For those of you who would prefer to listen:
The Dow rallied 14% in October, marking the biggest monthly move since the 1970s. Price action has been choppy. Volatility continued into November, a theme we’ve been accustomed to in 2022. Interest rates jumped again, as expected, with the Fed sticking with its hiking campaign. Another 3/4-point rate hike came this week. Inflation is still public enemy #1.
Fed Chair Powell said the Labor Market is still overheated and said the Fed does not see any signs of softening yet. That was confirmed Friday with another strong job report for October, though the unemployment rate ticked up a bit. The Market took the news in stride while stocks continued their wild ride. This, ahead of one of the most anticipated events on the calendar: The 2022 midterm elections.
Typically, by October, the path for the midterms has already cleared up. Not so this year. 2022 is anything but clear. Polls suggest Republican success on Tuesday. That said, you know what to think about polls. One thing that is clear: Americans still vote with their wallets. Democratic Strategist James Carville was right in 1992. He’s right about 2022; “It’s the Economy Stupid…”
The Market doesn’t play politics. Elections always have an influence. But they’re seldom the driving factor. As the American Economy slides towards a 2023 recession, change in Washington seems certain.
I am in Denver this week for Schwab’s national conference. It was the first in-person event since 2019. It was very well attended. I spent most of my time with discussions around the Market, the Economy, the future of America and, of course, the election.
2022 is not a Presidential year for the ballot. But Presidential popularity matters. President Biden’s popularity is in the low 40s. It’s up from the 30s, earlier this year. Presidents almost always face heat in their first midterm cycle. America is extremely divided.
One thing that seems to be united; The American people overwhelmingly think the country is headed in the wrong direction. They just don’t agree on why. 81% of Republicans think it’s the Democrats’ agenda which is responsible for the nation’s problems. No surprise, 79% of Democrats think it’s the Republicans’ fault. Economic concerns and inflation are by far the biggest issues for voters. Republicans should be strong favorites to win the Senate. That would be normal for this cycle. But Republicans have nominated a number of candidates widely considered to be weak. 2022 is anything but normal.
In the House, all 435 seats are on the ballot. Republicans just need a 6-seat gain to win control. That has always seemed likely given the historical average of a 30-seat loss for a President’s party in first-term midterm elections. Trump lost 40 House seats in his first midterm. Obama lost 60. There’s a pretty clear theme.
President Biden and the Democrats took the White House in 2021 with momentum. RealClearPolitics had Joe Biden entering his Presidency with a 55% approval rating. It didn’t last. It seldom does. President Biden’s approval rating took a massive hit with the abrupt Afghanistan withdrawal and has been underwater since the Summer of 2021. It appeared to bottom in July at 37% and has risen to 43%, roughly where most modern Presidents are at this point in their first term.
Since 1922, the party of the sitting President has lost an average of 30 seats in the House of Representatives and 4 in the Senate in the first midterm. Only 3 times did the incumbent party pick up seats in the House. In fact, it’s only happened 4 times since the Civil War. Losing the midterm is a defined trend. A Red Sweep is a 63% probability, as I type.
The 2022 midterms are set up similarly to that of 1994. Back then, President Clinton faced a Republican Red Wave as well. Democrats had both the House and Senate while the Fed was raising interest rates from 3% to 6%. Newt Gingrich and the Republicans reversed the Democrats’ control of Congress. The Stock Market set off on a 23% surge as the Fed cut rates the following year. A triggering event for the cuts was a reckless blow up in Orange County, resulting in bankruptcy and serious stress in the financial system.
Despite some similarities to 1994, 2022 has few peers. The Fed says it doesn’t plan on cutting rates next year. Inflation is still its nemesis. The Market disagrees, assigning a better than a coin flip chance rates are lower by the end of 2023. Yields are showing signs of peaking. A looming recession is the driving factor there. The Market sees one by Summer.
The midterms are important to the Fed since they will determine whether there will be more fiscal stimulus. If the Democrats maintain control of both chambers, they would likely keep spending. This would make it harder for the central bank to tame inflation and could lead to more rate hikes. Conversely, if Republicans win control of at least one chamber, spending would freeze. Gridlock would return. That means the Federal Reserve will only have the monetary lever to pull. The Market seems to like the prospects of that result.
