In thinking about the impact of the elections next week, there are two channels that we want to analyze. The first is the likely impact on policy and the second on financial markets.

In terms of policy, the scenario that I think would lead to the most dramatic change from the status quo is if there were a red wave, if you will—if the Republicans were to hold both houses of Congress. In that scenario, I think it’s highly likely that we would see more expansionary fiscal policy, specifically tax cuts. I think the narrative among the Republican Party would likely be that the tax cut package passed this year was strong enough to carry them through the midterm elections, and that a similar sort of package—perhaps a little smaller, but a similar sort of package—would be a good idea as they maintain their grip on power.

I think that in the event of a Democratic sweep, where the Democrats hold both the House and the Senate, it’s likely we would get a very modest expansion of fiscal policy, likely through spending rather than tax cuts. But given the difficulty that I think a Democratic Congress would have in working with President Trump, it’s unlikely that we would see a dramatic change in policy.

In terms of the market outcomes though, I think that we could see a very dramatic difference between a red wave scenario, if you will, and a blue wave scenario. In a red wave, where the Republicans hold both houses, I would expect asset markets and risk markets to respond quite favorably. I think that the perception of the probability of an additional tax cut would go up. Trump’s economic policies have generally prioritized short-term growth, whatever the longer-term consequences may be. And for financial markets, that has been a very favorable mix.

In the event of a Democratic sweep, I think that risk markets would likely struggle. I think that concerns about increased regulation, a very low probability placed on additional tax cuts, and indeed some probability that parts of the tax cut passed earlier would be rolled back, would weigh on risk sentiment.

And when we translate those to fixed income markets, in the event of a Republican win, higher near-term growth, higher near-term inflation, more expansionary fiscal policy, all point toward higher interest rates. In the event of a blue wave, you might get a modest fiscal expansion, but I think that the deterioration in risk sentiment in financial markets would likely push interest rates lower.

All that said, I think it’s important that we all recognize that there is a great deal of uncertainty around the market response to any political event. It was only two years ago, after all, that most of us would have expected the stock market to perform poorly in the event of a Trump victory. And in the event, the opposite happened.

So, while we might have expectations around what will happen next week, we want to make sure that we’re not allocating investment portfolios or making major investment decisions based on those expectations. We will continue to watch the policy developments very closely. Because, over time, it’s the policy developments, rather than the short-term market reactions, that will drive the decisions that we make and that we think investors ought to make.

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