This post was written with contributions from Charlotte Irwin. Charlotte is a Research Strategist in the ETF and Mutual Fund Research Team.

Falling at the halfway point of the president’s four-year term, congressional midterm elections are often seen as a referendum on presidential policy. Midterms also have historically driven political cyclicality because the party that recently lost the presidency tends to turn out in droves. That’s sparking talk this fall of a “blue wave” to threaten Republicans’ current single party control of the executive and legislative branches.

An increasingly partisan environment could amplify the probability of change this election season, especially with presidential job approval ratings at historic lows. The chart below shows how partisanship has affected voters’ views of the US President from the 1950s to today, with the top dot representing approval ratings from the President’s own party, and the bottom from the opposition. As one would expect, there has always been a divide in approval ratings along party lines, but that gap has steadily widened since the Clinton administration and now stands at more than 77 points. Today, while President Trump’s approval rating sits at a record low of 7% with Democrats, 84% of Republicans approve of his performance.   

What are the House and Senate numbers like this cycle?

The US legislative branch operates under a bi-cameral structure, meaning that Congress is divided into two chambers – the House of Representatives and the Senate. The House consists of 435 members, with seats allocated on the basis of population, while the Senate has 100 members, two from each state. Representatives serve two-year terms and all 435 seats are on the ballot this November. Senators serve six-year terms and are elected in classes. This cycle, 33 Senate seats are up for election, plus there are two special Senate elections to backfill vacant seats. Additionally, 39 states and territories will hold gubernatorial elections, as well as numerous state legislature races. 

Republicans now control the House by a margin of 18 seats, with 6 seats in the chamber currently vacant. This means that Democrats would need to pick up 24 seats, without conceding any losses, to reach the 218 seat threshold of majority control. Roughly 48 House seats are considered competitive, with Republican incumbents in 41 of those seats versus 7 for the Democrats. In addition to favorable math, the majority of these races are in districts that registered thin margins in 2016’s presidential election, with 25 going to Clinton. 

This gives the Democrats a decent shot at taking control of the House for the first time since 2010. In fact, polling aggregator FiveThirtyEight sets the odds of a Democratic majority come January at 79.6%. History also supports this outcome. Since 1914, the President’s party has lost an average of 28.8 seats in the midterms – more than enough to swing control of the House to the Democrats this time around.

Control of the Senate is far less likely to change. There, the Republicans hold a slight 51-49 majority, but the math is much less constructive for change. Seats on the ballot include 26 Democratic incumbents, including two independents who caucus with the party and just 9 Republicans. Importantly, 10 of the Democrats’ seats up for grabs are in states Trump won in 2016. Democrats would need to hold each of these, as well as swing two more states to take control of the Senate. With the odds of a Democratic Senate remaining fairly constant, around 1-in-3, it is improbable, though not impossible, that Democrats can achieve a full congressional majority.  

While both chambers are technically in play, more attention will be paid to House races. In the six federal elections since 2006, US voters have changed the party in power in at least one of the branches five times. Should one or both chambers go to the Democrats, gridlock could increase leading into the 2020 election and leave issues from taxes to impeachment hanging in the balance. 

What do the midterms mean for markets?

Historically, markets have performed quite well around the midterms. As shown below, performance has tended to accelerate mid-October and finish strongly at yearend. On average, the fourth quarter has been the market’s strongest in midterm years since 1962, with S&P 500 returns historically being negative in August and September before posting an average 3.9% return in October. This year, however, the S&P 500 was up 3% in August and is on track for a positive September. This sets us up either for an outlier or a bumper October that could potentially drive the US to extend its outperformance over the rest of the world, where it is already outperforming the MSCI ACWI Ex-US by 14% this year.

Encouragingly, performance has not historically declined immediately following elections, regardless of the party in power. It’s almost as if the finality of an election’s outcome settles investor nerves. According to Strategas Research Partners, the S&P 500 has not posted a negative return in the 12 months following a midterm election since 1946, instead rising an average 15.3%. However, that doesn’t mean investors are complacent this time around. The SKEW index which tracks positioning to hedge tail risk events is at all-time highs, having closely tracked an uptick in global policy uncertainty.

Should Democrats swing one or more chambers, however, uncertainty could spike as the President’s agenda would be jeopardized, from pro-cyclical policies like the planned second round of tax cuts, defense spending and financial de-regulation to platform issues like healthcare reform and environmental regulation. Google search popularity for “gridlock” has already nearly doubled since the start of the year.  And, lest we forget, the next Congress will need to negotiate the debt ceiling immediately upon assuming office. This could exacerbate a scramble to pass laws before the midterm elections. The chart below shows that this is not unusual toward the end of a congressional term. Historically, 20% of the laws enacted during a session have, on average, been passed in October of the second year of the session. This means we could be in for a lot of headline risk in the coming weeks given the current elevated levels of gridlock. 

What’s ahead for 2020?

Political business cycle theory holds that following the midterms, attention quickly turns to the next election cycle, 2020 in this case, as the party in control seeks to use their power to pass legislation to boost the economy and keep sentiment high. 

After the election, potential gridlock, coupled with economist consensus for a recession in 2020 and the possibility that the Fed’s rate hikes could invert the yield curve next year, could heighten legislative volatility – creating winners and losers on industry lines. For the time being, the market will be left to guess which way the political winds are shifting, setting us up for an interesting fall. All this coincides with a Q3 earnings season where companies are projected to have over 20% growth for the third consecutive quarter, while having downgraded forecasts. In fact, eight sectors have lower growth forecasts than in June and 76% of company guidance announcements have been negative, above the five year average of 71%.

As we get closer to November 6, check back to see how the political contests are shaping up, what key issues have emerged, which market segments may stand to benefit and how to position portfolios accordingly. Until then, get your popcorn ready and don’t be surprised if the market’s frayed nerves overreact to the news of the day, while punishing firms who miss on earnings more than usual.