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How will markets respond to the US midterms?

The second half of 2018 has seen a constellation of geopolitical risks cast a shadow over global markets. In recent months, Brexit negotiations have increased in urgency and acrimony. US-China trade tensions have escalated. Fringe political parties have swept to power in Europe and South America, preaching a gospel of economic populism. The resulting outlook for global markets is uncertain, and that’s before you’ve considered the most consequential – and unpredictable – geopolitical event of them all: the US midterm elections.

Predicting the impact of elections on markets is difficult, not least because elections themselves are difficult to predict. In 2016, most pundits and polls were confident of a Hillary Clinton victory. But experts didn’t just get the outcome wrong in 2016: they also got the outcome of the outcome wrong. At the time, conventional wisdom dictated that victory for Donald Trump – whose defining message was criticism of the globalised world economy – would be disastrous for markets. In reality, the stock market has thrived.

In the two years since Trump’s election, Wall Street has delivered returns of 30%. Whether the president can claim credit is up for debate. While it’s undoubtedly a continuation of a trend which began during Barack Obama’s first term, most economists agree Republican tax cuts have boosted the economy in the last year. Whatever the explanation, one thing is certain: if the economy wasn’t in such good shape, Trump’s approval rating would be much lower, and his Republican party would be in a much worse position heading into the midterms.

Historically, markets have had a difficult time of it in September and October before midterm elections. This is probably explained by uncertainty, as whoever controls the executive branch tends to lose seats, if not entire congressional houses. History also shows stocks starting to stabilise around election day, then doing increasingly well as the shock of the election fades and a new political equilibrium is reached.

So, will the volatility that has plagued markets in recent weeks begin to fade after the midterms? Perhaps. But there is reason to believe that these midterms, like so much about this presidency, are different. At time of writing, Nate Silver’s FiveThirtyEight.com gives Democrats a roughly 85% chance of taking back the House of Representatives. If the Democrats do win the House, their control of various investigatory committees will empower them to implicate the president in scandal. They could, for example, subpoena Trump’s tax returns, thereby possibly revealing as-yet-undisclosed entanglements with Russia, or simply reopen the investigation into allegations against Supreme Court justice Brett Kavanaugh. With nefarious dealings laid bare, the prospect of impeachment could have a chilling effect on markets.

That said, impeachment – which requires a two thirds super-majority vote in the Senate – remains a remote possibility, even after the midterms. In the Senate, where Democrats face an uphill struggle because so many of their voters are concentrated in a small handful of states, the Republicans are favourites to hang on to their slender majority. Still, a split congress, with a Democratic House and Republican Senate, brings its own problems, with raised fears of legislative gridlock and government shutdowns.

Most important, however, is the impact the midterms could have on the president’s economic agenda. If the Republicans get a drubbing on 6 November, Trump may consider it a repudiation of his protectionist policies, which have already hurt key Trump-supporting demographics (in August his government announced a $4.7bn bailout for US farmers adversely impacted by retaliatory tariffs imposed by China). Or – and this would be more consistent with his presidency so far – he may double down on the ‘economic nationalism’ that proved a winning formula in 2016. Either way, it’s difficult to see the president embracing a more moderate position.

The 2018 midterms have felt more akin to a presidential election in terms of interest generated. Deep partisan divisions, amplified by Trump’s rhetoric and crystallised by the recent battle over Kavanaugh’s nomination to the Supreme Court, have given rise to a sense that there’s more at stake in 2018 than in any other midterm elections in history. Whether political intrigue translates into market movements remains to be seen.

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