What matters for markets in the midterm elections

James G. Cole

There’s plenty of political drama surrounding the Nov. 8 midterm elections. Will Donald Trump’s chosen candidates run the table? Is the future of democracy really at stake? Will the guy in the hoodie actually make it to the stuffy Senate?

The financial stakes are high, too, even if you’re not a political junkie. With control of both houses of Congress on the line, the outcome of the midterms will determine what type of legislation Congress passes and how the whole government functions for the next two years, setting the terms for the 2024 presidential election.

There are five possible outcomes, with the size of the ruling party’s majority in the Senate being important, since it affects the filibuster and the vote margin required to pass legislation.

1. Democrats retain control of both houses of Congress with a one- or two-seat majority in the Senate (unlikely).

2. Democrats retain control with a majority of three seats or more in the Senate (unlikely).

3. Republicans gain control of the House while Democrats keep the Senate (possible).

4. Republicans gain control of the Senate while Democrats keep the House (unlikely).

5. Republicans gain control of both houses, with a single-digit majority in the Senate (possible).

If Republicans win one or both houses, that will effectively end President Biden’s legislative agenda, since they can block any Democratic bill from passing. Congress will still have to pass must-do legislation, such as funding for defense and other government functions. But even that could be rocky, with Republicans threatening to block routine spending bills, as they have done before. Democratic Sen. Chris Murphy of Connecticut warned recently that if Republicans win one or both houses, they’ll generate “a series of shutdowns and funding crises.”

That may be hyperbole. Shutting down the government has mostly been a Republican exercise during the last 25 years, and voters typically punish them for it. So Republicans might seek new tactics. One test will arrive around the middle of 2023, when Congress will have to extend the federal borrowing limit again. Democrats passed the last debt ceiling extension in December 2021 without fanfare, so the contrast would be stark if Republicans face the task and can’t get it done.

Republicans might try to block one Biden policy already in place: beefing up the IRS. The Inflation Reduction Act Congress passed in August includes $80 billion in additional funding for the Internal Revenue Service to hire new auditors, upgrade ancient computer systems and improve customer service, through 2031. That money is on top of the IRS’s annual budget of about $13 billion per year.

U.S. Senate Minority leader Mitch McConnell (R-KY), answers questions during the weekly Republican news conference on Capitol Hill in Washington, U.S., September, 13, 2022. REUTERS/Evelyn Hockstein

U.S. Senate Minority leader Mitch McConnell (R-KY), answers questions during the weekly Republican news conference on Capitol Hill in Washington, U.S., September, 13, 2022. REUTERS/Evelyn Hockstein

If Republicans controlled both ends of Congress and passed a law clawing back this money, Biden wouldn’t sign it. But they could also try to pass spending bills that cut the IRS’s annual budget, offsetting some of the new funding. Biden wouldn’t sign those, either. But this is one way a government shutdown could happen: With Republicans in charge of the legislative process passing spending bills that include some measures Biden strenuously opposes, and each side blaming the other for whatever impasse develops.

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If Republicans control one or both chambers and a recession occurs, fiscal stimulus could be more restrained than if Democrats were in charge. “Should the economy enter recession, there is likely to be less of a fiscal put under part Republican control,” Libby Cantrill of investing giant Pimco wrote in a recent analysis. “The market cannot depend on Congress from saving the economy from a downturn with more fiscal support as it has over the past few years.”

What happens if Democrats keep control?

Markets seem to have priced in a limited Congressional agenda during the next two years, which makes sense since most analysts think Republicans will win at least one chamber of Congress, despite Democratic gains during the last couple of months. It gets more interesting if Democrats keep control of Congress.

Biden has signed several big bills during his first two years as president, including the COVID relief act early in 2021, a bipartisan infrastructure bill later in 2021, the green-energy legislation this year, and the CHIPS Act meant to boost economic competition with China. But he also has a large unfinished agenda that mostly includes social welfare spending.

This is where the size of the majority in the Senate would matter. Democrats couldn’t pass the left-leaning social-welfare plan largely because of opposition within the party from Sen. Joe Manchin of West Virginia, and to a lesser extent Kyrsten Sinema of Arizona. Neither is up for re-election, and if Democrats keep control but still maintain the puny one-seat Senate majority they have now, Manchin and Sinema would probably still exert de facto veto power over the Democratic measures they’ve already scuttled. That includes tax hikes on businesses or wealthy Americans, which Manchin would accept under some circumstances, but Sinema opposes.

U.S. Senator Kyrsten Sinema (D-AZ) waits for an elevator to go to the Senate floor at the U.S. Capitol in Washington, U.S. August 2, 2022.  REUTERS/Jonathan Ernst

U.S. Senator Kyrsten Sinema (D-AZ) waits for an elevator to go to the Senate floor at the U.S. Capitol in Washington, U.S. August 2, 2022. REUTERS/Jonathan Ernst

If Democrats keep control and add at least two Senate seats, however, Manchin and Sinema matter less, because Dems could pass bills even if the two spoilers vote against them. That would put some of Biden’s social-welfare priorities back on the table. This, markets do not anticipate.

Early in his presidency, Biden proposed an “American Families Plan” including free college, subsidized child care, free universal pre-school, paid leave and many other benefits, mostly for middle- and lower-income Americans. The cost was close to $2 trillion.

To pay for it, Biden would have raised the corporate tax rate from 21% to 28% and hiked a variety of taxes on high-income Americans. None of those measures ended up in legislation that Congress was able to pass since Biden took office. The only meaningful tax hikes were a minimum 15% tax on big companies that don’t otherwise pay federal income tax, and a new 1% tax on certain stock buybacks.

If Democrats pull off a November upset and increase their margins in both houses, these abandoned measures could return as part of a “reconciliation” package Democrats could pass by bypassing the Senate filibuster that requires 60 votes. Markets would have to adjust to the prospect of more spending and higher taxes.

Can Democrats do it? Most forecasters doubt it, given Biden’s weak approval rating, a spate of incumbent Democratic retirements and the traditional midterm snapback effect in which the president’s party typically loses seats. But it’s not a normal midterm cycle. The Supreme Court’s overturn of national abortion protections in June seems likely to boost Democratic turnout in November. Trump remains a factor, since he has endorsed a number of far-right candidates who won Republican primaries but could bomb in the general elections. Democrats have outperformed in a handful of Congressional special elections, suggesting they could surprise in November, as well. Take nothing for granted.

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