From Morgan Stanley

Investor complacency regarding U.S. midterm congressional elections is understandable given that prediction markets are indicating a high likelihood of Democrats losing control of at least one chamber in the midterms.

But political pundits have been proven wrong before, and markets have a history of misinterpreting policy impacts of election results. With tax, healthcare and tech regulation among policy variables that could hinge on the outcome, planning ahead — and leaving room for a scenario that goes against the consensus — is especially important.

“While we’re not arguing that Democrats are likely to keep Congressional control, we do think the consensus is likely too complacent, opening the door to volatility in the pockets of the market that we’ve flagged as sensitive to election outcomes,” says Michael Zezas, Head of U.S. Public Policy Research and Municipal Strategy at Morgan Stanley Research.

Signals to Watch

Prediction markets — which are exchange-traded markets for speculating on events — recently implied a 90% chance that Republicans will win at least one chamber of Congress.

Prediction markets often are closely correlated with the final outcomes and significant moves in the weeks immediately before the election and can give investors a signal they may need to adjust.

Likewise, a president’s disapproval rating, and in turn his party’s midterm prospects, track closely with inflation and generic ballots — which are polls that indicate the political party voters plan to support — and have a solid track record of predicting election results.

Recently, both indicators pointed to a Republican win of at least the House and a high chance of winning the Senate too. Investors should watch these numbers in the months ahead for potential signs of a different outcome than expected in November.

What the possible outcomes may mean

To understand the potential regulatory implications on sectors, including pharmaceuticals and technology, as well on as issues such as China competition, taxes and climate, Zezas and analysts across a dozen research disciplines explored the plausible policy paths of three outcomes.

Policy Path #1: Republicans win control of both Houses

Republicans need to gain four seats to take the House. Meanwhile, a 50/50 Senate means they need to net one seat to gain control. With such relatively low barriers to victory, prediction markets recently implied a 74% probability that Republicans would win both chambers and control of the legislative agenda.

Market Impact

This outcome would make major new spending initiatives unlikely to materialize over the next two years, while fiscal policy would remain reactive rather than proactive. “In this scenario, certain legislative priorities are immediately off the table — like tax increases or investments in clean energy — while others become much more difficult to achieve,” says Zezas.

Moreover, if Republicans won’t have the ability to push their policy preferences past the White House, investors should prepare for gridlock.

Policy Path #2: Split control of Congress

While the Democrats are significant underdogs in the midterm election, there is a chance they could retain control of at least one chamber. Prediction markets recently gave a 19% probability of a Democratic Senate and Republican House and a 4% chance of Republican-led Senate and Democratic-controlled House.

Market Impact

This scenario could provide a little room for new legislation in areas where significant bipartisan consensus already exists, such as technology and crypto regulation, prescription drug pricing and energy investments. However, the outcome would be narrower in scope than what could be passed in a Democrat-only scenario.

Fiscal expansion would come only as a reaction to deteriorating economic conditions or an external shock to the economy, something we saw in the passing of the 2020 CARES Act and subsequent fiscal aid measures.

“This bipartisan action will likely be more limited in reach than what is possible under a unified government outcome, narrowing lawmaker ambitions as well as potential market impact,” Zezas says.

Policy Path #3: Democrats Retain Control

Polls and historical precedence indicate that Democrats are unlikely to sweep both chambers in 2022 and have a 10% probability of retaining control. Still, with a favorable Senate map and a redistricting process that protected more Democratic seats than originally anticipated, any major event in the run-up to the election could motivate turnout and give Democrats a narrow win.

Market Impact

Democratic control of both houses would create the smoothest path to legislation likely to impact the market. However, the gap between far-left and center-left Democrats in Congress means legislation would have to be moderate enough to gain widespread support.

The most likely outcome of this scenario would be additional fiscal stimulus in the form of a slimmed-down version of the $3.5 trillion Build Back Better agenda, paid for with tax increases on corporations and wealthier people.

“We believe that these hikes can plausibly be paired with the most popular pieces of the rest of the Build Back Better Act,” says Zezas. “While the entire initial proposal would likely not have sufficient support, popular provisions such as climate funding are likely to be pursued in this scenario.” 

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