Two days after the U.S. midterm elections, control of the House and Senate still hangs in the balance. Kim Parlee speaks with Christian Medeiros, Portfolio Manager, TD Asset Management, on what these developments may mean for financial markets.
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[AUDIO LOGO] Americans went to the polls yesterday for the US midterm elections. Pollsters were predicting a red wave with Republicans easily taking the House and possibly the Senate. But as a 5:00 PM the day after, the House and Senate control still hang in the balance, perhaps tilting in a direction we're going to find out just a moment. So What do these developments mean? Joining me to dissect the results Christian Medeiros. He is Portfolio Manager with TD Asset Management. Great to have you here in person. Thank you. Let's just start with, what do-- what do the midterms mean for the markets, high level? So Republicans are expecting a red wave. Instead they got a bit of a red ripple. That probably means that they just take the house by a small margin and the Senate remains Democratic. But for markets, they were just hoping for a divided government. That's the best case scenario for them. Because in a gridlock scenario, there's no new policy, minimal interference in markets, and there's much less policy uncertainty. So markets probably will get what they wanted when all the votes are done and counted. Yes. I guess it gets rid of those extreme options, when you have the gridlock, which is what people tend to worry about. Historically, I know we've talked about it before. I think-- I can't remember, 17 of the last 19 midterms or something like that, markets have gone up. Is that true, first off? Yeah, it's true. So we look back at all the midterms since 1950. And what we found is that markets tended to be up on average, 14%, in the following 12 months. And they actually never experienced a negative return. So this could just be a statistical anomaly. But the intuition behind this is that-- what generally happens in a mid-term is, it's a repudiation of the president's party. He tends to lose a lot of seats. That results in gridlock government. Investors no longer have to worry about policy for two years. And they're happy. No guarantee that happens again this time. There's a lot of other factors like potentially recession or hawkish central banks that could get in the way. But historically, this is what we've come to expect. Interesting, I mean, good for investors. Maybe not good for society, there's gridlock. But it does-- stability in the markets and moving up. What about-- I kind of, tried to couch my words a little bit when I was introducing you, just by saying that we don't have final results, but does look like things are tilting in certain directions. If the Republicans take the House, maybe, even it's by a small margin, what does that mean? And specifically, when you take a look about sectors or policy? Yeah, there's some marginal winners on the sector side. First is being defense. Defense spending will go up in either scenario, but particularly if Republicans are our winners of the House. The second issue is energy. There's a bit of bipartisan agreement on energy permitting reforms. That would be more energy infrastructure, getting rid of red tape. So that would be beneficial for oil and gas and also for utilities as well. So that's possible. The last one is, health care tends to really love gridlock. Because in a situation in which no new legislation can get passed, there's less chance of drug pricing reform and less chance of insurance changes. And in that situation, health care really likes the status quo. So those are three sectors that will benefit on the margin from this outcome. Who doesn't benefit? Or what sectors don't? It's a great, great question. In a divided Washington, the one thing that everyone agrees on in this moment is to be tough on China. We've seen a lot of action over the past year on semiconductors, potential delisting a bunch of action. We expect more tough on China legislation over the coming year. So, obviously negative for Chinese stocks on the margin. But also negative for American multinationals that rely on production in China or of high-revenue sensitivity to China. So that's one headwind to worry about. The other is technology. Both parties also agree on regulating technology, being tough on technology. But they can actually agree on what's the problem or why they need to do it. We'll see if they can figure that out over the next two years. But more regulation of technology is possible. Do your views change materially? And I think because at the margin, I'm sure there's always a little subtleties, if the Democrats manage to retain control of the House, or if Republicans end up winning Congress-- House and the Senate. So if you see all one side, all the other. Does any of that change? Because you mentioned defense spending. And I'm like, defense spending is going up regardless. I guess it's a magnitude of how much. But what do you see there? Yeah, so if the Republicans were to also win the Senate, which is possible. We probably have a runoff in Georgia that will decide it on December 6. And we wait. But that won't really change the outcome. All that will do is maybe block some appointees from the Biden administration. And that will just gum up any more regulatory actions, so maybe beneficial to financials. But that's not too material. It's divided government either way because Biden can veto anything that the Republicans want to do in Congress. On the other side though, if Democrats were to pull off the unlikely scenario, retain both houses of Congress, that'd be very market-negative. Two reasons. One is, likely there'd be higher tax on corporations and higher tax on income earners as well as capital gains tax. All of those are negative for markets. The second, we're in a high inflation regime. That's the number one concern for investors. There's a lot of fiscal spending that Biden wasn't able to get done from his Build Back Better agenda. So if that comes back on the radar for investors, there's going to be a lot of worries. So I think the market would not take a Democratic retention of both houses very lightly. Interesting. Debt ceiling showdown. It feels like something we kind of get ready for all the time when it's coming in again. Early January, I think, is when this is happening again. What do you see happening there? And what does it mean for markets? Yeah, so sometime early next year, they're going to have raise the debt ceiling. We're going to come against that limit. And if it doesn't get done, the government will shut down. And a lot of negative ramifications from that. So what we're going to see is because, in the most likely scenario where the Republicans have the house, they're going to be able to use as leverage against Democrats to try and extract some concessions, whether that be spending or other policies. So because of that, we could see brinksmanship, another showdown like we saw in 2011, when a Republican house really-- as well-- in a divided government, with Obama's president, really pushed things to the brink. And we saw the US debt downgraded. And we saw a market sell off 20% that summer. So it is definitely a risk if we do see a brinksmanship on that issue. So does it tail risk, I think, we need to watch for. And I expect more headlines on this debt ceiling issue going into next year. A US debt downgrade now hurts more than it did probably back then, just given the interest rates and the amount they have to pay an interest, I'm sure, in that process. If the US does end up with this divided government and the gridlock, any kind of idea of what that might mean for an upcoming recession? I mean, you mentioned the fact there'd be less spending, good for markets, maybe, and probably, good for not causing inflation, bad for people who can't afford to do stuff, right? Yeah, no, that's exactly it. When Republicans are in the minority in Congress, what they're going to want to do is care about the deficit. They're going to care about spending priorities. And so there's going to be a lot of pushback on any pro-cyclical fiscal spending coming from the Democrats in the case of a recession. So I'd expect less fiscal spending in a coming recession than we would have expected in 2020 or before. And as a result, that might mean that the recession could be more drawn out and take longer to resolve without that fiscal push. Excellent roundup, Christian. Thanks so much for coming on. Thank you. [AUDIO LOGO]
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