What might be ahead in Washington

Rhys Williams, Chief Strategist, Spouting Rock Asset Management
November 1, 2022

As the mid-term elections and an important Federal Reserve (Fed) meeting rapidly approach, we feel confident in the results, but think the spin could greatly influence the market reaction.

While Democrats capitalized on the Supreme Court’s abortion decision to bounce strongly in the polls last summer, it appears October has broken for Republicans, almost regardless of candidate quality. The swing-vote suburbs that carried Biden to the presidency, now seem to care more about inflation and crime than abortion. We believe the House is a virtual certainty to move Republican and the Senate will likely be close.

While Fox News will enjoy election night and MSNBC could resemble a funeral dirge, we don’t think policies will change that much. The new legislation will come to a screeching halt, but Biden controls the regulatory agencies and will still make policies with executive actions. Thus, the Great Society 21st century bills that were passed in Biden’s first two years will be implemented by regulators hungry to make an impact. So, for companies, the practical impact of a Republican House will be muted.

Washington will still be a very unfriendly place for mergers and regulators will likely look skeptically at most industries from big tech to big pharma. We think the courts will be busy refereeing. On the positive side, the Inflation Reduction Act (aka IRA) is a lollapalooza for clean energy spending by corporate America. Solar, wind and carbon sequestration and many other environmentally-friendly initiatives have a guaranteed return thanks to the landmark legislation.

For those who like “inside the beltway” games, a Kevin McCarthy-led House will likely launch some payback for perceived Democratic excesses. While Alexandria Ocasio-Cortez (aka AOC) and some of the Squad will not get Committee assignments in return for what happened to some of the fringiest Republican Congresspeople during the last two years, this could create more media frenzy than market impact. We may also see gamesmanship using the need to raise the debt ceiling to force Biden to give in to some Republican priorities. After two years of ignoring Republicans, Biden will be forced to the table. Provided there is no debt default, the market probably applauds less government spending.

We do believe one substantive change will be made by a Republican house: Zelensky will lose his blank check in his fight against Russia. Presumptive Speaker McCarthy practically stated this in a recent interview. We think Republicans will fund Ukrainian playing defense and returning to pre-2022 invasion borders, but we believe they will not fund Ukraine taking back Crimea.

Foreign aid is never popular, as politicians prefer domestic priorities. Additionally, Crimean invasion would greatly lengthen the war, well beyond 2023, and the better Ukraine does in Crimea, the greater the chance of nuclear weapons being deployed. We think the complete unity that the US and European coalition has with Ukraine now withers under the glare of another cold winter in 2024 and the unknown consequences of trying to keep a nuclear war limited. We do think a Republican victory will likely shorten the war as Ukraine will eventually be on a tighter leash. President Biden and his Democratic friends don’t need the Ukraine war in the 2024 election either, though that doesn’t seem to enter their calculus currently. Any resolution to Ukraine is a very stock market positive event, how positive depends on whether Russian energy can return to Western Europe or whether it is a frozen conflict.

However, this end game plays out over many months, so we do not expect a significant hit to defense stocks on November 9. The war will continue to be featured on the Nightly News and the fighting in Donbas will be fierce, supporting all things defense.

The other reason we don’t believe that defense stocks will collapse emanates from Beijing. The 5-year party Congress just concluded with all internal threats to Chairman Xi purged from the politburo. In general, the pragmatists favoring economic interests were replaced by those focused on security, party discipline and the reunification of Taiwan. The most recent Biden decision to ban semiconductor capital equipment sales of leading-edge equipment plays into the hands of Chinese hardliners, as a cold war with China turns progressively hotter. From Xi’s point of view, if the West won’t sell him leading-edge semiconductors or the equipment to make his chips, then Taiwan probably looks that much more enticing. Unfortunately, those in the Communist Party leadership who urged caution toward Taiwan reunification have been replaced by those favoring a more muscular foreign policy.  And those that focused on economic ramifications have been overwhelmed by those favoring party discipline.

While it is hard to imagine that a war over Taiwan starts imminently, the threat will only continue to grow over the next few years, especially, if China is incapable of persuading Taiwanese hearts and minds. This will keep defense spending high for the West, even if the Ukraine conflict is somehow solved in the next year.

Overall, we expect the mid-term election to be a slightly market-positive event. The stock market has historically done well with a divided government when power is not controlled by one party in all branches of government. We do not see how the Ukraine war ends but think that both Russia and Ukraine will be more motivated to find a solution after what could be a brutal winter of death and destruction and if their funders and enablers grow less tolerant of the huge economic price the world is paying.

The Fed enters the picture too as we believe that another 75-basis point rate increase is imminent the week before the mid-term election and market reaction will depend on the spin they put on the future. If they say future increases will be smaller and the Fed understands that monetary policy works with a lag, markets will surely rise. If they continue to be solely focused on trailing CPI numbers and fighting inflation as job one, two and three, then markets will probably respond negatively. Either way, we think the Fed will have to slow future increases by year-end as the incoming data could be significantly negative. We also expect to see unemployment rise shortly after Christmas, if not before, and at that point, a sustainable market rally could happen as the Fed will stop being the enemy.

We favor building positions in stocks and bonds during any dips in the fourth quarter, as we expect the Fed and a divided government to be helpful for stocks in 2023.  Buying during times of stress should be rewarded, as the market will be much higher once the all-clear signal is beaming bright.


The views expressed are those of Spouting Rock Asset Management platform, as of November 1, 2022, and are not intended as investment advice or recommendation.  For informational purposes only.  Investments are subject to market risk, including the loss of principal.  Past performance does not guarantee future results.  There can be no assurances that any of the trends described will continue or will not reverse.  Past events and trends do not imply, predict, or guarantee, and are not necessarily indicative of future events or results.  Investors cannot invest directly in an index. 

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