According to our Washington sources, a divided government would mean President Biden’s legislative agenda would be over. Republicans would have little political incentive to work with the President ahead 2024. Realistically, the 2024 election begins Wednesday.
Our sources believe that if the Republicans win the House, tax hikes are dead in the water and defense spending is headed higher. If the GOP wins both the House and Senate, defense spending could go up even more and an Energy infrastructure bill and extension of certain business tax breaks would be more likely. If Democrats retain control of the House and Senate, tax hikes to pay for social spending would be back on the table.
Republicans seem destined to win control of the House. Democrats could maintain control of the Senate. Republicans experienced that result in the 2018 midterm election, where Democrats won 41 House seats, but Republicans gained two Senate seats due to a favorable Senate map that year. Democrats have a more favorable Senate map this year. A divided government under this scenario would still mean little legislative activity. However, a Democrat-controlled Senate could still confirm President Biden’s nominees to agency positions where there would be more pressure to pursue executive actions to deliver on campaign promises ahead of the 2024 presidential election.
Removing the possibility of legislative risk would be a good outcome for some sectors that Democrats have targeted under their control. Oil & Gas and Big Tech are atop that list. A Democratic loss of Congress is considered bad for green energy companies losing some key financial incentives. According to our sources, legislation to lower drug prices seems less likely to happen next year since Democrats addressed the issue in their reconciliation package this year. Additionally, Republicans would be less likely to provide additional Covid funding after Democrats passed a $2 Trillion package in March of last year.
Historically, Presidents pivot their attention abroad when they lose control of Congress because it reduces their ability to impact the domestic agenda. A winner of divided government will be the aerospace and defense industry. Republicans will push for increased defense spending, and greater threats posed by China and Russia will make it harder for Democrats to oppose. However, Republicans may not be as inclined to provide unlimited financial assistance to Ukraine. There’s no blank check for Ukraine right now.
One area of potential Congressional compromise is increased incentives for American companies to bring supply chains back home. The threat posed by China is an area of bipartisan concern and helps fuel a protectionist view that both parties appear to embrace.
Things are quite complicated overseas. A month ago, the Organization of the Petroleum Exporting Countries (OPEC)+ announced a 2 Million barrel per day cut in Oil production. It won’t take effect til later in November. Gas prices rose as higher future prices are more factored into purchases. This is not a good look for the President after he visited Saudi Arabia back in July looking for a production increase. He got a decrease.
President Biden took credit for lower gasoline prices since they reached a $5 peak in June. No surprise, Republicans are now blaming him for the price increases. Lower gas prices helped offset some of the pain voters were experiencing due to higher grocery, electricity, and housing costs. Now they’re back up as the American people head to the polls.
Both President Obama and President Trump pivoted to executive actions to bypass an unwilling Congress to deliver on campaign pledges ahead of their respective re-election contests after suffering midterm losses. At a basic level, executive orders are easier to challenge in court because they are not laws. Their duration can be limited to the term of an administration since the subsequent administration can easily undo them. Expect more of that ahead.
We are hearing that a Red Wave would increase pressure on President Biden to announce that he is not seeking a second term since it would be viewed as a clear rejection of his Presidency. That could set off a scramble for Democrats to replace him. That said, there is no clear alternate candidate today. In addition, many senior cabinet leaders could depart the White House to preserve their private sector prospects.
What does this all mean for the Market? Well, it started rallying in October, around the time that polls reversed back suggesting a Republican House and Senate. The Market has gotten anxious about excessive spending and seemingly likes the prospects of a return to gridlock in Washington.
Regardless of who wins, the Market historically has done very well the following year. A split government has provided the best returns. The top framework for rallies has been a Democrat White House and a split Congress. That’s provided a 10.4% annualized gain going back to 1901. Next best has been a Democrat President and Republicans controlling Congress with 9.1% gains. The Market would like the reduction in spending that a divided government would bring.
Hang on tight and stay tuned for Tuesday.
Have a nice weekend. We’ll be back, dark and early on Monday.