Year in Review: The pollsters got the midterms right

Equities 5 minutes to read

Eleanor Creagh

Australian Market Strategist

Summary:  Come January, the Democrats will assume their majority position in the US House of Representatives. For politics, this means gridlock but despite the hope for at least some bipartisan cooperation, the outlook for equities isn't promising.


For once, the pollsters got it right: in this year's US congressional elections, the Republicans kept the Senate, and the Democrats took the House. The upshot of this is political gridlock. Lawmakers won’t be able to enact major policy changes or undo market measures already in place.

The corporate tax cuts introduced by President Donald Trump in 2017 were viewed as supporting economic growth and company profits. In the lead up to the elections, many investors were concerned that a big swing to the left (a Democratic win) could lead to a reversal of these cuts. As it turns out, equity markets have taken comfort from the Republican Senate majority, which means a policy reversal is unlikely.

The second round of tax cuts proposed by Trump is viewed less favourably by the market. That’s largely because it includes tax cuts for individuals. The concern is that individuals who have to pay less tax may spend a lot more on goods and services, and this spike in demand could push up prices. That’s often not a bad thing, especially in an economy that is weak, but in an economy that is already growing strongly, as the US is, this procyclical policy could push up prices too fast for the liking of policymakers who have a mandate to keep prices growing at a more stable and predictable pace.

Prices that fluctuate too fast can threaten the stability of the economy because they make it harder for people and businesses to predict future prices, and without knowing what prices will be in the future, it’s very hard to make financial decisions, whether that be saving to buy a new car or in the case of a company, investing in a new factory to produce goods. A sudden spike in prices could prompt the country’s central bank, the US Federal Reserve, to raise official interests in order to rein in consumer spending and curb price rises. As a side effect, this would also hurt a lot of companies by making it costlier for them to borrow the capital they need to invest in their businesses – bad news for stocks.

Thanks to the Democrats taking the House, the second round of tax cuts are virtually dead in the water now, and the markets are breathing a sigh of relief. The pause on tax cuts is also good news for the government’s ever-ballooning budget deficit, which is a constantly recurring concern for investors. More tax cuts, if not offset by spending cuts, would have pushed the government’s deficit higher as they spend more than they tax. Increased government deficits need to be financed through government debt, and high levels of government debt pose long term risks to financial stability. High levels of debt serve to further increase deficits as interest must be paid on the debt, creating a viscous cycle.

Besides tax cuts, the other notable policy change proposal in the pipeline was a package of infrastructure spending, which would be positive for industrial stocks. An infrastructure bill appears to have support from both the Democrats and the Republicans, so it could still happen, but the problem is how to fund it. At any rate, the US$1 trillion bill that was promised in Trump’s election campaign is now highly unlikely, meaning less pressure on the deficit.

One potential downside of the split Congress is that the Democrats are likely to be emboldened and to use their House majority to investigate Trump, thus increasing political uncertainty.

The imminent finale of Special Counsel Robert Mueller’s investigation will coincide with the Democrats formally taking the House of Representatives in January. Democratic House committee chairs will now have subpoena power, which means they can require a person to appear in court as a witness or require the production of documents. This is a power they are highly likely to exercise.  It potentially gives them access to tax returns, campaign finance payments, business dealings, information regarding the firing of former FBI Director James Comey, possible collusion with Russia and anything else that could be used to tarnish Trump’s image. 

The legal risks are rising for Trump and these issues heighten political risk and unpredictability during the second half of his term in office. This political risk could be an ugly distraction for equity markets to contend with throughout 2019.

For US equities in particular, the political disruptions add to the headwinds facing corporate earnings coming off a cyclical peak as the effects of the tax cuts fizzle out. Expectations for earnings growth next year are significantly weaker than in 2018 (9% in 2019 vs 20% in 2018). Corporate profit margins have peaked this year and the outlook for 2019 looks patchy, factoring in political instability, slowing economic growth, higher interest expenses, and cost inflation. These factors, combined with a decline in dollar liquidity and tighter financial conditions, mean market conditions in 2019 will remain volatile and challenging. 

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK Limited
Rooms 2001-02, 20/F York House
The Landmark
15 Queen's Road Central
Hong Kong

Hong Kong S.A.R

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: Rooms 2001-02, 20/F York House, The Landmark, 15 Queen's Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.