Post Election Outlook & Analysis

November 21, 2018

Remember: the last midterm election after which the market was lower 12 months later occurred on November 5, 1946.
Ultimately, Tuesday's election followed the most probably route (for a change). With the GOP losing the House, making gains in the Senate, and maintaining a slim edge in Gubernatorial offices as Democrats managed a small net gain.
The most interesting aspect of the night? The Democratic conquest of the House. And it's worth a closer look. As we believe the GOP House defeat had three primary causes.
First, the unique aspects of the 2018 electoral landscape that saw Republicans had to defend 41 open House seats. Of which eight were in districts carried by Secretary Clinton in 2016. Seven went to Democrats. Another 10 were suburban districts where Trump won only by single digits in 2016. Eight of those went Democratic. In at least three districts, GOP incumbents who had declined to identify with Trump -- and Mike Coffman of Colorado, Barbara Comstock of Virginia, and Carlos Curbelo of Florida -- were sent to defeat.

So, an election conducted as a referendum on President Trump had the effect of reinforcing the ranks of Trump's loyalists. The most embarrassing defeats were suffered by non-Trumpers. With very notable election night victories by Governor-Elect Ron DeSantis (currently in recount) and Senator-Elect Rick Scott (currently in recount), Governor-Elect Brian Kemp in Georgia, and Senator-Elect Kevin Cramer in North Dakota.
The second factor in Tuesday's House contest was suburban white women with college degrees. A group that went Democratic by 20 points. And cost GOP contenders close races in which they'd led in the polls just before the election in some of the more posh burbs of Virginia and Chicago. Why?
Gettysburg College History Professor and Political Analyst Allen Guelzo theorized, "Women in the Whole Foods suburbs were unimpressed by Mr. Trump's good economic news because they had never experienced the brunt of the Great Recession: Their mortgages had never been underwater, and their men were not killing themselves with opioids. They saw nothing in Mr. Trump and Republicans but misogyny and indifference to healthcare."
The third factor? Money. Democrats dramatically outspent Republicans on House races $292 million to $247 million, between September and November. And demonstrated an admirable investment savvy as the Democratic leadership managed the task of becoming simultaneously the party of big dollars as well as of democratic socialism, of Tom Steyer and Representative-Elect Alexandria Ocasio-Cortez.
So, what now?
Old Party Playbooks
While little will be accomplished legislatively, both parties will stick to their traditional playbooks. Yet, unless they can locate the genetically repressed bi-partisan gene that has been missing these last two decades? We don't have high hopes.
However, that doesn't mean victorious House Democrats won't try to force pet issues down the pike. Which could see them re-litigating the 2017 Tax Cuts and Jobs Act in the House Ways and Means Committee.
They'll raise issue with areas such as depreciation. And the new pass-through deductions. While attempting to demonstrate that the tax cuts were a huge, unfair giveaway to the nation's wealthiest.
Countering, Republicans will attempt to provide evidence that the tax cuts created job growth. While benefiting small businesses. Effectively thwarting Democrat attempts to raise taxes. With such efforts remaining unlikely as the Senate remains in Republican hands. And President Donald Trump will hardly be enthusiastic about rescinding the core benefits of his tax reform act.
In the end, Democrats will be able to provide a good show for the party's base. Which may be reason enough for the entire production. As they begin to position themselves for the much bigger competition in 2020.
Expect the Unexpected
And yet, anyone expecting the drama in D.C. to unfold as the blathering punditocracy expects it to has not kept abreast of history. The only thing to expect is the unexpected.
But what scenarios may play out among central casting in the nation's capital?
President Trump will likely attempt an "Art-of-the-Deal-style" middle ground. Attempting to work with Democrats on policies of mutual interest. Like infrastructure. Immigration. Attempting modest successes through a Bill-Clintonesque triangulation. And salvaging some of the next two years.
If Democrats respond by spurning every opportunity to deal and focus only on the politics of destruction, they will likely fail. As Republicans did in '98-'99 with President Clinton. And in '11-'12 with President Obama. Moreover, were that to happen, the Trump administration may even cede to letting some of the recent economic gains slip. And then attempt to pin such losses on the Democrats heading into the 2020 elections. We doubt it gets to such tactics. But don't rule it out.
Another scenario sees the likely Speaker of the House, Mrs. Pelosi, reaching out to Majority Leader Mitch McConnell and Senate Republicans. In an attempt to reach consensus on legislation concerning healthcare, the budget, taxes and infrastructure. Independent of The White House. Allowing Pelosi to throw any blame for failure or opposition on the President's lap. Isolating him. And encouraging the emergence of Republican rivals.
Were Machiavelli alive, his calendar would be full. His modern-day acolytes, however, are plotting as we speak. Weighing the pros and cons of every strategy and tactic. All of which will render the next two years as fascinating to watch.
More encouraging than the potential dynamics emanating from D.C. are the historical trendlines coming out of past midterm elections.
Bullish on Gridlock
History reveals that the market has delivered consistently positive returns in times when the party that controls Congress is different than the party in the White House. The rationale? Following a midterm election, a president's power wanes. Particularly if Congress is split. Because the probability of enacting meaningful, business-oriented legislation for either party diminishes significantly. Creating an atmosphere of certainty that markets appreciate.
