US midterm elections: Market implications

Thomas Mucha, Geopolitical Strategist
Michael Medeiros, CFA, US Macro Strategist
2022-12-01T12:00:00-05:00  | S1:E18  | 22:55

The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.

Episode notes

US midterm elections can be pivotal for financial markets, especially when they result in divided government. Macro Strategist Mike Medeiros joins host Thomas Mucha to discuss what 2022’s surprise midterm results may mean for equity and bond markets, US foreign and domestic policy, and the 2024 US presidential election.

Key topics:

1:35 - Midterm results

2:45 - Surprise election outcomes

4:10 - US domestic policy implications

6:50 - US foreign policy impacts

10:30 - Divided government's effect on equity and bond markets

13:15 - Republicans' lessons from midterm results

15:00 - Democrats' lessons from midterm results

16:15 - 2024 US Presidential Election outlook


MEDEIROS: Even though consensus expectations going into the midterms were for divided government there was still that small unknown probability that the Democrats would hold. And so with the event out of the way, the probability of further fiscal easing over the next two years has gone down. And I think the bond market is starting to reflect that.

MUCHA: Today’s topic is the US policy and markets backdrop after the midterms. The outcome of divided government has historically been a positive one for markets. But will that hold in the current and increasingly complex macro, policy, and geopolitical environments? For a quick rundown on how we’re thinking about this latest political development and what divided government means for our global portfolios, the economy, and key national security issues around the world I’m joined once again by my friend and colleague Mike Medeiros, macro strategist and a member of the firm’s Alternatives Group. Mike, welcome back to WellSaid.

MEDEIROS:T, thanks for having me, it’s good to see you.

MUCHA:    You too. So let’s start with your assessment of the results here. Why do you think we got this particular outcome?

MEDEIROS:So I think overall it was a very good night for Democrats. And so going into the midterms there were two competing narratives about what the results could be. The first which was the most likely case, was a shift to divided government, which we got. Given voters’ concerns around inflation at a 40-year high, the economy, and the historical precedent that usually in presidents’ first midterms they lose seats and potentially lose the majority. The second narrative though was more around social issues. And in the aftermath of the Dobbs decision, we saw significant increase in the concerns around rights in general and that included reproductive rights. And which of those two narratives would play out? I think they both did. We saw with the results there was a shift to divided government. But it was extremely narrow. I think in the end, the Republican majority in the House will only be anywhere from, you know, call it mid-single digits and the Democrats actually retained control of the Senate, so this is obvious now but it was this outperformance relative to market expectations going in. And relative to what some of the polls were suggesting.

MUCHA:    Anything surprise you about the outcome here?

MEDEIROS:I guess what was surprising – and this ties in to a point going into 2024 - was the strength of the youth vote and so there were a lot of indications that youth enthusiasm was up and so the 18-to-39 demographic voted in pretty significant numbers in 2018, in 2020, and now again in 2022.

MUCHA:    So this isn’t a one-off.

MEDEIROS:This is not a one-off. And in 2024 that demographic will be 40 percent of the total electorate. And I think one of the concerning elements for Republicans going into 2024 is that this group of voters is motivated and they’re showing up to vote. To give you specifics, in the midterms this year according to exit polls 18-to-29 voters broke for the Democratic candidates 76 percent in Arizona, 70 percent in Pennsylvania, and 64 percent in Nevada. And so these are obviously pretty critical swing states in a presidential election year. And the fact that this demographic is turning out in a midterm year is very positive for Democrats but also I think could shape the policy environment over the next five to 10 years as well.

MUCHA:    Well, let’s get into the policy environment.


MUCHA:    You know, both short-term and then into next year. So how are you thinking about the key issues going forward? And let’s start in the lame duck session. And then let’s say the first six months or so of 2023. I mean what should we be keying in on here?

