Steven Blitz, chief US economist at GlobalData.TSLombard, has articulated a nuanced perspective on the impact of the recent US midterm elections on equity markets, asserting that policy decisions by the administration and the Federal Reserve, alongside geopolitical developments, will prove more decisive than the electoral outcome itself. While acknowledging that the new Congress will exert a degree of constraint on the current administration, Blitz posits that it will not fundamentally dictate the executive agenda. This viewpoint challenges conventional interpretations of midterm election impacts, suggesting a shift in market drivers from partisan shifts to the substance of economic and foreign policy.
Post-Election Market Dynamics: Policy Over Politics
The prevailing narrative following US midterm elections often centers on which party has gained leverage and how this might translate into legislative victories or stalemates. However, Blitz’s analysis, shared by GlobalData.TSLombard, shifts the focus towards the more intricate mechanisms that influence market performance. "Rerating is not the equity market’s major problem going forward, policies are," Blitz stated, underscoring his conviction that tangible policy shifts, rather than abstract valuation adjustments or the simple victory of one party over another, will be the primary determinant of US equity returns.
This perspective is rooted in an examination of historical patterns. Blitz points out that the party securing a midterm victory has historically shown no consistent correlation with the direction of the equity market. "In four of the six midterms beginning 2002, the market continued in the same direction after the election that it was heading in before," he noted. This historical data suggests that markets often operate on momentum and pre-existing trends, which are then influenced by external factors rather than being solely reactive to the immediate electoral news.
Examining Historical Precedents: A Deeper Dive
To further substantiate his argument, Blitz presented specific historical examples. In 2018, a year marked by Democrats gaining 41 House seats, the equity market experienced a decline of 9% from Election Day to the end of the year. Blitz attributes this downturn not to the Democratic gains but to the Federal Reserve’s tightening monetary policy during that period. Similarly, in 2002, the market saw a 3.9% fall between Election Day and year-end, despite the Bush administration strengthening its congressional majority by adding eight House seats and two Senate seats. These instances serve as empirical evidence that the market’s trajectory can diverge from the traditional interpretation of election results.
The impact of midterm elections on market volatility also appears to be less pronounced than commonly assumed. Blitz’s analysis of the VIX index, a widely watched measure of market volatility, revealed no consistent pattern around midterm elections. The VIX averaged 21.9 before elections and 19.5 afterwards, a difference Blitz characterized as "a statistical difference with no meaning." This suggests that the inherent volatility of the market is not significantly altered by the immediate aftermath of midterm contests, further reinforcing the idea that other factors are at play.
Valuation Landscape: A Fairly Priced Market
Beyond the influence of electoral outcomes and policy shifts, Blitz also addressed the current valuation of the equity market. His assessment indicates that the market is "fairly priced" relative to bonds and the broader nominal economy. He cited the S&P 500’s forward price-to-earnings ratio of 21, which translates to an earnings yield of 4.78%. This valuation implies that, at current rates, stock prices would double in approximately 15 years.
This outlook is contextualized by comparing equity returns to other investment avenues. The average annual nominal economic growth over the past decade has been 5.7%, a rate that would lead to a doubling of GDP in 13 years. Furthermore, a 10-year zero-coupon bond yielding 4.9% suggests that capital invested in such bonds would also double in about 14 years. Blitz concluded that "The 10Y is not yet cheap enough to pull money from stocks," indicating that while bonds offer a competitive return, they are not sufficiently attractive to lure significant capital away from equities.
Even sector-specific indices, according to Blitz, exhibit similar pricing. However, he noted that valuation gaps become more pronounced among the top 20 largest companies by market capitalization. This nuanced view on valuations reinforces his overarching thesis: the market’s fundamental attractiveness is not at an extreme, making policy decisions a more potent catalyst for future movements than any perceived mispricing.
The Role of Policy and the Federal Reserve
The emphasis on policy decisions by the administration and the Federal Reserve is a critical component of Blitz’s analysis. In the current economic climate, characterized by persistent inflation and ongoing efforts by central banks to manage it, the Federal Reserve’s actions are of paramount importance. Interest rate hikes, quantitative tightening, and forward guidance from the Fed have direct and significant implications for corporate borrowing costs, consumer spending, and overall economic growth, all of which are key drivers of equity market performance.
The administration’s policy initiatives, whether in fiscal stimulus, regulatory changes, or trade agreements, also play a crucial role. For instance, legislative efforts aimed at infrastructure spending, clean energy initiatives, or tax reforms can create new investment opportunities and reshape industry landscapes, thereby influencing stock prices. The interplay between these executive actions and the Federal Reserve’s monetary policy creates a complex environment where market participants must closely monitor policy signals.
Geopolitical Factors: An Unpredictable Element
Adding another layer of complexity to market dynamics are geopolitical events. In an increasingly interconnected world, conflicts, international relations shifts, and global economic disruptions can have far-reaching consequences. The ongoing war in Ukraine, for example, has significantly impacted global energy markets, supply chains, and inflation, creating a backdrop of uncertainty that influences investor sentiment and market volatility. Any escalation or de-escalation of geopolitical tensions can trigger rapid market responses, irrespective of domestic political developments.
The New Congress: A Check, Not a Halt
Blitz’s projection that the new Congress will act as a "constraint on the administration, but not to control its agenda" suggests a scenario of divided government or at least a shift in the balance of power that necessitates compromise and negotiation. This can lead to a more deliberate pace of legislative action and potentially less sweeping policy changes. For the market, this could translate into a period of relative stability regarding major legislative overhauls, with attention remaining fixed on executive actions and the Federal Reserve.
However, a constrained administration can also lead to policy gridlock, which can have its own set of implications for investor confidence and economic activity. The ability of the executive branch to implement its preferred policies will be tested, and the legislative process may become more arduous. The specific composition of the new Congress, including the margins of control in both the House and the Senate, will be crucial in determining the extent of this constraint. If the margins are slim, bipartisan cooperation may be necessary for any significant legislative achievements, further moderating the pace of change.
Implications for Investors
For investors, Blitz’s analysis offers a clear directive: focus on the fundamental drivers of economic growth and corporate profitability, and remain attuned to policy signals. This means paying close attention to:
- Federal Reserve Commentary: Understanding the Fed’s stance on inflation, interest rates, and its economic outlook is paramount.
- Administration Policy Announcements: Monitoring initiatives related to fiscal policy, regulation, and international trade will be essential.
- Geopolitical Developments: Staying informed about global events and their potential impact on markets and supply chains.
- Company-Specific Fundamentals: With a fairly valued market, the performance of individual companies and sectors will become even more critical for generating alpha.
The midterm elections, while a significant political event, may prove to be a secondary factor in the short to medium term for equity market performance. The true drivers of returns are likely to be the tangible outcomes of policy decisions made in Washington and by the Federal Reserve, set against a backdrop of evolving global economic conditions and geopolitical uncertainties. The era of policy-driven market movements appears to be firmly established, demanding a sophisticated and vigilant approach from investors.