In fact, gridlock (Congress and White House ruled by different parties) has occurred 25 times since 1900. Providing periods during which annualized returns have been positive 68 percent of the time.
No Change in China Policy
Even with Congressional power redistributed, there will be little movement on China. Largely because, for all of the caterwauling between both parties on Chinese trade and tariffs, establishing a fair and balanced trade policy with the world's second largest economy remains a priority for both parties. With the GOP seeking to placate large corporations. And Democrats working to please the big U.S. labor unions.
Nor can Democrats or Republicans do much to ease political and trade tensions with China. As such policy remains largely in the hands of the executive branch. And little has been done to signal that a new trade deal is near.
In two weeks, President Trump will meet with Chinese President Xi Jinping at the G20 summit in Buenos Aires. Market watchers will view the meeting intensely for details about what the next steps are in resolving these issues. But odds favor little to no movement in the near term.
Infrastructure a Bi-Partisan Opportunity
There remain few objectives that Republicans and Democrats agree on. Though infrastructure may be one.
Before the midterm elections, there were subtle notes of bipartisanship regarding an infrastructure bill. In October, legislation called the "America's Water Infrastructure Act of 2018" passed with broad bi-partisan support. The new law authorizes water resource projects and policies nationwide to be administered by the U.S. Army Corps of Engineers. It provides federal funding for water infrastructure projects. And aims to expand the country's water storage capabilities. While seeking to upgrade wastewater, drinking and irrigation systems. Because of the deficit effects of the tax cut, it seems that the trillion plus dollar infrastructure projects that Trump wants may be unreachable. Yet, there could be smaller deals that win dual-party support.
Winners and Losers
Who might be the market winners and losers as a result of the midterms? Two of the biggest are those we've long touted.
The sector likely to gain most? Healthcare. As the risk of more regulation looks diminished. And the chances of increased government healthcare spending (as a result of the election of Democrats in key states) seems higher.
Another beneficiary could be the defense and aerospace sector. With the sector's strong earnings growth set to continue amid very positive trends in contract acquisitions and revenue. And with Democratic House control potentially representing the best scenario for government defense spending. Because gridlock traditionally keeps budgets intact. And defense remains a bipartisan issue. Last year's Congressional defense appropriation the biggest ever. And NATO appears to be succumbing to Trump's desire to see Europe foot more of the Continent's defense bill. Meaning that big money will likely continue to flow into U.S. aerospace and defense contractors. As well as those specialty players in Europe and Israel.
Positive inflows could also find their way to engineering, construction and infrastructure companies and indexes. As the one big bi-partisan piece of legislation which stands a chance of getting done is infrastructure. Which would really pour fuel into such opportunities. Last month's Water Act served to lubricate our long-time thesis on and position in the water industry. And we believe there will be more to follow.
On the flip side, the sectors likely to lose out are banks and telecom. Both of which seem likely to face much greater scrutiny by the now Democrat-led House.
We also think Big tech may be put in time out. Sadly, increased scrutiny and regulation of the sector seems to be one of the few areas of bipartisan agreement right now.
The Long and Winding Road
Much of the blathering punditocracy has decreed that the midterm upswing won't apply this year due to extenuating circumstances like tariffs, geopolitical tensions and rising interest rates, among others. Yet, these other historic post-midterm run-ups have occurred amid a much larger range of incidents and oddities. 1962 occurred amid the Cuban Missile Crisis. 1998? The Russian ruble crisis and the Asian Contagion.
So, while recent market weakness has been challenging, market weakness going into midterm elections is commonplace.
U.S. stocks now enter an historically bullish three-quarter stretch. Since 1926, S&P 500 returns during Q4 of a midterm year - and each of the subsequent two quarters - have been positive 87 percent of the time. Far better than stocks' non-midterm 64.6 percent quarterly frequency of positivity. Look at the empirical evidence. In the 23 historical nine-month periods between September 30 of a midterm year and the subsequent June 30, U.S. stocks rose 21 times. Equating to a 91.3 percent frequency.
Yet, this year's rocky October, during which the S&P 500 fell -6.9 percent, has investors wondering if midterms' bullish impact has been discounted.
Historically, weakness prior to midterm elections is surprisingly common. The S&P 500 declined in eight midterm-year Octobers since 1926. Yet, the subsequent Q4 periods finished negative only twice. The nine-month period? Only once -- in 1930. Market weakness, especially ahead of the vote, is not uncommon. In fact, you have to return all the way back to 1958 to find an example where the market didn't experience some sort of weakness in advance of the midterm election. Leading us to conclude that pre-midterm weakness doesn't negate the bullish affect midterms typically exert on markets.
Of course, the only thing more effective at disappointing a large and fawning constituency than politicians would be the market. Yet, unlike politics, investors learn over time that what is comfortable is rarely profitable. Whereas in politics, one best hope for comfort. Because profit of any sort is rarely an option.

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