MEDEIROS:Sure. So in the lame duck session there are a few things that need to be done and so we have the Georgia runoff election on December 6th and so the Democrats are already at 50 votes in the Senate but the result of that will determine how big the majority is which as we’ve learned over the last two years does matter. On December 16th, that’s the government funding deadline. It looks most likely right now that we’ll have a short one-week continuing resolution and then a broader omnibus deal either two days before Christmas or at some point in the middle of Q1. That would likely include the National Defense Authorization Act, which would be important, I know we’ll get to this in a few. But historically why markets tend to like divided government is because there are limited domestic policy implications. And so in practice for the next two years had the Democrats held the House and the Senate then there would have been a certain probability that taxes would go up in the next two years. There would have been a higher probability that spending would increase. Something you and I have talked a lot about over the years and on this podcast has been the idea of polarization. And right now, the current Congress, the Democratic and Republican Party vote together the least amount of time in history. And so I don’t see much in terms of a bipartisan domestic agenda with respect to fiscal policy. One key issue they will need to deal with is the debt ceiling. It looks most likely that the debt ceiling will not be dealt with in the lame duck although that could change. And so we’re looking at late Q1, early Q2. Now part of the issue with this latest iteration of the debt ceiling is the narrow majority in the House. Whoever the Republican Speaker of the House is will not only have to deal with the very narrow majority but about 40 to 50 members from the Freedom Caucus that historically have wanted to utilize the debt ceiling to enact fiscal changes. And so that’s a big concern for the first half of the year. But I think actually most of the action is going to be in your space when it comes to defense spending and the geopolitical implications and I know, you know, one of the things you and I talk about a lot is after elections what changes but also what doesn’t change. And so, you know, I think what changes given divided government is probably a lower probability of further fiscal changes. But what doesn’t change is probably more in your space in the foreign policy side.

MUCHA:    Yeah, let’s dig into the foreign policy aspects for a minute here. This is a US election of course but it does have implications around the world. Given how challenging the geopolitical environment is. And Congress always plays a role in foreign policy through the allocation of spending as well as the key national security committees that we have in both the House and the Senate, armed forces, intelligence, and the like. In terms of what I’m looking for after the midterms here and what the global implications are, I’d say three. Russia, obviously. China, and the broader defense backdrop that you’ve alluded to. Now on Russia, you know, I think the key issue here will be what happens on the battlefield. I still think, you know, given the recent battlefield successes by Ukraine there’s a lot of bipartisan support for this effort. I think that’s going to carry well into 2023. But you will see cracks developing in the US domestic political backdrop the longer this war goes on. And I think another key factor here is what happens in Europe with the energy situation and how that plays out. But, you know, in my recent talks with US policy makers, NATO officials in Brussels, EU leaders, you’re seeing a stronger sense of urgency on these battlefield conditions. And what that means for the eventual outlook for ceasefire negotiations. Now on China, you know, this is the critical long-term area to watch, you and I have talked about this a lot. This is where there’s a lot of bipartisan agreement. Both parties have come to the same conclusion that China represents a real strategic and military risk to US geopolitical influence. And I think we’ll see an ongoing policy response to address this bipartisan view. I think this means an ongoing focus on strategic sectors that are on this front lines of great power competition. You know, the ones we talked about in the past, semiconductors, next-gen communications, space-related technologies. But also biotech, rare earth and other critical minerals, green energy is getting a lot of focus through this national security lens. And of course, you know, AI quantum, as big data becomes another key area of intense competition between the US and China. Now on defense spending and the broader geopolitical backdrop, I think the more dangerous geopolitical environment will keep defense as a policy priority regardless again of who controls Congress or the White House in coming years. Again I think this is a structural long-term shift in the geopolitical and policy backdrops. 

MEDEIROS:Each time we speak too it seems like your list of the impacted industries with a national security perspective continues to grow as well.

MUCHA:    I think there’s been a sea change in how policy makers view these dual use civilian/military industries.


MUCHA:    You know, the ones that are driving these doctrinal military shifts and obviously it’s high-tech-focused, it’s broader than that.


MUCHA:    Right. They’re looking at all of these areas that have these long-term implications not only for military power but for economic power.


MUCHA:    Going forward. So, you know, there are more tools in the tool kit. I think that’s going to continue. So let’s get back, Mike, to the markets here. And the impacts of the midterms. You know, what’s the outlook for equities here? What’s the outlook for bonds? I mean how are you thinking about, you know, the market impacts?

