How markets will likely react to a change in congressional power

With the midterm elections approaching, financial markets have already priced in a scenario in which Republicans cough up enough seats to lose their majority in the House of Representatives but maintain a majority in the Senate.

“In a divided government, very little gets done legislatively and more gets done by executive policy-making,” said Brian Nick, chief investment strategist at Nuveen.

As the most likely outcome, Mr. Nick said that would trigger the “least jarring reaction” from the financial markets. But he still would expect higher market volatility in 2019.

Two less likely scenarios involve Republicans losing both houses of Congress, or Republicans maintaining majorities in both chambers.

“If the Democrats take control of both houses, there would be a higher likelihood of investigations and more impeachment talk, which would be more disruptive for the financial markets,” Mr. Nick said. “The short-term reaction would be negative for stocks, and it would probably move long-term interest rates lower.”

The gridlock in Washington under that scenario would be similar to the period 2011-13, he said.

The third scenario, which the markets are not pricing in — just as they hadn’t priced in Donald J. Trump’s 2016 election — might be best for the financial markets longer-term, but could cause short-term volatility because of the surprise factor, Mr. Nick said.

“If Republicans hold both houses, we would probably see a little jump in long-term interest rates, a pop in the dollar and a market pop,” he said. “It would be similar to what the markets have liked this year, because it takes some risks off the table, shifting all the focus toward 2020 with some market-friendly policies enacted in the interim.”

The markets’ dislike of uncertainty is documented and helps explain why the months leading up to midterm elections don’t have strong performance records.

Past is prologue

Dating back to 1949, the third quarter prior to a midterm election has averaged the second-worst performance of the 16 quarters making up a four-year presidential cycle. The S&P 500 Index averaged a gain of 0.1% during third quarters immediately prior to midterm elections.

The worst quarter in that cycle is the second quarter of the midterm year, which averaged -2.8%.

Although the S&P 500 gave up some ground last week, prior to that sell-off it hadn’t followed its historic pattern of declining in the run-up to the midterm elections, and its resiliency had been attributed to the boost from last year’s tax reform package.

“The big issue is the tax cut last December, which was large, and led to a big run-up in stocks because analysts revised their earnings projections,” said David Templeton, principal and portfolio manager at Horan Capital Advisors.

Prior to passage of the tax cuts, the earnings projections for 2018 were about 9%. The reality is now expected to be closer to 22% for the year.

The flip side is that those higher levels will be difficult to match in 2019, which could create a future drag on market performance.

In the meantime, Mr. Templeton is relying on history as a guide to what lies ahead by pointing out that the two best-performing quarters in a four-year presidential cycle have been the final quarter of a midterm election year and the first quarter of the following year.

The fourth-quarter average return is 8%, followed by an average gain of 7.5% in the first quarter of the next year.

The best average annual return was 18.3% with a Democratic president and a Republican Congress, while the worst was 8.7% with a Republican president and a Democratic Congress.

“The stock market did fine under Obama and it’s doing fine under Trump, and we’re talking about two different policies,” Mr. Templeton said. “At end of the day, politics doesn’t really matter to the markets.”