The consensus view expects a split Congress outcome with a largely muted market reaction, though many are not ruling out a surprise.

In order to assess the medium-term market impact of the midterms and recommend trade ideas, SocGen economists, strategists, and analysts have worked under three different scenarios according to the election outcome.

• Scenario 1: Gridlock - GOP Senate and DEM House (most likely): Markets would fear that economy would be more vulnerable from now on with the absence of any further economic stimulus in the event of economic slowdown.
• Scenario 2: Blue Wave - DEM Senate and DEM House: Markets would stir on speculation of a lame duck presidency and potential impeachment proceedings. Potential upside risk on Infrastructure.
• Scenario 3: Red Wave - GOP Senate and GOP House (least likely): The least expected scenario for the market, which would probably trigger a short-lived risk-on environment. Trade tensions and Fed tightening will quickly be back in the market focus.

SocGen's US economist has provided potential policy outcome stemming from these three potential elections outcomes:

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Stocks

Largely representing consensus, Deutsche Bank's equity strategists believe that the environment is ripe for an equity rally into year end. Markets have historically rallied around midterm elections, though this is equally due to historic coincidence (growth has tended to be strong around elections) as the actual elections. They expect this scenario to repeat, as growth looks strong, positioning is light, and Democratic gains could act as a check on the president’s trade war policies. On the other hand, some Democratic politicians have expressed support for President Trump's trade war, so they may actually support an escalation against China.

As Deutsche Bank explains, the base case is the Democrats taking over the House and holds the potential to reduce downside risks from trade policy friction. We see a variety of possible channels through which the administration’s agenda on trade is likely to be curtailed by a switch in majority. Congressional investigations and potential impeachment proceedings, even though nominal, would likely use up significant bandwidth while a growing number of Democrats and even Republicans are likely to attempt reducing Presidential power in dealing with trade. If trade frictions reduce, that allows the market focus to shift back on strong US growth; and also ease pressure on global growth and in our view would lead to a stronger eventual rally. The market is currently pricing in almost no growth implying significant scope for a catch-up rally.

If Republicans keep control of both the House and the Senate that would be interpreted by the administration and the market as public support for the trade war, likely leading to further escalation. In the very short term, while the market might rally due to the aforementioned base of investors who attribute strong growth to the Republicans’ policy, we think it prolongs the period of trade uncertainty and hurts growth.

The Economy

Goldman seems to represent well the consensus Wall Street opinion that the result of the US midterms won’t change the economic outlook significantly.

The upcoming US midterm elections look likely to result in a split Congress, with Democrats capturing the House and Republicans holding onto the Senate. In that base case, political divisions should leave the overall direction of policy broadly unchanged. But investors should watch out for the tail scenarios.

• A Republican sweep could bring incremental action on tax, propping up stocks sensitive to taxes and regulation.
• On the other hand, a Democratic sweep could be disruptive for those slices of the market.

And as our chart of the week shows, it could also deliver a hit to Pharma stocks, since Democrats have a better shot at healthcare policy changes if they control both chambers.

A Democratic sweep in the House and Senate could hit Pharma stocks

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Source: FactSet, PredictIt, Goldman Sachs Global Investment Research.

But no matter how the elections shake out, we don’t think they’ll change the US growth outlook in any meaningful way. The same goes for US-China trade tensions, at least in the near term. We still think it’s more likely than not that the White House imposes tariffs on the remaining $267bn of Chinese imports.

So while political noise around the midterms will eventually subside, policy risk probably won’t.

Bonds

However, as Bloomberg points out, votes in the U.S. midterm elections Tuesday may be more front of mind than those cast later this week in the FOMC meeting, some rates strategists wrote in weekly research reports.

Bank of America (Carol Zhang, Nov. 2 report)

• Split Congress and muted market responses expected out of midterms, though a Republican sweep would push higher yields and steeper curves
• Remain bearish duration and in 2s10s curve steepeners; BofA closed long 5y TIPs breakeven trade amid recent weakness in energy and housing markets
• “Lack of reserve manager demand puts pressure on real yields”
• Chinese officials may elect a “passive UST portfolio roll-off” amid domestic growth concerns
• In 2019, lower tax revenue could be a risk for a higher budget deficit given market performance across asset classes this year

BMO (Jon Hill, others, Nov. 2 report)