MEDEIROS:So historically the midterms tend to be very important for the bond market. Especially if we go from full control to divided government. And so, two of the last sustained selloffs in Treasurys, 1994 and 2018, those selloffs actually ended the day of the midterms. In 1994 the midterms represented a shift to divided government from full Democratic control, and in 2018 it represented a shift from full Republican control to divided government. And so, the implication being when you have full control the probability of fiscal easing is significant, and when you go to divided government there are more checks and balances on getting fiscal policy passed. And so fiscal policy is more likely to be restrictive. In the current environment I find it interesting that since the day before the midterms 10-year Treasury yields are down about 30 basis points and so we’re still early on in this but so far that historical precedent, sample size of two, so take it with a grain of salt, is holding, but I think the current environment is important for that to hold in the sense that inflation is obviously elevated, it’s still a big problem, rates have gone up a lot this year. Part of what’s driven that, at least cyclically, has been fiscal policy and the impact that that had on aggregate demand. And so even though consensus expectations going into the midterms were for divided government there was still that small unknown probability that the Democrats would hold. And so with the event out of the way, the probability of further fiscal easing over the next two years has gone down. And I think the bond market is starting to reflect that. Historically the best year for equities is the third year of a presidential term after the midterms. Similar dynamic with respect to divided government, that it lowers the probability that tax code changes take place, which is good for business planning, etc. I think the current environment is a little different in the sense that there are factors that are far more important for the market outlook including Fed’s reaction function, extent of a recession or whether or not there is one next year, etc. But at the margin the shift to divided government should help in that sense.

MUCHA:    Yeah, there are a lot more uncertainties in the market and policy environments that go beyond the midterms, right?

MEDEIROS:Exactly. Yeah.

MUCHA:    I mean we’ve got so much going on right now.

MEDEIROS:Absolutely. And I think that that’s especially true this year as well.

MUCHA:    Now, you know, you’ve mentioned the small margins.


MUCHA:    And that dynamic and how that’s going to play out. So if you’re in the GOP leadership, you know, what concerns you the most right now?

MEDEIROS:The biggest concern I think if you’re in GOP leadership, taking a step back and looking at the results, would be the strength in the youth vote or the 18-to-39 just a couple weeks ago. Because that is more likely than not to increase with respect to turnout going into 2024. I think from a governing perspective, potential speaker McCarthy, if it is Speaker McCarthy or whoever the Speaker is, they’ll have a very I think difficult time because as I said before the Freedom Caucus is about 40 to 50 members but there’s a number of more moderate members that on some issues could want to caucus with the Democrats. And so we’re not used to margins this tight and every Congress there’s a number of members that resign. Republicans really can’t afford really any resignations. And so I think it makes governing difficult. I think McCarthy would try to toe the line between adding committees that appease some of the Freedom Caucus members but also making sure that House Republicans are passing domestic policy items – even though they won’t get through the Senate - that are consistent with their overall economic goals. But we’ve talked about polarization. That’s been largely masked by the fact that we haven’t had divided government, but I would expect over the next two years especially going into a presidential election that to really rear its head.

MUCHA:    Yeah, that point you just made about committee members is really important from my perspective too.

MEDEIROS:Yeah. Totally.

MUCHA:    You know, McCarthy is out there talking now about removing key members off of these key committees. I think there’s going to be a lot of domestic political friction that’ll bleed over into the foreign policy side. Given, you know, this polarization that we’ve been talking about.


MUCHA:    What about, same question from the Democratic side of things? How do you manage this set of characters at this margin?

MEDEIROS:So I think if you’re the Democrats you’re probably pretty pleased with the results even though they lost the House the Democrats really defied expectations. The concerns the Democrats should have are number one, from a turnout perspective there was a significant tailwind from the aftermath of the Dobbs decision. Which most likely will not be there going into 2024. Most of the country per polling has decided on this issue. And then the second is that the Republicans actually did have some really strong performances: Governor DeSantis in Florida getting 60 percent of the vote, Governor Kemp in Georgia, a state Biden narrowly won in 2020, winning by 7 percentage points. That’s really important and that’s something the Republicans can build on going into 2024. And so, listen, it’s a divided country, no matter how you cut up the election results you can really see that, and so there are clearly takeaways for both sides. But if I was a Democrat that’s what I would be discouraged about going into ’24.

