Manage client expectations through the midterms

Inflation remains the hot-button issue for voters in advance of the 2022 midterms. Nationwide Economics expects consumer inflation to remain highly elevated into 2023 while gradually slowing over the next year. The Federal Reserve is projected to tighten the Fed funds target rate sharply through the end of 2022 as it fights inflation. Interest rates are expected to remain higher next year and into 2024 to prevent a renewed surge in prices, even with an economic downturn likely in 2023.

That doesn’t bode well for the party currently in control of Congress, the Democrats, nor for the future of unified government with Congress and the White House under one-party control. It should be noted the outcomes of the midterms are uncertain as of this writing. However, historical precedent points to the difficulty of maintaining unified government after midterm elections. That raises the likelihood of divided government over the next two years.

How could the midterm elections affect the economy?

With all the uncertainty around the election outcomes, it’s hard to say what the impact on the economy will be after Election Day. Democrats have been able to enact some priorities from their agenda while controlling Congress over the last two years. That has helped sustain the economy through the COVID recovery, but seems unlikely to continue under divided government.

We don’t expect any significant changes in federal government spending in the next Congressional term, even if Democrats are able to hold on to the House and Senate. The stimulus efforts that were passed under unified government, such as the infrastructure bill, should continue to provide some modest support to the economy over the next two years and beyond. This likely means the Fed will remain the greater focus for economic policy changes in coming years. Moreover, should the economy slip into a recession next year, the odds of further fiscal stimulus support are low.

Watch our recent midterm election perspective video for insights on the impacts for the markets and economy.

How could the midterm elections impact financial markets?

Midterm election years have historically been very volatile for equity markets. Seen through that lens, it doesn’t seem surprising for markets to be so volatile this past year. In the months leading up to the midterms, uncertainty tends to stress investors, creating market turbulence. In addition, the party in power often adopts policies intended to rally their base, not necessarily to spur economic growth.

Stocks have faced a litany of challenges this year, on top of the uncertainty that has loomed over the midterm elections. However, market performance has historically performed well in the six months following an election than in the six months prior. (See chart above.)  Moreover, since World War II, every 12-month period after the midterms have seen positive returns for the S&P 500 with an average 12-month gain of 17%.

This year’s stock market downturn, which has led to year-to-date losses of approximately 24%, certainly fits the historical narrative. But persistently high inflation, hawkish central bank policy and recession uncertainty are likely to create headwinds that could stifle a post-midterm equity rally.\

How financial professionals can guide clients through election season

The election cycle can be a tricky period for financial professionals, as they help clients keep their long-term focus and avoid emotional decisions. Historically, election outcomes and political control of government have had little impact on financial market performance. (See chart below.) Guidance for clients should emphasize tuning out the noise and turning to the fundamentals of economic and business performance, which have a more significant impact on the return opportunity from their investments.

That may be easier said than done. With the rise of political polarization and tribalism in recent years, clients who are more politically inclined may see connections between their political leanings and their financial plans that don’t exist.

Nowadays, we all have more information at our fingertips. Investors have to rely on their judgment and their financial professionals to identify valuable insights in the information glut. Our updated white paper on Investing in a Highly Politicized Climate can help maintain perspective and stay focused through the noise of the election cycle.