If you’re hoping for a “blue wave” in November, know what you’re rooting for.
The odds seem greater than 50-50 that Democrats will win control of the House of Representatives in the upcoming midterm elections. There’s a much smaller chance they’ll win the Senate and take total control of Congress.
But if they do, a triumphant moment for Democrats could collide with a grim reckoning in financial markets, as investors assess the consequences of a revived Democratic party—and conclude it’s bad news.
The worry wouldn’t be about a gridlocked government in 2019, but a higher likelihood of a left-leaning Democratic president winning in 2020. “Investors [would] perceive a greater chance of a progressive agenda in 2021, which could include a rollback of fiscal stimulus and deregulatory efforts,” Morgan Stanley analysts wrote in a recent election preview. “A ‘blue sweep’ doesn’t immediately shift policy, but implies an electorate that makes medium-term change more likely.”
Democratic policies haven’t mattered much since Trump won in 2016. With Republicans in charge of the legislative and executive branches, they’ve been able to pass sweeping tax cuts, slash regulations and bury just about every Democratic initiative.
The Democrats’ agenda would suddenly get more attention if Dems swept the midterms—and investors might discover some planks unfriendly to markets. Democrats, for instance, want to roll back some of the Trump tax cuts, pushing the corporate tax rate from its new level of 21% to at least 25% (it was 35% before). They’d also raise taxes on wealthy individuals and impose the estate tax on more families. They also favor a much higher minimum wage than the current federal standard of $7.25 per hour. Those might be reasonable policies, but they’d likely detract from corporate profits and put downward pressure on stocks.
New agenda could cut profits
The “Medicare for all” plan Bernie Sanders ran on as a presidential candidate in 2016 has caught on with more Democrats, even though it would require a doubling or even tripling of federal taxation. Then there is Sen. Elizabeth Warren’s “Accountable Capitalism Act,” legislation designed to redirect some of the profits of public companies from shareholders to workers. Again, these ideas might have merit, but they’d also remake parts of the economy in ways that could cause great uncertainty and trim corporate profits.
While Trump is president, he’d still be able to veto any legislation a Democratic-controlled Congress might pass. And there’s no chance Dems can gain a veto-proof majority. So split government through 2020 would probably produce a lot of political sparks—and perhaps a Trump impeachment vote—but Republican policies Trump has put in place would remain.
A Democratic sweep in 2018, however, would indicate a stronger preference among voters for leftist policies than most political forecasters currently detect. That would suggest a bigger opening for a Sanders-style Democratic presidential nominee than there was in 2016.
If Democratic gains in November are more modest than the blue-sweep scenario, stock investors could enjoy decent post-elections returns. Stocks typically struggle in the weeks before a midterm election, as investors wrestle with uncertainty. But there’s typically a rally once the election is over.
Since 1945, the S&P 500 has risen an average of 16.7% in the 12 months following a midterm election year, according to research firm CFRA. And stocks have registered a 12-month gain following every single midterm during that timeframe. When there’s a change in the majority in Congress—which seems likely this year, if Democrats take the House—the 12-month gain in the S&P 500 is smaller, but still averages 13%.
By this time next year, however, the rally could be kaput. Many economists expect economic growth to decline in 2019, as the tax-cut stimulus and a recent surge in government spending peter out. Political turmoil could further darken the outlook, with President Trump facing mounting legal problems. And if stocks sink before the next presidential election, that could become a political issue, too.
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Rick Newman is the author of four books, including “Rebounders: How Winners Pivot from Setback to Success.” Follow him on Twitter: @rickjnewman