US mid-terms: tight race points to split Congress

Key takeaways

• Amid poorer than expected results for the Republicans, the Party still looks likely to win the House with a slim majority, while the race for the Senate remains very tight
• A divided Congress would increase policy gridlock. We expect a tougher line on fiscal discipline – e.g. on any stimulus during the upcoming recession, but the risk of a fight over the debt ceiling has receded somewhat. Financial support for Ukraine could come under more scrutiny
• The bigger market driver remains the trajectory of monetary policy. We see interest rates peaking around 5% and a tough three quarters ahead for the US economy
• We retain an overweight position in US Treasuries and the dollar, and favour quality stocks within our US equity holdings.

US mid-term elections on 8 November saw an unexpectedly tight race, with early results indicating that the Democrats could narrowly hold the Senate – although the results are too close to call either way – and the Republicans win a slim House majority. At the time of writing, the Democrats had 48 seats in the Senate versus the Republicans’ 48 (51 needed for a majority). In the House, the Republicans had 199 seats versus 178 for the Democrats (218 needed for a majority¹). The final results might not be known for weeks, and in Georgia there is the possibility of run-off elections in December. The results may also be legally contested, extending the questioning of US democratic processes that began with the 2020 presidential election.

The President’s party historically tends to lose seats in the mid-terms, and Joe Biden’s low approval levels (53% of Americans disapprove of the way he is handling the job²), were expected to weigh on the Democrat’s performance. Over the summer, the Democrats fared better in the polls: a strong labour market, the Inflation Reduction Act’s (IRA) passage, the Supreme Court’s abortion decision, and petrol prices easing from June highs were all boosting their chances.

But at the ballot box, concerns over the economy weighed heaviest on voters’ minds. The cost of living is creating strains across the income spectrum. Petrol prices are rising again, while voters are also concerned about crime and illegal immigration, slowing growth and 8.2% annual inflation, all of which strongly favoured the Republicans. However, the Republicans, and in particular candidates supported by former President Donald Trump, are underperforming expectations that they would see stronger gains.

More policy gridlock

The key impact of an expected divided Congress would be greater curbs on the Democrats’ ability to pass new legislation, increasing policy gridlock, and forcing more bipartisan compromise in areas such as defence, support for Ukraine and reducing supply chain dependence on China. Still, there is already broad agreement on the latter, and we do not expect significant changes in taxes, environmental legislation or technology firm regulation following these elections.

With a split Congress, the Republicans will likely take a tougher line on fiscal discipline, for example curbing any stimulus the Democrats may seek to launch during the coming recession. That said, the Democrats had frontloaded many key policy initiatives and stimulus into their first two years, including the IRA, almost USD 1.9 trillion in spending on infrastructure, clean energy and semiconductors, as well as drug pricing and Medicare reform, and changes to heads of regulators and other agencies. Tighter control over fiscal spending may also raise the risk of government shutdowns, should Congress not renew annual government funding before a 16 December deadline, and the new Congress takes office. The deadline traditionally falls around October, and the risk of disruption may reappear in 2023 and 2024.

Tighter fiscal discipline and debt ceiling risks

A thin Republican majority in the House would reduce the risk that the Party uses the US debt ceiling to try and force the Democrats into spending cuts and concessions. A breach of the ceiling in the coming months may trigger extraordinary US Treasury measures. Republican Patrick McHenry, the likely new chair of the House Committee on Financial Services, has highlighted the risks of using the ceiling as a bargaining chip, suggesting that sense will again prevail. We thus believe the chance of a technical default is very slim. Meanwhile, Democrats are reportedly discussing ways to raise the ceiling – potentially as far as 2024 – in the coming months before a new Congress is sworn in.

While there is broad consensus for sanctions on Russia following its invasion of Ukraine, Republican gains could see more opposition to US military and financial aid to the Ukraine. Eight months into the conflict, Republicans are divided over spending with little sign of the conflict ending. Some are asking for greater oversight and accountability; others question whether funds should rather be spent on domestic economic problems. Democrats could seek funding for Ukraine by passing an aid package before 3 January, when Congress will change hands.

Losing control of the House will make President Biden’s remaining tenure more difficult, and reduce his chances of standing for office again in 2024. The Republicans may launch probes into his executive actions. A likely Republican decision to close the investigation into the 6 January 2021 attack on the US Capitol could further divide a country where the political system remains under fire and tensions high. However, poorer-than-expected mid-term results for the Republicans, and a resounding win for Republican rival Florida Governor Ron DeSantis, may complicate Mr Trump’s expected run for the 2024 Presidential elections. The former president is expected to announce his candidacy on 15 November.

A crucial time in the cycle

The mid-term elections come at a crucial moment in the economic cycle. While they are an important test for a beleaguered US political system, the bigger market driver, of course, remains the trajectory of US monetary policy, which depends on progress in fighting inflation, and, crucially, on developments in a tight labour market.

While October data showed jobs growth continuing to cool, labour shortages mean the unemployment rate remains persistently low and pressure on wages uncomfortably high, keeping pressure on the Fed to tighten policy. After November’s fourth straight 75 basis point (bps) hike, we expect a slowing to 50 bps in December, and rates to peak at around 5.0% in 2023. We forecast three tough quarters ahead for the US economy, and real gross domestic product growth of just 0.7% next year, with both the housing and labour markets suffering under tighter financial conditions.