Counting US mid-term votes, bracing for recession

Key takeaways

• The US’s mid-term elections will determine the pace of policy change over the next two years of the Biden administration
• The Fed anticipates a higher terminal rate. A slower hiking pace would leave more space to monitor the economic impact of higher borrowing costs
• We expect US growth to slow, with potential for a recession starting late 2022 and lasting through the first half of 2023
• We prefer US to European sovereign debt, remain underweight US equities, favouring quality stocks, and keep our overweight exposure to the US dollar.

America’s voters are preparing for mid-term elections on 8 November. The world is watching the US economy as its monetary policy evolves to reflect slowing inflation, and braces for an expected recession in 2023. We will share an assessment of the election results as soon as they become clear.

After the 2020 presidential election’s claims that Donald Trump was deprived of a second term, much attention is on the political integrity of the US voting system. Once the mid-term voting ends, the result may take days to count. If some ballots are subjected to legal challenges, which seems likely in the currently polarised environment, a result could be even longer. While discussions about the fragility of US democracy surround the vote, investors are more concerned with the evolving path of monetary policy.

The elections fall at a key moment in the US’s economic and monetary policy cycle. The economy is consistently top of voters’ concerns and consumer spending, according to credit card data, is slowing. US inflation remains stubbornly high, at 8.2% in September, despite the fastest interest rate hikes in four decades. The job market is only slowly reflecting the effects of rising borrowing costs. Its evolution will be key to monetary policy. The American economy added 261,000 jobs in October, the third consecutive monthly decline in new positions. That lifted the unemployment rate by 0.2% to 3.7%, barely higher than the 50-year, pre-pandemic low, suggesting that workers remain in demand despite recession forecasts.

If these trends continue, they will add to justifications for the US central bank to slow its rate hikes. Last week, the Federal Reserve signalled two important shifts in outlook. First, its rate hikes will start to slow, probably as soon as December and second, it will not wait for confirmation that inflation has peaked before shifting gear. After four consecutive 75 basis point (bp) increases to bring the target rate to 3.75%-4%, the pace of rate hikes may therefore drop to a 50 bp increase in December, and to 25 bp at the February and March 2023 meetings. The chances are also rising that further rate hikes are needed, perhaps into May. That would take the US’s so-called terminal, or peak interest rate, to around 5%.

Watching and waiting

In the process, the central bank is building itself more room to observe the impact of higher borrowing costs on the real economy, which in turn lowers the risk of monetary policy mistakes. The less positive side of that approach is that it leaves the US economy lingering in a phase of limited growth, or recession, for longer. In December, the Fed will release a new outlook for interest rates.

It looks highly probable that the cost of containing inflation will be a US recession. Once the slowdown materialises, we expect tighter monetary policy to impact the job market, increasing unemployment, weakening wage growth and further cooling the already-slowing housing market.

Monetary policy does not of course play out in a vacuum. US economic growth, on the face of it, looks sound. The American economy expanded by 2.6% in the third quarter of 2022, following declines in the first two quarters of the year. However, that headline figure masks that housing and consumer spending are both in decline, and exports of crude oil helped exports, cutting the trade deficit. Overall, we see the potential for the US economy to fall into recession as soon as late 2022, continuing through the first half of 2023. GDP growth for 2022 is therefore likely to be 1.5% and closer to 1.4% in 2023.

Poll dance

In line with mid-term elections historically, opinion polls are pointing to the Democrats losing seats in both the House of Representatives and Senate. Recent studies show that whatever the state of the US economy, or the popularity of the sitting president, the incumbent party historically consistently loses ground in mid-term elections. 2022 is unlikely to be an exception. President Joe Biden has poor approval ratings of around 40%, and core inflation, which excludes the most volatile elements of food and energy, remains at its highest level since August 1982, weighing on consumers’ willingness to spend.

As a result, a model run by FiveThirtyEight, a polling website, points to an 85% probability of the Republicans winning a majority in the House of Representatives where all 435 seats are up for election and the Democrats currently hold a majority of just eight seats. Polling for the Senate, where 35 out of the 100 seats are being contested, is much closer to call, in line with today’s even split. Further, a series of state and local offices will be decided that will affect the Biden administration’s ability to pass legislation over the next two years.

In this polarised scenario, we see little chance of significant change in taxes, environmental legislation, nor restrictions on technology firms. In the short run, a newly elected Congress with a higher share of Republicans may decide to push the US towards a political fight over the country’s debt ceiling, forcing the Biden administration into budget cuts. Before 2024’s next presidential election, a more polarised Congress will undoubtedly deliver less fiscal spending. Still, the Biden administration has already passed fiscal stimulus worth USD 1.2 trillion to increase spending on infrastructure, a further USD 390 billion to stimulate the transition to cleaner energy, and USD 280 billion to improve innovation and investment in the country’s semiconductor industry. These programmes will not be reversed, even if control of either or both chambers of Congress flips to the Republican Party.