Investors who have ridden the bull market to new heights after the surprise election of Donald Trump to the presidency nearly two years ago are now looking for clues about the upcoming midterm elections to the U.S. Congress, which could have a major impact on stocks. The voting, which takes place on Nov. 6, is likely to flip control of the House to the Democrats and leave the Republicans with a slimmer majority in the Senate, according to Goldman Sachs. This, in turn, is bound to create increased political and stock market turmoil because it will sharply boost the odds that  Congress misses deadlines for spending authorization and boosting the debt limit. It also diminishes the chance that stocks will rally in the fourth quarter as they usually do after the midterms. As Goldman puts it: "Fiscal compromise will become more challenging. As a result, these deadlines would pose a risk for financial markets. Fiscal concerns weighed on equity prices under divided government in 2011 and 2013."

 The six biggest post-election impacts that Goldman foresees, based on its prediction of a divided Congress, are summarized below.

6 Big Post-Election Impacts of a Divided Congress

  • Rising stock market volatility
  • Higher of risk of missed deadlines for extending spending authority and raising the debt ceiling
  • Diminished chance of a 4Q stock rally
  • Lower odds of new drug price regulations
  • Reduced chances for passage of a big infrastructure spending bill
  • Federal spending on aerospace and defense will remain strong

Source: Goldman Sachs

Significance For Investors

Goldman's expectation of a divided Congress reflects the views of three different sources: their own political economists based in Washington, the consensus among their clients, and the odds registered in prediction markets. The most likely consequences, Goldman believes, will be an increase in investigations and more uncertainty about meeting the deadlines necessary to avert shutdowns of the federal government. 

The report indicates that policy uncertainty has been at historically high levels during the last two years, but not markedly higher than that in the run-up to this year's elections. As a result, volatility has not experienced an additional uptick in this pre-election period. Goldman observes that the market typically rallies in the fourth quarter of midterm election years, as presented in the table below, as uncertainties are resolved. This year, however, they expect no such resolution, and thus lower odds of the pattern repeating itself.

Historical 4Q S&P 500 Returns:

Stocks May Fail To Rally In 2018

Years Median 4Q Return
Midterm Election Years 8%
All Years 4%

Source: Goldman Sachs

Goldman believes that, should the Democrats take control of both the House and the Senate, they are likely to make health care policy a major focus, including legislation that may be damaging to pharmaceutical industry profits. In a divided Congress, however, legislation affecting drug pricing probably will not advance. In aerospace and defense, Goldman notes that these stocks have continued to outperform, suggesting that "the market does not expect a major tightening of fiscal policy."

Looking Ahead

Regardless of the election outcome, trade conflicts look "unlikely to be resolved in the near future," Goldman writes. The lack of political consensus on trade policy, plus the president's veto power, indicate to Goldman that neither party is poised to make positive steps. Goldman adds, "In fact, market pricing suggests that the China-U.S. trade conflict is worsening: A basket of U.S. stocks with high China sales has underperformed the S&P 500 Index by 400 basis points this month, and a basket of China stocks with high U.S. sales has lagged local peers by a similar magnitude."