Investors brace for government gridlock as Republicans seen gaining in U.S. midterms

By Saqib Iqbal Ahmed

NEW YORK (Reuters) – Investors are expecting Republican gains in U.S. midterm elections, a result that could ease worries about 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. With Democrat Joe Biden in the White House, that result would lead to a split government, an outcome that has been accompanied by positive long-term stock market performance in the past.

While macroeconomic concerns and Federal Reserve monetary policy have been the market’s key movers this year, politics could exert its own influence on asset prices.

A Republican win would help quell concerns that fiscal largesse could exacerbate already-high inflation and lead the Fed to raise interest rates even higher than expected, investors said, potentially buoying the stock market’s most recent rebound while supporting Treasury prices and helping curb the burgeoning dollar.

“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 either side from making 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.

The S&P 500, which finished up 0.6% on the day, has risen about 5% over the last month. The index is down about 20% for the year.

Over the longer term, however, 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 Ingalls & Snyder in New York.

Analysts at Goldman Sachs (NYSE:) wrote, “the need to raise the debt limit in 2023 could lead to meaningful fiscal tightening in 2024, and divided government could make a fiscal response to a potential recession less likely to pass and smaller if it does.”

With U.S. equity options market positioned for relative calm, a surprisingly strong showing by the Democrats could throw the markets for a loop, potentially bringing to the fore concerns about tech-sector regulation as well as budget spending that could buoy already-high inflation, options strategists said.

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.

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