Michael Zezas: Preparing for an Uncertain Election

This coming Tuesday is the midterm election in the U.S., so what should investors watch out for as the results roll in? And which outcomes might influence market moves?

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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Wednesday, November 2nd at 10 a.m. in New York.

On Tuesday, Americans will cast their ballots for members of Congress. Well, most Americans will. Many will have already voted by mail. And that's important to know, because it means that, like in 2020, investors may have to wait days to reliably know who will control Congress. And that uncertainty could spell volatility in the bond markets, under the right conditions. Allow me to explain.

Like in 2020, the increased use of vote by mail means that early vote counts reported may not be a good indicator of who's winning a particular race, especially in races expected to be close. Mailin ballots are typically cast more often by Democrats than Republicans, and in many jurisdictions are counted after in-person voting. That means that early reported results may look favorable to Republicans, but like in 2020, leads can vanish over time. And so we'll need to reserve judgment on which party seems poised to control Congress.

While that uncertainty is playing out, it helps to know which outcomes would be market movers and which ones might have no immediate impact. For example, let's consider what it would mean if Republicans take back control of one or both houses of Congress, which polls and prediction markets are pointing to as the most likely outcome. We wouldn't anticipate this 'divided government' outcome being a market mover, at least not in the near term. That's because the most we can take away from this are some hypothetical concerns. A divided government tends to deliver a weaker fiscal response to a recession. And Republicans have publicly touted their intent to use the debt ceiling and government funding deadlines as negotiating points to reduce government spending in 2023 and 2024. But in recent years, markets have dismissed those types of negotiations as political theater. So perhaps these events would only matter in the moment if the economy and or markets were already showing substantial weakness.

But what if instead Democrats do what the polling data suggests they're very unlikely to do, not only keep control of Congress, but expand their majorities. If the early vote counting makes this seem like a real possibility, perhaps because Democrats outperform in early tallies in places like Pennsylvania, then expect market gyrations, particularly in the bond market. That's because if Democrats were to pull off such an outcome, bond markets could come to see a risk that fiscal policy will be pulling in a different direction than monetary policy, meaning the Fed could have to hike rates even more than currently expected to bring inflation down to target. Expanded Democratic majorities could be a signal that inflation was not the electoral challenge many feared. Without that political constraint, investors could equate these expanded majorities with an increased chance that Democrats would revisit many of their previously abandoned spending plans.

So bottom line, be prepared. The polls are showing Democrats are unlikely to expand majorities, but the history of markets is rife with examples of unexpected outcomes creating market volatility.

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