At the beginning of the year, we predicted that Republicans would make gains in the House, but did not expect them to capture the Senate. In the end, it appears that President Obama's declining approval ratings along with mounting criticism over his administration's handling of such issues as rising geopolitical threats and the Ebola scare were enough to turn the tide in favor of the Republicans.
The 2014 election was not a “wave election” like 2008 when Democrats won the White House and made massive gains in both houses of Congress, or the 2010 mid-terms when Republicans took over the House and picked up several Senate seats. Rather, the fact that Republicans will now control both houses of Congress does represent a shift in the balance of power, but it is a modest shift.
From an economic and markets perspective, then, we would say these election results do matter, but we wouldn't say this election was a game changer. It will certainly be easier for Republicans to pass legislation to send to President Obama, but it's an open question whether he signs such legislation and the extent to which Republicans and the president work together.
What to expect with a Republican Congress
Now that the Republicans control Congress, we expect they will want to use this opportunity to demonstrate to the American people that they can govern effectively. In the run up to the 2016 elections, we think the GOP will want to focus on a few issues they could quickly pass through Congress and get onto President Obama's desk:
• The long-debated expansion of the Keystone Pipeline would likely be high on the agenda. Legal challenges surround this project and it is unclear if the president would approve the construction. If the additional phase comes to pass, this would likely be a boon to energy and infrastructure-related companies.
• Changes to health care would almost certainly pass quickly through a Republican-controlled Congress. Specifically, Congress is likely to repeal the medical device tax. This would require the president's cooperation, but President Obama may agree since the tax has been so unpopular and roundly criticized. Such a repeal would help the medical device industry.
• Faster adoption of liquefied natural gas exports from the United States is likely to be on Republicans' radar screens, and this development would be a positive for the energy sector. Additionally, the GOP will probably push for increased defense spending, which could benefit companies in that industry.
Issues to watch
In addition to this short list of legislation, investors should keep their eyes on some key policy issues over the coming years:
Tax reform may be in play, specifically reform of the manner in which U.S. corporations pay taxes from overseas (aka “corporate inversions”). Pressure has been mounting to increase the amount of taxes U.S. companies pay on their overseas earnings or limit their ability to incorporate overseas. This issue will continue to heat up since the Treasury department recently tightened the tax rules around corporate inversions. We think there is a chance that the inversions issue may open the door for a broader tax reform discussion. The extent of such reform is anyone's guess, but corporate tax restructuring is more likely than individual tax reform.
Energy policy will be on the U.S. government's list to evaluate. U.S. energy production is increasing at a furious pace while demand is actually declining thanks to increased efficiency. The United States is on course to becoming energy independent by the end of this decade, and the U.S. is becoming a net energy exporter. This will have far-reaching effects on everything from energy production policies and energy-related taxes to international relations and trade agreements.
Other important items such as
healthcare legislation,
financial regulation,
trade agreements and
immigration laws will likely remain at the forefront of political discussions and could affect the economy and markets.
Elections and stock market cycles
So far we have outlined some important high-level issues, but how will the elections affect the stock market as a whole? Elections do matter, but we believe they are less important than the state of the economy, the direction of corporate earnings, valuation levels and the fundamentals that determine a company's stock price. That said, investors should understand some long-term historical trends that surround election cycles.
Equity markets have historically experienced a bounce following mid-term elections (often after rough patches that precede elections). It is not uncommon for equity markets to experience downturns in advance of mid-term elections. And, indeed, in 2014 we saw the sharpest correction in years when the S&P 500 index experienced an intraday peak-to-trough decline of 10% between Sept. 19 and Oct. 15.
Markets have since recovered, which is also part of a familiar mid-term pattern. Since 1930, in fact, the S&P 500 index performed significantly better on average in the last quarter of a mid-term election year than it did earlier in the year, as can be seen in Exhibit 1. This effect has tended to last into the following year. Since 1950, the S&P 500 experienced positive returns in every six-month period following the last 16 midterm elections, with an average gain of 16%. One reason for this trend may be that elections remove uncertainty, and if there is one thing investors love, it is clarity.
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The third year of a presidential term has historically been the strongest average year of the four-year election cycle, as shown in Exhibit 2. It's impossible to say why with any degree of certainty. One theory is that as presidents approach reelection or start to consider their legacy, they focus on the economy and try to enact policies that promote growth, which are usually friendly to equity markets. Should 2015 follow this “three-year effect” pattern, it could be another tailwind for equities.
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Looking ahead to 2016
The dust has barely settled and already politicians and prognosticators have their eyes on the next set of elections in two years. Two years is an eternity in politics and it's little more than background noise to be speculating about who will run for president (much less who will win).
But such talk does have a practical effect, since it means that President Obama and the 114th Congress will have only a brief window to enact any new legislation before everything in Washington becomes overshadowed by the next presidential campaign.
And for those of us breathing a sigh of relief that the campaign commercials are over, the unfortunate reality is that it's probably only a brief respite.
Robert C. Doll is senior portfolio manager and chief equity strategist at Nuveen Asset Management.
