Republicans appear headed for a narrow majority in the House but face uphill odds to take control of the Senate, with the resolution of the remaining races days if not weeks away. The three-day S&P 500 rally ahead of the midterm elections is facing a bit of a letdown in Wednesday's stock market action.
The S&P 500, Dow Jones and Nasdaq composite all opened moderately lower Wednesday and continued to lose ground as Wall Street processed the incoming results. The battle for the Senate might once again come down to a runoff election in Georgia, unless Democrats can pull a victory in a tight Nevada race that might not be settled for a few days.
Still, divided government — by far the most likely outcome as final votes are tallied — is usually good news for stocks. And it's unclear whether a more strident GOP, emboldened by a takeover of both the House and Senate, would be more favorable for the S&P 500 than a split Congress.
GOP To Spur Fiscal Tightening
The primary impact in either case will be to freeze President Biden's legislative agenda and turn fiscal policy into more of a drag on economic growth. That might help to counter inflationary pressures and potentially limit the degree to which the Federal Reserve has to hold interest rates higher for longer.
Expectations for a "slightly disinflationary effect" from the midterm elections "is largely intact," despite a likelihood Democrats will hold the Senate, Matt Gertken, BCA Research chief political strategist, said in a Wednesday webinar.
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Still, efforts by the GOP-controlled House to impose fiscal restraint will be offset by new spending in the pipeline from Biden's first two years. The 2021 infrastructure bill includes $550 billion in new spending. The CHIPS Act passed in July provided a $50 billion to boost semiconductor manufacturing. The Inflation Reduction Act includes $485 billion in spending on clean energy incentives and prescription drug subsidies, but that spending would be offset by tax increases over the first five years. Beyond that, it's projected to reduce the deficit. Then there's Biden's student-loan forgiveness program, which is seen costing as much as $400 billion.
"The biggest policy implication is simply that it will be harder to pass any legislation if we have a mixed government," LPL Financial strategists Barry Gilbert and Jeffrey Buchbinder wrote this week. "This would take any meaningful risk of tax increases on households or businesses off the table."
Divided Government Usually Bullish For S&P 500
Markets tend to like a Democratic president and GOP or mixed Congress, they write. Since 1951, that combination has yielded S&P 500 annual returns of 17% vs. the average 12%.
Strategist Ed Yardeni of Yardeni Research writes that the third and fourth years of a presidential term also tend to be good ones for stocks, with an average S&P 500 gain of 13.5% and 7.4%, respectively, dating back to FDR.
Still, past performance is hardly a guarantee that the next two years will be good ones for stock market investors. A shift in the balance of political power will have much less impact on stock prices than the potential of a Fed-induced recession.
"None of these political cycles will matter if inflation doesn't moderate significantly in coming months," Yardeni wrote.
If aggressive Fed tightening does provoke a recession, a divided government means there won't be a fiscal stimulus to jump-start growth. "A recession may be incrementally deeper, if we have one, due to a smaller fiscal response," Gilbert and Buchbinder write.
"Gridlock may not be bullish this time if the government can't function because of extreme partisanship," Yardeni said.
Debt-Ceiling Standoff Coming?
One obvious risk is a fight over the debt ceiling, Yardeni says.
The 2011 debt-ceiling fight, which sparked an S&P 500 sell-off and a downgrade of the U.S. debt rating, came after the GOP took over the House but fell short in the Senate during President Barack Obama's first term. Biden, as vice president, helped negotiate a resolution to the 2011 debt-ceiling impasse.
The debt ceiling, last increased by $2.5 trillion in December 2021, will likely have to be raised in the second half of 2023 to avoid a debt default.
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The narrower-than-expected GOP majority in the House means that the "most conservative members would exercise significant influence in the next Congress," wrote Thomas McLoughlin, UBS Chief Investment Office fixed-income strategist. If their votes prove critical to passing legislation, that "could pose an obstacle for votes related to the budget, foreign aid and the debt ceiling."
However, BCA's Gertken thinks a narrow GOP win in the House will force moderates on both sides of the political divide to work together. That could begin to moderate political polarization, he says. Gertken sees such an outcome as consistent with Trump's perceived bad day in the midterm elections, since there wasn't a wipeout for Biden and the Democrats.
On other hand, Florida Gov. Ron DeSantis was a big winner, trouncing Democrat Charlie Crist by 19 points and cementing his status as a leading contender for the GOP presidential nomination.
Ukraine Funding At Risk?
One potential flash point would be an insistence by GOP House members that Congress offset emergency spending, such as aid for Ukraine, with spending cuts.
An increase in Republican power typically benefits financials, energy and defense, the LPL Financial strategists say. But that doesn't always translate to better stock performance. Energy stocks stumbled under President Trump and surged under Biden.
If the GOP does manage to win a majority in the Senate, that would stack the deck toward more spending cuts. The Senate has a PAYGO rule that requires automatic spending cuts to offset deficit-increasing legislation. But Democrats waived those spending cuts — including a 4% Medicare cut — at the end of 2021, and the lame-duck Congress may do so again this year. That would push a fight to the end of 2023 under GOP control.
S&P 500 At Key Level
The S&P 500 pulled back 1% in Wednesday afternoon stock market action. Meanwhile, the Dow Jones fell 1% and the Nasdaq composite lost 1.3%.
The S&P 500, after rising 2.9% over three sessions, ended Tuesday 20.2% off January's all-time closing high. The S&P 500 is fighting to hold support at its 50-day moving average. The next potential catalyst for a move higher — or lower — will be Thursday morning's consumer price index data.
The Dow is 9.9% below its peak close on Jan. 4, while the Nasdaq has fallen 33.2% from its highest-ever close.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