• Midterms will be a bigger driver for markets than the Nov. FOMC meeting on Nov. 7-8
• If 2s10s curve breaks flattening resistances in 26.5bp-27.3bp range, expect an upward-sloping trend line to come in near 25bp, then a “swift move” toward 18.3bp session flat
• “Bearish momentum picture across the curve has failed to drive rates to a significantly higher territory”
• BMO exited 10s/bunds trade at the end “overdone move largely played out,” but sees good opportunity ahead amid “ever-changing geopolitical and monetary policy landscape”

JPMorgan (Alex Roever and Matthew Jozoff, Nov. 2 report)

• Little market reaction expected from midterm elections if Democrats take House but Republicans retain the Senate, though other less likely outcomes could sway markets
• Either a red or blue sweep could steepen curve on risk of increased fiscal stimulus, but likely wouldn’t have lasting effects
• Recommends staying short 3Y USTs and holding 10s30s flatteners
• Macro data point to “further policy normalization, and cyclical dynamics supportive of higher yields”

SocGen (Subadra Rajappa and Shakeeb Hulikatti, Nov. 1 report)

• Short the 5Y in 2s5s10s fly and stay in 2s10s flatteners
• Most likely U.S. midterm outcome is split Congress, with a Dem. House and GOP Senate, and “minimal” impact on Treasuries markets, which will return to a bearish trade bias
• Blue wave scenario could cause bearish sentiment to “fizzle as risky assets are likely to come under renewed pressure” and investors may return to the safety of bonds
• A Republican sweep would renew positive risk sentiment and cause yields to rise, though uncertainty over tariffs and trade wars could have a “negative impact on growth in a rising inflation environment”

Barclays (Rajiv Setia, others, Nov. 2 report)

• Barclays turns tactically neutral on long 10Y USTs and 2s10s curve flattener trades as U.S. midterms are an event risk, but looks to “reinitiate them later”
• “While a Republican sweep looks unlikely based on the polling data, so did the election of President Trump based on the then polling data”
• Baseline midterm election scenario sees a Democratic House and Republican Senate, which would have little market impact but lead to a Congress “unlikely to pass any significant legislation leading to a gridlock”
• “Knee-jerk” reaction to a Republican Congress would be higher yields on potential for more fiscal stimulus
• If Democrats take control of Congress, expect a “knee-jerk risk off leading to lower yields”
• Still, long-term yields are at attractive levels given geopolitical and global economic environments

Morgan Stanley (Matthew Hornbach, Nov. 2 report)

• Midterms will be bigger for markets than the FOMC meeting later this week
• MS is neutral on both duration and curve shape ahead of midterms and FOMC meeting
• Environment isn’t there to monetize negative term premium in the short end of the yield as well as positive term premium in the long end

Citi (Jabaz Mathai, others, Nov. 2 report)

• Status of U.S.-China trade dispute is a bigger market driver than U.S. midterm elections, and a near-term “compromise deal” would be a “boost to risk sentiment” and have bearish implications for USTs
• Divided Congress -- with a blue House and GOP Senate -- would have little effect on markets, though other scenarios would have bigger market impact
• Republican sweep: “Treasury sell-off on expectation of further tax cuts”
• Democrats take both chambers: “Treasury rally on resistance to White House policies and tail risk of impeachment proceedings”
• 10s30s are too steep and flattening lays ahead in next three months, though 30s may cheapen as we approach the 30Y auction on Nov. 7

Deutsche Bank (Steven Zeng, Nov. 2 report)

• November’s refunding announcement is “on the margin biased toward a steeper nominal curve, a flatter yield curve, and steeper breakevens”
• Treasury supply will “slow notably” easing upward pressure on yields; but in near-term, DB still sees 10Y yields ending 2018 at 3.50%
• Dealers generally see Fed’s balance-sheet normalization ending in early 2020

TD (Gennadiy Goldberg and Priya Misra, Nov. 2 report)

• Fed is looking to relax banking system regulation, especially for smaller banks, by proposing to ease LCR and NSFR rules for banks with $250bn-$700bn in assets and eliminate LCR, NSFR and SLR rules for banks between $100-$250
• Effective fed funds rates will rise slower because smaller banks tend to be the “prevalent borrowers” of that market
• Near-term, TD sees a 5s30s steepener amid equity market weakness, followed by a medium-term flattener as Fed hikes continue

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Finally, a graphical look across asset-classes at typical US election and midterm performance...

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And a more nuanced look at Midterms, depending on outcome...

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