Midterm elections are the halfway point between Presidential elections, and it generally serves as a referendum on the incumbent presidency. With inflation soaring and approval ratings for Joe Biden plummeting it would not be a surprise if the Democrats get some bad news on November 8th. The Democratic control of both the Senate and the House of Representatives are both very much at risk as Americans voice their concern about the rising cost of everyday living. For investors, 2022 has already posed big challenges and now it appears more uncertainty is on the horizon. But before hitting the panic button, investors ought to be aware the data is clear: Midterm elections are historically quite bullish for the stock market. Will this year’s midterms keep that tradition alive?
4-Year Election Pattern
U.S. stock market has historically demonstrated a familiar and identifiable pattern in conjunction with the four-year Presidential election cycle. Of those four years, the year of the midterm election is often found to be the weakest for stock market returns. On average, the S&P 500 rose only 5.8 percent on average going all the way back to 1932. However, market gains in the 12 months following the midterms tended to be the most robust. Since 1990, the average one-year gain after the midterms has been 17%. Gains have ranged from as much as 32% to as little as 5% but all have been positive. Since 1950, there have been 18 midterm elections, and in the twelve months following, the stock market has always had positive returns.
Annual Total Returns After Midterm Elections
1990 – 2018
Source: FactSet, S&P Dow Indices. Slide created by Franklin Templeton’s Global Research Library. Important data provider notices and terms available at www.franklintempletondatasources.com.
Gridlock is Positive
We know markets do not like uncertainty, but interestingly they do seem to like political gridlock. One of the main reasons stocks have tended to see above-average returns following midterms is because there’s a tendency for more political gridlock and less legislative risk from the U.S. government. All else equal, more gridlock and less legislative risk tends to boost investor sentiment. However, in 2022 there are other factors to consider which may mean all else is in fact not equal. Inflation is obviously way too high, and the Federal Reserve is aggressively trying to rein in inflation with front-end loaded policy rate tightening. Tight labour markets and the geopolitics in Russia and China suggest higher inflation (and higher interest rates) may be with us for a considerable while longer. This has implications for economic growth, future corporate earnings, and ultimately stock market performance over the next year.
One big question is just how much of the Fed’s inflation fight is currently priced into financial markets? Ultimately, we can never be absolutely certain but there is no shortage of bearish investor sentiment on the street right now. Can the midterm election cycle follow its historical record, and will it dovetail with a Fed pivot on rate hikes? If so, investors ought to consider that before abandoning solid long-term investments.
Who’s in Charge?
While gridlock is good, the stock market has historically shown a preference for the Republicans to control Congress while a Democrat is in control of the White House. Returns have historically been somewhat less robust in the case of Democrats controlling the presidency and both chambers. The ideal situation for markets is for one party to control the Senate while the other controls Congress. Polls suggest a high probability the 2022 midterms will deliver the best mix for the stock market.
Source - RBC Capital Markets U.S. Equity Strategy, Haver Analytics; based on price returns and does not include dividends.
It’s Pretty Fundamental
Identifying repeating patterns in political cycles makes for interesting reading, but we believe sound economic fundamentals matter more. The prospect of recessions and their impact on corporate profits matter more to investment returns than what political party is in legislative control. Recessions are often accompanied by equity bear markets, but it’s during those periods of high economic uncertainty—often when headlines are at their worst and investor sentiment is rather negative—early hints of economic recovery spark a new bull rally usually well before the recession ends. Markets can, and do, recover before the end of a recession, but it seems unlikely that they will trough before its actual onset.
History suggests we could be on the precipice of strong stock market performance surrounding midterm elections. Although market performance patterns associated with elections have shown to exist, investors should remain aware that election uncertainty is not the only challenge faced by investors today. Indicators of economic growth momentum still point to an ongoing slowdown and risks remain still firmly skewed to the downside. If the trough in economic growth is still ahead of us, then it is unlikely that stocks can post a sustained rebound at this time. Slower growth coupled with persistent inflation and tighter monetary policy have us maintaining an underweight to equities with a preference to hold more fixed income and cash instruments in our programs.