Why The Split Congress May Be The Best Stock Market Election Outcome

The Democratic takeover of the House in Tuesday’s midterm elections, as the GOP narrowly held the Senate, is likely the best outcome for Wall Street. While stock market strategists had generally opined that continued GOP control would be the best outcome for the Dow Jones industrial average, S&P 500 and Nasdaq, history suggests otherwise. So does the threat of an escalating China trade war.

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First, look at historical returns for the stock market. Going back 60 years, to the election of 1958, a divided Congress has the best track record, followed by a rubber-stamp Congress run by the president’s party. The worst combination has been a unified Congress controlled by the party in opposition to the president.

Gridlock Good For Stock Market?

The historical record suggests a need for clarification of the Wall Street adage “gridlock is good,” based on the idea that markets do well when Washington doesn’t get in the way. It seems that good gridlock — coming from a divided Congress — is good, while gridlock at the hands of a hostile Congress might not be so great.

Here’s what IBD found, looking at S&P 500 returns during each two-year election cycle, from election day to election day. The best outcome, an average 18.7% two-year return, came when Congress was divided. Unified control of Congress by the same party as the president yielded an average 17.3% two-year gain. When control of Congress was unified under the opposition party, gains averaged 15.7%.

Housing, Dot-Com Bubbles More Powerful Than Congress

Admittedly, there’s a huge caveat to basing conclusions on these historical results. While political control of Congress can be important for markets, macroeconomic and geopolitical factors often are a much bigger influence on stock market direction. For example, the writing already was on the wall before the housing bubble burst, dragging down the stock market after Democrats took control of Congress in the 2006 election, in opposition to President George W. Bush.

In the 1990s, the dot-com bubble made divided government — the White House controlled by one party and Congress by the other — look great. The inevitable bursting of that bubble and coincident recession can’t really be blamed on the Congress voted into office in November 2000. In fact, the next Congress saw a rare change of control in between elections. Vermont Sen. Jim Jeffords left the GOP to become an independent in June 2001, handing control of the Senate to Democrats.

Still, while Wall Street strategists don’t expect major market consequences from any of the outcomes, continued GOP control was generally seen as the most market friendly. That’s because odds of another Trump tax cut would be slightly higher, if still pretty low. Meanwhile, the defense sector would continue to see higher federal spending.

Democratic control might have yielded a lot of investigations of Trump and little in the way of policy. An exception is that Democrats might have been more likely to gang up with Trump against the pharmaceutical industry.

One of the key issues for Wall Street is whether the China trade war will escalate. China President Xi Jinping will surely have a lot more influence than the next Congress. Yet a Democratic takeover of the House might dent Trump’s confidence in his invincibility. As Trump faces a momentous decision whether to dramatically escalate the China trade war or accept a deal that only moderately narrows a massive trade deficit, it’s just possible he’ll be more likely to seek a deal.

Trump could begin to ask himself whether the trade war is really worth the economic price and political risk, and Wall Street, of course, would be delighted to see a deal that keeps the world’s most important economic relationship intact.

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