Investors prepare for government gridlock as Republicans seen gaining in U.S. midterms By Reuters

By Saqib Iqbal Ahmed,Swiss foreign exchange dealers Carolina Mandl and Laura Matthews

NEW YORK (Reuters) - Investors are expecting Republican gains in U.S. midterm elections, a result that will likely temper potential Democratic spending and regulation but set up a bruising fight over raising the U.S. debt ceiling next year.

Republicans are favored to win control of the House of Representatives and possibly the Senate, polls and betting markets show, though there are still hours left to vote in some districts. With Democrat Joe Biden in the White House, that result would lead to a split government, an outcome that historically has been accompanied by positive long-term stock market performance.

In early results, several Republican senators won re-election, however with the majority of polls closed in half of the 50 U.S. states, the initial returns would not alter the balance of power in the 50-50 Senate, which Democrats currently control with a tie-breaking vote.

While macroeconomic concerns and Federal Reserve monetary policy have been the dominant forces behind market moves this year, Capitol Hill politics could exert influence on asset prices going forward.

A strong performance by Republicans likely allay investor concerns about higher fiscal spending exacerbating inflation and raise the chances of the party freezing spending via the debt ceiling, analysts at (NYSE:) wrote earlier this week. That could support a rally in 10-year Treasury bonds and help stocks extend their recent gains, they said.

"I think the markets are rallying at the prospect of gridlock," said Jack Ablin, chief investment officer at Cresset Capital in Chicago. "Fiscal spending has created a challenge for central banks worldwide. The prospect of no legislation is a bullish inflation signal."

Historically, stocks have tended to do better under a split government when a Democrat is in the White House, with investors attributing some of that performance to political gridlock that prevents major policy changes.

Average annual returns have been 14% in a split Congress and 13% in a Republican-held Congress under a Democratic president, according to data since 1932 analyzed by RBC Capital Markets. That compares with 10% when Democrats controlled the presidency and Congress.

A Republican Congress could end fiscal stimulus and make "the Fed’s job a little bit easier to break inflation,” said Troy Gayeski, chief market strategist at FS Investments.

Ahead of the election results, the S&P 500 finished up 0.6% on Tuesday. The benchmark index has risen about 5% over the last month, cutting its year-to-date decline to about 20%.

Still, a split government could lead to heightened tensions over raising the federal debt ceiling in 2023, setting up the kind of protracted battle that led Standard & Poor's to downgrade the U.S. credit rating for the first time in 2011, sending financial markets reeling.

"If the Republicans really gain some power here, in the House and Senate, they can make (raising the federal debt ceiling) a really difficult process," said Tim Ghriskey, senior portfolio strategist at Ingalls & Snyder in New York.

With U.S. equity options market positioned for relative calm, a surprisingly strong showing by Democrats could upend markets.

Options positioning on Monday implied a decline of 1.5% in the S&P 500 on the day after the vote should Democrats pull off a stronger-than-expected showing, according to Tom Borgen-Davis, head of equity research at options market making firm Optiver.

PERFECT TRACK RECORD

Many strategists are quick to cite the stock market's perfect post-midterms track record: The S&P 500 has posted a gain in each 12-month period after the midterm vote since World War Two, according to (ETR:).

Graphic: Post-midterm perfection for U.S. stocks - https://image.fx9003.xyz/static/ts/img/202211/1555.png

But some investors cautioned against expecting a repeat this time, given uncertainty over how quickly the Fed will be able to tame inflation and end its market-bruising monetary tightening.

Indeed, while the election outcome could put some uncertainty to rest, investors remain on edge about the outlook for stocks, as shown by volatility futures tied to the Cboe Volatility Index trading at historically elevated levels well into next year.

Graphic: Worries aplenty - https://image.fx9003.xyz/static/ts/img/202211/1556.png

One potential catalyst for volatility comes Thursday with the U.S. consumer price report, a data point that has spurred sharp market moves throughout 2022.

"Next year's earnings estimates are still too high, Fed policy is still tight and tightening, inflation is still too high," said James Athey, investment director at Abrdn. "This is all bad news for equities."

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