The bullish and bearish implications of the midterm elections

In my weekend post, I wrote that the US equity market is getting close to a bottom (see Getting close to a bottom, but not yet), but I neglected to add the likely bullish effect of the US midterm elections in November.

As things stand today, the Republicans have lock on the control of the House. The latest FiveThirtyEight forecast is that the GOP has a 65% chance of controlling the Senate, though other polling organizations have higher odds. The sports books odds at PaddyPower shows a 79% chance of the Republicans taking the Senate.

In the past few weeks, Wall Street has been pre-occupied with other distractions, such as China, Europe, Russia-Ukraine, Ebola, etc. I have seen little discussion of the likely impact of the November electoral results on the markets. Therefore the election of a Republican controlled House and Senate, which are considered to be more business friendly than the Democrats, should provide a bullish boost for the stock market in early November. The response from the Barron`s Big Money Poll is confirms this view.

This scenario is also consistent with the one I indicated on Sunday of a market bottom in the next week or two.


Watch out for the bearish blowback
Assuming that the GOP does re-take control of the Senate, the short term bullish boost could be offset by the bearish effects of fiscal gridlock in early 2015. Bill McBride at Calculated Risk recently highlighted a note from Goldman Sachs on the risks involved:

In many policy areas, a shift in Senate control would simply result in a new flavor of the gridlock that has prevailed since the 2010 election. The split between Congress and the White House would still exist and, while Republicans would set the agenda in both chambers if they held a majority, a degree of bipartisan support would still be necessary in the Senate light of the 60-vote threshold necessary to pass most legislation.

The exception would be the annual budget resolution and legislation related to it. The budget resolution sets out annual targets for federal spending, revenue, and debt. More importantly, it can be used to clear a procedural path for legislation that includes policies to reconcile the level of spending, revenue, or debt under current law with the levels in the budget resolution. Such “reconciliation” legislation is not subject to filibuster and can therefore pass both chambers with only a simple majority (i.e., 51 votes in the Senate).

That's because of the market uncertainty surrounding another potential battle over the debt ceiling in March:

The result is likely to be less predictability regarding the process surrounding major fiscal deadlines. Since the confrontation between House Republicans and the White House over the debt limit in 2011, markets have gradually become inured to fiscal brinksmanship, as these debates have started to follow a predictable pattern. If Republicans win majorities in both chambers as polls currently suggest they might, that pattern seems likely to change, which could lead to renewed uncertainty ahead of future fiscal deadlines.

By all means, position for a tactical rally in US equities at year-end, but don't be so quick to celebrate. Be aware of another looming Washington budget crisis early next year.

Be forewarned: The market gods giveth and they taketh away.