MUCHA:    Yeah, it’s going to be difficult for either side.


MUCHA:    At these margins. All right. Well, we’ve sort of danced around it throughout this whole conversation but let’s get into 2024. The presidential election. I think it’s early, but you always want to talk about it so let’s talk about it.

MEDEIROS:Yeah, presidential politics, it’s the best.

MUCHA:    So, let’s start at the big picture here. What do you take from the mood of the electorate right now in terms of midterms? What can we spin forward and learn from this?

MEDEIROS:So the big thing is election security, in the sense that those secretary of state candidates in key swing states that did not through their rhetoric accept the results of the 2020 election did not win.

MUCHA:    So this reduces the probability of a congressional or a constitutional crisis.

MEDEIROS:Especially if in the lame duck session the Electoral College Act is passed. The vote they’ve been working on in Congress since the events of January 6th. And so I think that’s really important.

MUCHA:    So it’s a good thing for democracy.

MEDEIROS:It’s a great thing for democracy. I certainly had some open questions about how those candidates would fare, how the state legislatures would fare, that would retain a lot of power in terms of the Electoral College. And the results clearly went against those that challenged the results from 2020. And so that’s clearly I think a positive.

MUCHA:    How do you see the Trump factor playing out in the GOP? Like how damaging is this likely to be? The results and Trump’s reinsertion into the party?

MEDEIROS:It’s difficult I think for Republicans because from a policy perspective low taxes and hawkish actions around trade and immigration is the party norm right now. But the takeaway for I think Republicans is bring it back to the point around election security and peaceful transition of power and that’s clearly a headwind. And I think what you’re starting to see from Republican-leaning media is a push to retain some of those policies but without the transfer of power concerns and the election results challenging concerns. It will significantly depend on who the Republican candidate is. And so, I don’t have an answer for you. It’s pretty clear Trump will run again. It’s pretty clear DeSantis should run. Other candidates, Glenn Youngkin from Virginia, I would even throw Brian Kemp out there given how strongly he did in Georgia. I’ve mentioned Liz Cheney before. I think if Trump runs, she will run as well. 

MUCHA:    You mentioned DeSantis.


MUCHA:    How credible do you think his candidacy would be?

MEDEIROS:I mean anyone that wins 60 percent of the vote in Florida is automatically credible. And he’s one of the more popular governors across the country as well.

MUCHA:    So President Biden has said he will run. Let’s take him at his word. But if he doesn’t, who would you look to step into those shoes? You know, are we going to have a wide open race?

MEDEIROS:I think so. I think Joe Biden as he’s alluded to, it’s his nomination. He’s the incumbent president. His age is certainly a concern that the White House will admit but he just had a really strong midterm result for an incumbent Democratic president, the best since JFK, and so, his kind of brand of politics is resonating. If President Biden decided not to run then you’d see I think two buckets of candidates. The first would be from the more progressive wing of the party and so people like I think Elizabeth Warren come to mind. Bernie Sanders would come to mind. And then you’d have another bucket of candidates more on the moderate side. And so Secretary Buttigieg, Vice President Kamala Harris, Gavin Newsom, Tim Ryan, potentially Gretchen Whitmer. And some other more moderate governors or senators but I think similar to what we saw in 2020 there’d be a large number of potential candidates that would be vying for that spot. 

MUCHA:    What do you think the issues will be in 2024 that dominate the election?

MEDEIROS:So I think there’s two main issues going into 2024. One will be what’s the state of the economy then. Inflation is a problem right now. The country is worried about that. I think there’s growing and significant recession risk going into ’23 and ’24. And the aftermath of that will be critical in determining what the electorate is focused on at least in the short term for 2024. I think the second piece of that though is the geopolitical backdrop. And all of the developments you spoke about earlier around Russia, China, etc. Whether any of those structural concerns flare up in the next two years.

MUCHA:    Yeah, I think you and I will have a lot to talk about between now and 2024 and even beyond that. So again, you know, Mike Medeiros, thanks so much for joining us, macro strategist and a member of the firm’s alternative group.

MEDEIROS:Thanks for having me, Thomas.



Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For  professional/institutional investors only. Your capital may be at risk. Podcast produced November 2022.

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