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John Toohey.jpgBy John Toohey, CFA
Head of Equities

 

 

 

 

 

 

KEY TAKEAWAYS

 

  • This week’s U.S. midterm election will likely calm one of the key factors contributing to recent stock market volatility. As long as there is not a “wave” election dominated by one of the parties, we expect little market reaction to the voting results.
     
  • But even if U.S. political uncertainties are resolved, there are a number of other sources of volatility. These include rising interest rates, growing global trade tensions and fears that Italy might seek to follow Britain out of the European Union.
  • The Federal Reserve is almost certain to raise short-term rates next month. We are more focused on Fed policy actions in 2019 as the central bank deals with expectations of a slowing U.S. economy. Moving too fast poses sizable risks. 


A key contributor to the market volatility spike that hammered the stock market in October will likely be resolved this week when, after months of hard-edged campaigning from coast to coast, we learn the composition of the new U.S. Congress.

 

There are three possible outcomes from the 2018 midterms: Republicans retain majorities in both the Senate and the House of Representatives, the Democrats win majorities in both, or we end up with each party controlling one of the chambers. Polling has for months suggested that the third possibility is likeliest, but the polls are not infallible.

 

A divided Congress has in the past been good for stocks, though a number of investors have expressed worries in the event that Democrats win at least one house of Congress.

 

The basic thinking is that this outcome will almost certainly lead to a relentless atmosphere of conflict on Capitol Hill, including impeachment efforts aimed at the president and the newest Supreme Court justice. In this grim scenario, the hostile political environment spills over into markets in the form of heightened uncertainty and asset price swings.

 

In our view, the prospect of full-on intraparty war within Congress is an overly dire outlook. We believe none of the possible election results will cause a significant market disruption as long as the post-election majorities are narrow, regardless of which party holds them.

 

Again looking to the polling, small majorities are seen overwhelmingly as most likely, so if electoral results meet current expectations, we would expect some volatility to be taken off the table. If, on the other hand, we somehow end up with a blue or red “wave” election, it could drive up volatility.

 

But even if the midterms play out as scripted by the polls, there will still be several potential sources of market turmoil that each could be more potent than politics. These include rising interest rates, ongoing trade disputes and growing fears that Italy could try to follow Britain out of the European Union.

 

The Federal Reserve policymakers will likely bump up short-term rates at its final meeting of the year in December. The latest numbers for new jobs and wage growth for October, both released last Friday, were higher than expected. This comes after reports that real GDP grew 3.5 percent in the third quarter and consumer confidence is at an 18-year high.

 

With the December rate hike all but assured, we are more focused on next year.

 

Current expectations are three Fed interest-rate increases in 2019, a pace that we consider too fast if there is not a spike in inflation. We understand that the Fed wants to be able to use rate cuts to fight the next recession, but given that we are in the later stages of the current economic cycle, the risk is that unnecessarily aggressive Fed policy actions will actually hasten or amplify the next recession.

 

Forecasts already call for a slower-growing U.S. economy as the stimulative effects of last year’s federal tax cuts and a 2018 increase in government spending diminish. Changing global trade regimes may also add headwinds.

 

A slowing economy could impact stocks. While stock prices are well down from their September peaks, third-quarter revenue and earnings continue to surprise to the upside and fourth-quarter expectations are also strong.

 

The result is more attractive equity valuations, as the top numbers in the price-to-earnings and price-to-sales ratios decrease at the same time the bottom numbers increase. Valuations closer to the long-term average provide some market support and dissipate some risk.


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