7 november 2018


by Raul Elizalde

This article also appeared on Forbes.com.

Midterm election results were largely anticipated: Democrats took the House, while Republicans kept the Senate. Democrats also picked up seven state governors, and increased representation in many state legislatures. Despite these gains, they lost significant ground in the Senate. Until now, they were able to lean on one or two moderate Republican senators on critical votes, but the gap is now too wide. The midterm elections have placed Senate control strongly in Republican hands, which has implications for judicial nominations, appointments, and approvals for any bills that may come out of the Democratic-controlled House. The results do not represent a clear win for the Democratic Party.

Is the outcome positive or negative for investors?

Investors, like any other Americans, would benefit greatly if their government was not bogged down in gridlock and petty fights when the nation is facing important and difficult problems. Take health care, for example. The U.S. spends 17% of GDP in health care, while the average OECD country spends around 10%. The difference – 7% of GDP – amounts to close to $1.5TN per year. Freeing that much money could make a strong impact on improving productivity and creating long-lasting prosperity.

Alas, the likelihood of accomplishing something that monumental is virtually non-existent, and the election results have not changed that outlook a single bit. The remaining Republicans in the House seem to be less moderate and more aligned with the President. This, and the fact that Republicans have solidified their control of the Senate, could make Congress even more partisan and divided than it’s been so far. This dims the chances for compromise, and it remains to be seen whether President Trump will change his largely confrontational approach to governing.

The market could be negatively impacted on the fiscal front. President Trump and the Republican House gave the economy a very strong fiscal stimulus in the form of a large tax cut and a spending increase. This has deepened the fiscal deficit substantially and is likely to create a debt crisis in the medium term. Since the House controls the nation's purse, Democrats now face the unenviable task of steering the country on a more fiscally conservative direction. Apart from the obvious negative political consequences, taking away the sugar bowl that has been so important in fueling stock market gains could affect corporate profits, slow down the economy, and put an end to the second-longest market rally in U.S. history.

Impact on investment advisors

If the market weakens due to less stimulus or more gridlock, the investment landscape could change in substantial ways. A nine-year-long market rally may have given investors the idea that expert investment advice was unnecessary: Why pay a portfolio manager to handle a portfolio when a cheap market-index ETF seems to yield similar returns? Of course, that cheap ETF will also track a market that tanks, which investors witnessed during the October volatility. Financial advisors and portfolio managers who are focused on managing risk could well see a surge of client inquiries on how to protect accounts from unwelcome volatility.

This is especially important in the current environment of rising interest rates. For more than 35 years, interest rates have been in a downward trajectory, which has been a boon for bonds. With the Fed firmly on track to more rate increases, that trend may be over. A crucial implication is that bond funds, which had provided the traditional “safe harbor” investment – moderate capital gains with income – may no longer serve that purpose but instead act as a drag on portfolio values. Expert advice may become increasingly important to protect people’s investments and savings, especially in fixed income.

Should investors make any changes to their portfolios in the wake of the midterm elections?

Markets are non-partisan, and investors should pay attention to the clues offered by market dynamics rather than try to anticipate its direction. Notwithstanding the possibility that markets could suffer as outlined, this is by no means a given. The day after the election, in fact, was hugely positive for stocks. More time is needed to discern the true impact of the election on stock values.

More generally, making changes to an investment portfolio in response to political developments runs the risk of reflecting behavioral biases rather than sound decision-making. Many Republicans missed the stock market rally during the Obama administration because they couldn’t believe that his politics were good for the market. Many Democrats made the same mistake with President Trump. Investors should examine their political biases to prevent poor investment decisions, and consult with a professional before making any change to their investment plans.

As a final note, investors should also remember that people around the world die fighting for their right to elect their government, and our Founding Fathers risked much so that future generations could have and retain that privilege. Investors and everyone else should make a commitment to vote in every election to exert those rights, strengthen our democracy, and preserve the capital markets that have contributed so much to our country's wealth.