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Morgan Stanley – How the Midterm Elections May Affect the Markets

A very short and insightful read by the folks at Morgs on the possible impacts this year’s midterm elections could have on the markets.

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Political Path #1 Republicans take control of both chambers

Republicans must win four seats to take the House. Meanwhile, a 50/50 Senate means they have to win a seat to gain control. With such low barriers to victory, prediction markets recently hinted at a 74% chance Republicans will win both houses and control of the legislative agenda.

Market impact: This outcome would make it unlikely that major new spending initiatives will materialize over the next two years, while fiscal policy would remain reactive rather than proactive. “In this scenario, some legislative priorities are immediately pushed aside – like tax increases or clean energy investments – while others become much more difficult to achieve,” says Zezas. Additionally, if Republicans don’t have a chance to push their policy preferences beyond the White House, investors should prepare for a stalemate.

Political Path #2 Shared Congressional Control

While the Democrats are significant underdogs in the midterm elections, there’s a chance they could retain control of at least one chamber. Prediction markets recently gave a 19% chance of a Democratic Senate and a Republican House and a 4% chance of a Republican-led Senate and a Democratic-controlled House

Market impact: This scenario could leave some room for new legislation in areas where significant bipartisan consensus already exists, such as technology and crypto regulation, prescription drug pricing, and energy investments. However, the outcome would be narrower in scope than might pass in a Democrat-only scenario. Fiscal expansion would only come in reaction to deteriorating economic conditions or an external shock to the economy, which we saw with the passage of the 2020 CARES Act and subsequent fiscal relief measures. .

“This bipartisan action will likely be more limited in scope than is possible under a unified government outcome, reducing the ambitions of lawmakers as well as the potential market impact,” Zezas said.

Political path #3 Democrats stay in control

Polls and historical precedents indicate that Democrats are unlikely to sweep both chambers in 2022 and have a 10% chance of retaining control. Still, with a favorable Senate map and a redistricting process that protected more Democratic seats than originally anticipated, any major event in the run-up to the election could boost turnout and give the Democrats a narrow victory.

Market impact: Democratic control of both chambers would create the smoothest path to market-impacting legislation. However, the gap between far-left and center-left Democrats in Congress means the legislation would have to be moderate enough to garner broad support. The most likely outcome of this scenario would be additional fiscal stimulus in the form of a scaled-down version of the $3.5 trillion Build Back Better program, funded by tax increases on corporations and the wealthiest individuals.

“We think these hikes can be plausibly associated with the more popular elements of the rest of the Build Back Better Act,” says Zezas. “While the whole of the original proposal is unlikely to have enough support, popular provisions such as climate finance are likely to be pursued in this scenario.”


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