 presidential election. And this could indeed have wide-ranging consequences for financial markets. All of which suggests investors should hedge against some outlier scenarios.

Currently, prediction markets attach a 60% probability to the Democrats winning control of both the House and the Senate. The chances of a split Congress, meanwhile, are priced at approximately 30%. 

There are, though, two possible outcomes outside this regular realm of expectations that could have a significant impact on equities and bonds were either to materialise.  

The first is a Democratic sweep accompanied by a very strong performance from progressive candidates in areas that previously supported Donald Trump alongside the approval of a wealth tax in California. 

The second is a Republican majority in both houses.

Both scenarios would point in the same general direction. Each would signal that the US electorate is more polarised than ever. And each would indicate that the 2028 presidential election could well boil down to a contest between candidates from the ideological extremes of the two parties – MAGA versus the hard left.

For scenario one to come to pass, each (or most) of the progressive Democrat candidates running in five crucial election battlegrounds – Senate ballots in Maine, Michigan and Minnesota, and Congressional contests in Montana and Texas – would need to secure victory (see Fig. 2). 

Were this to happen, markets would turn their attention almost immediately to the 2028 presidential elections, and begin to discount a possible victory for a hard left Democratic candidate such as New York congresswoman Alexandria Ocasio-Cortez.

Two worries in particular would occupy the minds of investors in this instance.

The first would be the prospect of a hike in corporate taxes. Although Ocasio-Cortez famously called for a 70% income tax on the super rich, a hard left administration would more likely focus on business taxes, an easier target. 

The federal corporate tax rate is currently near historic lows at only 21%, while corporate taxes account for just 9% of central government revenues. And all this despite the fact that corporate profit margins in the US are near record highs. Against this backdrop, it would be relatively straightforward for a hard left administration to make the case for a business tax hike.

The second worry for investors would be the regulation of AI. The progressive wing of the Democratic Party has supported stronger government involvement in, and oversight of, AI companies. Many influential figures in the party have gone further, stating that they consider AI services as public utilities and favour a large government stake in AI companies to share the economic benefits of the technology across society (see Fig. 3). In practical terms, this would result in a significant dilution of existing shareholders in AI stocks.

Together, worries about corporate taxation and AI oversight, would be sufficient to trigger a marked sell off in equity markets, led by technology stocks. Under this scenario, we would expect US equities to fall by some 10-15%. IT stocks would decline more sharply than the broader market, partly because it is the only sector to have exhibited a beta of above 1 over the past five years, leaving it more vulnerable to any correction. The average price-earnings ratio for US stocks, meanwhile, would fall back to its 30-year average of 16.5 times versus 19 times currently.

One way for investors to guard against this tail-risk would be to shift from a market-cap weighted equity allocation to a more equally weighted one. This would enable equity portfolios to benefit from any market gains but limit capital losses in the event of a fall.  

Under scenario two, in which Republicans retain both houses, we’d expect to see a resurgence of the Trump trade that characterised markets in the months immediately following his election victory in November 2024 (see Fig. 2).

Our preferred Trump trades have included being overweight US bank stocks versus global financials, a higher than index position in small cap stocks versus the average large cap and overweight allocations to US upstream oil and gas companies. This reflects our view that a re-energised Trump administration would press on with deregulation of the banking sector and efforts to boost domestic fossil fuel production.

Interestingly, there has been only one mid-term election in which a Republican administration lost control of both chambers of Congress (2006). And the market reaction at the time suggests investors should not expect too much volatility were this to materialise again. US equities lagged only slightly relative to global peers.

Broadly speaking, we see no reason to change our tactical asset allocation ahead of the mid-term elections (from the current small overweight positions in equities and emerging markets).

However, some protection against the outlier scenarios we have sketched out appears sensible given the solid equity market performance this year and the degree of optimism baked into consensus analyst earnings forecasts. It is also worth bearing in mind that gold and bonds should not necessarily form part of any insurance trade, if recent history is any guide.

Neither has consistently provided protection during equity market declines. A more effective hedge may be to buy relatively inexpensive short-term put options on the S&P 500. We estimate that protecting against a 10% decline in the index over the next month would cost only around 0.2% of the index value, or 2.5% annualised. That seems like a price worth paying.