The votes have been counted and Americans have chosen to shift the balance of power in Washington D.C., giving Democrats control of the House of Representatives. Republicans maintain their control of the Senate, meaning that we can expect legislative gridlock through the remainder of President Trump’s term in office.

Historically, the party that controls the White House tends to do poorly in the midterm elections. As expected, the Democrats took control of the House but were unable to gain control of the Senate, largely due to the conservative lean of the Senate seats up for election this cycle.

Global markets are mostly higher today, as this outcome was largely expected and priced in. Global bond yields are little changed while U.S. Treasury yields are modestly lower.

Let’s take a closer look at what this outcome may mean for future legislation, the economy and the markets.

A Divided Government

Prior to the election, a divided government — with the Democrats taking control of the House and the Republicans maintaining control of the Senate — was the consensus view. 

In the House, Democrats needed to gain 23 seats to take the majority.  With results still coming in, Democrats are on pace to pick up a net 34 seats. In the Senate, they fell short, leaving Republicans with their majority. Though divided government is seen as an impediment to progress on the policy front, it’s not necessarily bad for the markets. Historically, as illustrated in Exhibit 1, equity markets have performed better when Republicans control at least one branch of Congress.

Legislative Gridlock

With Congress divided, it’s unlikely that we will see much new legislation, though the pro-growth policies of the Trump administration are likely to stay in place. It’s possible that President Trump may be willing to work with Democrats on an infrastructure bill, but the current political climate may make that difficult, especially as there is little consensus on how such a bill would be funded.

Democrats could use their newfound legislative leverage to force Republicans to roll back some of the recent tax legislation in exchange for their votes on raising the debt ceiling or approving the revised North American Free Trade Agreement.

In taking control of the House, Democrats also take control of various House committees and their investigative powers, which could lead to investigations into a host of Trump administration actions and policies. Though the House can impeach with a simple majority, removing a president requires a supermajority in the Senate, which seems unlikely.

Looking Beyond the Midterms

Although the policy and legislative calendar may be limited given the potential gridlock, we don’t see the change in Congress having a significant impact on the macroeconomic environment, the expected path of monetary policy or the markets. And while we do not expect this outcome alone to change our asset class positioning, we do believe some sectors will benefit more than others. Under a divided government with more subdued expectations for growth and little progress on legislation, we could see defensive sectors like staples, telecom and utilities benefit. Financials may be under some pressure as a result of a slower pace of deregulation. Additionally, uncertainty about the permanency of tax cuts could negatively impact retailers and restaurants.

Though some short-term volatility is to be expected as the dust settles, historically, equity markets have been higher 12-months out from a midterm election. The U.S. economy and corporate earnings are healthy, and even though we are in the later stage of the cycle we do not see signs of a recession. As long as there is not a surprise surge in inflation, the Federal Reserve is likely to continue its gradual normalization of interest rates.

In our view, we remain in an equity-friendly environment, and have positioned investors’ portfolios modestly toward equities, with a slight bias to domestic equity. Volatility is likely to persist even though the uncertainty of the midterms is behind us, as the headwinds of trade tensions with China and the potential for a policy mistake still exist. That’s why we continue to incorporate fixed income and diversifiers to help buffer overall portfolios from downside market fluctuations as well as rising rates.

Ultimately, the midterm results and change of control within Congress should have only a limited, short-term impact on the economy and financial markets. Investors should therefore look beyond the midterms and remain focused on economic fundamentals — economic growth, earnings and inflation — as that is what drives markets.

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