U.S. Midterm Elections:
3 Things to Know

On Tuesday, Americans will cast their ballot for members of Congress. But with many people voting by mail, it may take days or even weeks to know with certainty who will control the House and the Senate.

Given the axiom that markets hate uncertainty, here are our three key takeaways to help investors cope with that lack of clarity.

Outcomes that meet expectations typically do not move markets very much. And judging from recent trends in both polls and prediction markets, Republicans are expected to win a majority in at least one chamber of Congress. Therefore, an outcome in which Democrats expand their majorities in Congress would buck expectations. It would also undercut the notion that inflation is an electoral liability for the Democrats. Investors could see this result as permission for the party to ease the political and legislative constraints that kept Congress from enacting some of the fiscally expansionary policies that were part of President Biden’s original “Build Back Better” agenda.

Hence, a better-than-expected election night for Democrats means markets could assign a higher probability to further fiscal expansion—with Congress and the Fed effectively pulling in opposite directions on inflation. In the short term, that could mean higher Treasury yields and a stronger dollar, reflecting the potential for a higher peak federal funds rate.

Investors often associate split government with benign neglect, but that won’t necessarily be the case if Republicans take control of one or both houses of Congress.

Republican leadership could bring new risks in the form of U.S. public policy choices. Following the 2010 midterm elections, for example, gridlock led to protracted debt limit standoffs and government shutdowns. The resolution to one such standoff was the Budget Control Act of 2011, which implemented contractionary fiscal policy while the economy was still weak. Indeed, when the legislation was passed in August of that year, the unemployment rate stood at 9%. The result was weaker growth and a slower economic recovery, which partially explains why the Fed delayed raising rates until 2015.

At present, Republican leadership is signaling its intent to deploy the same tactics if the party wins majorities—in other words there is the potential for gridlock. While markets could easily dismiss these negotiations as political theater, as they have in recent years, if the economic outlook sours in 2023 in unexpected ways, the specter of the Budget Control Act could weigh on risk markets such as growth stocks and higher-yield corporate bonds. At the same time, Treasury bills could be under pressure this time around at the same time as quantitative tightening is being executed, further pressuring market liquidity.

As in 2020, the increased use of mail-in voting means the early reported vote tallies may not be a good indicator of who will eventually win, especially in races that are expected to be close. What we saw in 2020 and in other elections is that mail-in ballots were cast more often by Democrats than Republicans and counted after in-person voting in many jurisdictions.

That means early reported results should look favorable to Republicans, but as in 2020, leads can vanish over time. Consider the Pennsylvania Senate race. Assuming mail-in ballots are cast in the same proportions and with the same party skew as they were in 2020, we estimate that the Republican candidate could win the in-person vote by 29% and still lose after all ballots are counted. Hence, we will need to reserve judgement—perhaps for days—on which party seems poised to control Congress.

This article is based on “Sunday Start | What’s Next in Global Macro: 3 Keys for Election Week in America” (Nov. 6, 2022) and “Election Results: Hurry Up & Wait” (Oct. 20, 2022). For more information, contact your Morgan Stanley representative for a copy of the report.