How will the stock market react if the Republicans take Congress?

The US midterms are set to take place on 8 November 2022, and although Biden isn’t the one on the ballot paper, the results will heavily shape his ability to pass policies in the second half of his term.

What are midterms?

Midterms are the elections for the House of Representatives that fall in the middle of a Presidential term – House elections are held every two years, so that’s one on election year and one mid-term. There are also often Senate seat votes that fall at midterms, as senators hold their positions for six years.

The 2022 midterms will see all 435 House seats be elected and 35 Senate seats up for grabs too.

Midterm elections are important because they ultimately influence the ability of the current President to pass policies. Biden is already finding it difficult to pass policies on gun control, climate change and reproductive rights, as the Democrats only have a slim majority in both the House and the Senate.

They’ve got 221 House seats to the Republican’s 208, with six vacant seats outstanding. The Senate is split 50/50 – but the tiebreaker vote is given to Vice President Kamala Harris, so you can guess which way she votes. For example, the Senate passed landmark legislation on climate change and healthcare that would see the largest investments in history – the result was evenly split but Harris cast the tie-breaking vote.

This means that if the Democrats lose even just a few seats in the House or the Senate, we could see Biden’s grip slip even more. The GOP will need five seats to win a majority in the House and one seat in the Senate. The states that could determine whether we see a flip are Pennsylvania, Wisconsin, Arizona, Georgia and Florida.

Will the Democrats win the midterms?

It remains up in the air whether Biden and the Democrats will win the midterms. But it wouldn’t be unusual if they did lose control of the House.

Midterm elections are often seen as a way for voters to pass judgement on the current government. If they’re unhappy with the policies going through, the primaries represent a good way to voice opinions and shift the power away from the current party.

For example, Democrats lost the House in 2010 midway through Barack Obama’s presidency, and Republicans lost the House after two years of Donald Trump’s.

How have stock markets reacted to midterms in the past?

During midterm election years, stock markets are historically at their weakest. In fact, for over 100 years the second year of a president’s term has (more often than not) been the worst for the stock market, according to a report by Ned Davis Research.

Not every second year sees real declines, but the annualised returns are smaller. The report on presidential cycles used the Dow Jones to show this:

• 12.7% for Year 1
• 3.1% for Year 2 (the midterm year)
• 14.8% for Year 3 (pre-election year)
• 7.4% for Year 4 (the election year)

For Biden’s second year, the stock market is already in decline due to the tightening financial conditions that are the result of the lingering impact of the coronavirus pandemic, soaring inflation and the war in Ukraine. In fact, the S&P 500 has fallen 4.08% in the year to date, and the Dow is down over 7.3%.

If we use Trump’s second year as a comparison, the GOP had just pushed through a huge package of tax cuts and consumer confidence had risen to new highs. But stocks still dropped 6.2% in the midterm year, due to the Fed raising interest rates and tensions increasing between the US and China. 

The theory suggests that after the dip in returns and volatility, the market will rebound late on in the year and into the next – with stocks moving higher in the two quarters after midterm elections are over. A study in the Journal of Wealth Management 2019 states:

“…by examining the quarterly total returns on the S&P 500 Index between 1954 and 2017, [the authors] show that, nine times out of 10, the index has been positive in the fourth quarter of a midterm election year and the following two quarters.”

Although these patterns exist, it’s important to remember that each year is different. The data above was recorded pre-pandemic, so there are a lot of different factors at play now.

This year, we’re still likely to see the Federal Reserve attempting to curb inflation and prevent a recession, which could dampen investor confidence further. Plus, a lot of US stocks also started the year with pretty expensive valuations, which has caused volatility in their share prices anyway.

For investors, these market movements can be daunting but, over the longer term, the impact of midterms tends to even itself out. But for traders, midterm volatility creates an interesting environment in which to go both long and short on US stocks and indices.

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What will happen to stock markets if the Republicans take Congress?

If Republicans take congress in the upcoming midterms, Biden will likely lose any chance of passing policies, but US stocks might actually gain ground.

According to historical data, from 1901 onwards, a Democratic president combined with Republican control of both houses of Congress has produced annualised real stock returns of 8% for the Dow Jones. The S&P 500 average return in years where Democrats have held the Presidency and both houses of Congress is 10.5%, compared to returns of 13.6% during a split Congress.

Source: Forbes and CFRA Research, based on S&P 500 data from 1944 - 2021

For example, when Barack Obama faced a split Congress from 2010 to 2014 – with GOP holding the House and Democrats the senate – the S&P 500 surged nearly 70%.

The idea of a split cCngress being a good thing is somewhat surprising, given that we typically think that markets like certainty and strong governments. But as it will make it more difficult for Biden to increase the federal minimum wage and increase tax on corporations, it’s not surprising a split Congress could benefit investors.

However, it would also lead to lower government spending, which markets have been enjoying over the last year. Biden has been passing bills aimed at stimulating the economy and domestic industries, such as:

• A $1.2 trillion infrastructure bill, which helped to boost the S&P 500 by 26% within 12 months
• A $52.7 billion CHIPs bill that will aim to boost the domestic semiconductor manufacturing industry – the iShares Semiconductor ETF was up 4.66% in the week following the announcement

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