US Mid Term Elections: Implications for Canadian Investors

US Mid Term Elections: Implications for Canadian Investors

Unlike with the 2016 US Presidential election, betting markets and election polls actually got the 2018 midterm election outcome correct. Democrats took the House of Representatives while Republicans retained (and, in fact, expanded) their majority in the Senate. The new Congress will be sworn in in early January 2019.

One would expect the party of a President presiding over very favourable economic conditions to enjoy a strong showing come the midterm elections. However, after adjusting for economic conditions and asset prices, Trump’s Republicans had the worst showing in 100 years. There have been larger seat losses – Clinton’s 1994 Democrats (-54) and Obama’s 2010 Democrats (-63) in recent memory – but these occurred in periods when employment, inflation, and/or equity and home prices lagged current conditions. (1) The result was, however, more balanced relative to expectations, as Republicans won a number of key headline Governorships (e.g., Ohio, Florida (for now)) and several centrist Republicans in the Senate were replaced with farther-right Republicans who are likely to be more beholden to the President. Note that a more Republican Senate makes it easier for the President to have his nominations confirmed, with Cabinet changes likely in the next few months.

The reaction in capital markets has been relatively positive, with US equities rising approximately 2% since the election outcome became clear, while bond yields and currencies have been broadly unchanged. Markets historically do better under divided government: since 1928, average annual total returns have been +12% during years where a Republican president held office and Congress was split. (2)

A split government typically increases the probability of gridlock on key fiscal decisions relating to taxes and spending. The exception may be infrastructure, which is a key issue for both sides and something former White House economic advisor Gary Cohn speculated in September would be the first thing the two sides got to work on, post-election. Despite having broad bipartisan support, however, infrastructure will nonetheless likely suffer from differences of opinion on how to fund spending. We remain balanced on the prospect of an infrastructure bill, and may increase equity and/or credit exposures in client portfolios should signs of a House-led bill emerge in early 2019. With the President’s support, its chances of passage might have actually improved following the mid-term elections as a result of President Trump’s consolidation of power in a Republican Senate, and Democrats’ desire to demonstrate their ability to govern ahead of the 2020 elections.

Beyond infrastructure, any gridlock would have important implications for the global economy. Throughout 2018, the United States has been a leader in cyclical activity growth and continues to grow at about 1% above trend, while the rest of the world has slowed to 1.3% below trend, due primarily to weaker growth recently in China and Europe. Put simply, the continuation of the global economic expansion to date has relied heavily on the United States.

Much of the growth in the United States has been materially boosted by a combination of corporate tax cuts and an increase in discretionary spending. This impulse should continue during 2019, albeit at a more modest rate. However, absent additional policy measures, the US economy will face a major fiscal headwind in 2020 that will dampen growth in the US and globally.  It is unlikely heading into an election year that US Congress will allow such a fiscal cliff to occur, but the risks have now increased under a divided government.

Furthermore, the Trump administration will likely face significant distractions from investigations initiated by the Democratic House, that could further polarize government and increase the probability of gridlock. In effect, any party that controls either chamber has subpoena authority and can legally require anyone to testify in front of a Congressional hearing. As a result, there are Democratic Representatives who will be eager to pursue existing and new investigations into a laundry list of potential matters ranging from tax returns to campaign financing to obstruction of justice to election meddling. But the actual outcome of these investigations is less relevant than the degree to which it distracts the Administration from effectively governing, increases partisanship and polarizes relations – which would ultimately make it more difficult for government to respond to an economic or geopolitical crisis.

On impeachment, the choice of Democratic House Majority Leader will be an important determinant of whether the House pursues investigations that could ultimately impeach the president. The likely candidate, Nancy Pelosi, has already made it clear that she will not support an attempt to impeach President Trump unless there is bi-partisan support.

On trade issues, a divided Congress makes the ratification of the US-Mexico-Canada Agreement (or USMCA, the replacement to NAFTA) less certain. One estimate is that an agreement on trade is roughly 100 votes short in the House of Representatives, suggesting that a vote is not happening anytime soon. Democrats are also likely to seek to put their stamp on USMCA, which has the potential to slow the process and increase the risk of delays, or worse still, non-ratification and withdrawal. Democrats might, for instance, seek concessions relating to labour or environmental rules, or potentially an easing of tariffs relating to steel and aluminum. Delays in ratifying USMCA might also bring into question any exemption from auto tariffs, ahead of a report due in Feb 2019.

In their October Monetary Policy report the Bank of Canada (BOC) enhanced their growth forecasts to reflect the resolution of USMCA, however they left a residual drag given the agreement was not yet ratified. Therefore, while the mid-terms result introduces a risk USMCA gets delayed or canceled, there is arguably minimal impact for the BOC as this is already accounted for in their forecasts. At the margin, it might make the BOC slightly more cautious on a hike in December but that would likely only result from an escalation in rhetoric proposing a full dismantling of USMCA.

More broadly, we do not expect any significant change in US trade policy. There was some concern heading into mid-term elections that Republican-led tariff trade policy might hurt their candidates in farm states such as Ohio, but the result proved otherwise: the Republican candidate there won convincingly. Furthermore, President Trump’s more aggressive stance on trade has a degree of bipartisan support: both the Democratic House Minority Leader Nancy Pelosi (as mentioned, the assumed lead candidate to become Majority leader), as well as Democratic Senate Minority Leader Chuck Schumer have introduced legislation in the past targeting China for alleged currency manipulation. We expect China to remain the focal point of US trade policy, and escalation arguably the major economic risk to investors in both Canada and internationally.

(1) Source: Cembalest, Michael. “Eye on the Market.” J.P. Morgan. 7 November 2018.

(2) Source: Meyer, A., Song, J., Cabana, M., Subramanian, S. Blue wave breaches the red wall. US Watch. Bank of America Merrill Lynch. 7 November 2018.