With the federal government shutdown over and the 116th Congress finally getting into gear, how will a divided congress affect the stock market in 2019? Let’s think about the economics behind the question.
With a united Congress, obviously it’s easier to pass legislation than if the Congress is divided. But does that mean a united Congress is always better for the economy and benefit the stock market? Not necessarily. It depends on the agenda of the dominating party.
If the presiding party is all for economic stimulation and free trade, likely we’ll see a stronger economy under the united Congress. In contrast, if the dominating party is for trade protectionism, increased tax and tightening regulation, a united Congress may as well contribute to slower economy.
With that said, let’s take a look at the data since the 1980s to get a historic view of how the stock market performed under different congressional characteristics.
[See: 10 of the Best Stocks to Buy for 2019.]
From 1981 to 2018, we had an undivided Congress 28 out of 38 years, and a split Congress 10 years. Historically, does an undivided Congress see better stock performance than a divided Congress?
No.
In fact, an undivided Congress has seen the highest and lowest stock returns in the past 38 years. When Congress is united and dominated by Republicans, and when the president is from the Democratic Party, we see the highest average annual rate of return of the S&P 500. It occurred twice since 1981: for six years under President Bill Clinton and two years under President Barack Obama. During those six years, the S&P 500 averaged a return of 16.28 percent.
On the flip side, an undivided Congress also delivered the worst stock performance. During the eight years when Democrats controlled both the Senate and the House, with a Republican president, the S&P 500 saw the lowest annual return of 3.87 percent.
Now switching to the 10 years with a divided Congress. Regardless of the party affiliation of the president, periods of divided Congress saw pretty good returns. There were six years in history that mirrored the current situation with a Republican president, Republican controlled Senate and Democrat controlled House in the Reagan administration from 1981 to 1986. During those six years, the S&P 500 averaged an annual return of 10.78 percent, ranking third as compared to the other combinations.
But can this data from the past be used to predict the future?
No.
There are just too many factors at play and every historical period is unique in its own way. Even under the same regime, the stock performance fluctuates drastically from year to year. Again, using the Reagan administration as an example, although the average market return was 10.78 percent over six years, the annual stock performance ranges from minus 9.73 percent in 1981 to 26.33 percent in 1985.
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Obviously, there are other forces driving these differences other than Congress being united or not. For example, what was the Federal Reserve’s monetary policy during those periods? The Federal Reserve, in charge of the monetary policy and presumably independent of the executive branch and legislative branch of government, has a huge impact on the stock market. In addition, with a few decades of data, the difference between the returns are not even statistically significant.
What we can be sure is that with midterm election results in, investors change their expectations about the current presidency in their remaining term of office. For example, before the midterm election, the stock price had already built in the expectation that Trump would be tough on China and on immigration policy. The divided Congress should prompt investors to update their expectations as the administration is facing more resistance pushing through its agenda.
As for how investors modify their expectations, that depends on their attitude toward the public policies of the president and Congress. If you believe a trade war and tightened immigration policy is value-accretive to U.S. economy in the long-run, the results of this midterm election could lead you to lowering your valuation numbers. On the other hand, if you believe a trade war does more damage than benefit to the economy, the midterm results should boost your valuation.
Finally, how the political landscape affects stock returns is different from how it affects the GDP growth rate. The two may not match perfectly. The historic stock return rankings mentioned above do not imply GDP growth rankings, though they should be positively correlated in the long run. They don’t match perfectly, especially if you only single out a few years to examine. This is because stock prices, due to their forward-looking nature, incorporate forecasts about corporate performance in future years, not just one quarter or year.
Significant changes in policy take time to make an impact on the economy. For example, the 2017 corporate tax reform gave a windfall of cash to companies, but the effects of that cash on investment and employment will take quarters to see.
[See: Top Tax Tips for Investors for 2019.]
While investors build expectation into stock prices now, the real economy will act with a lag. And based on future results from the real economy, we’ll find out if we are too optimistic or not and revise our beliefs about the value of stocks.
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How the Midterms Impact the Market in 2019 originally appeared on usnews.com
