Stock week ahead: How the interim period could affect Wall Street

A version of this story first appeared in CNN Business’ Before the Bell newsletter. Not a subscriber? You can sign up right here.

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Last week was a volatile one on Wall Street, with stocks falling after Federal Reserve Chairman Jerome Powell dashed the market’s dreams of a pivot and hinted that more big rate hikes were likely to come. But Wall Street still turns its hopes to Washington.

Investors are betting on a big Republican wave in the midterm elections. If Republicans take at least one chamber of Congress in Tuesday’s midterm elections, it will likely result in more gridlock, which the market usually loves.

According to data from Edelman Financial Engines, the S&P 500 had an annual return of 16.9% since 1948 during the nine years when a Democrat was in the White House and Republicans held majorities in both houses of Congress. That compares to 15.1% during periods of full Democratic control and 15.9% during years of unified GOP government.

Investors are more than happy when politicians argue but don’t actually pass new laws that could hurt corporate profits.

An example is taxes on companies.

“What do mid-terms mean for the markets? If Republicans get the House, tax increases are dead in the water, said David Wagner, a portfolio manager at Aptus Capital Advisors. Republicans may be less likely to approve a windfall tax on oil company profits, nor are they generally in favor of tax increases on the wealthy.

The market is also betting that certain sectors can get a boost – even if the Republicans take control of the House or the Senate and presumably make it more difficult for President Biden to get laws passed.

That’s because there are some areas of consensus for the White House and Republican lawmakers.

“A GOP sweep could lead to more spending on defense,” Wagner said. “Increasing the budget for defense appears to be a bipartisan issue.” The House passed a record defense budget proposal this summer.

Biden and Republicans also appear to be on the same page when it comes to increasing infrastructure spending. It can give a boost to utilities, construction companies and some property stocks. Congress passed a more than $1 trillion bipartisan infrastructure bill last year that was, after all, championed by President Biden. But it’s not yet clear what the appetite for more spending is … although there is consensus that more is needed.

“Everything is polarized politically, but there has been common ground regarding infrastructure. It was even the case with [Donald] Trump and [Hillary] Clinton in 2016,” said Jim Lydotes, deputy chief investment officer for equities at Newton Investment Management. “As a country, we’ve underinvested in infrastructure. That’s an area where there’s a lot of agreement.”

Of course, there is no guarantee that Biden and other Democratic leaders will be able to work effectively with Republicans in Congress. After all, the political narrative will quickly shift to the 2024 presidential election when the midterms are in the rearview mirror. Congress and the White House can spend more time arguing than trying to pass legislation.

There could also be some significant downsides to a divided government, especially if fears of a recession come to fruition next year.

Rob Dent, senior U.S. economist at Nomura Securities International, said there could be less federal spending on social safety net programs if Republicans take control of Congress.

“All things being equal, that could lead to a longer recovery from a recession,” Dent said. That would be bad for stocks more generally since consumer spending drives corporate profits.

Dent added that there is also the unwelcome possibility of more bickering in Washington over the debt ceiling. The last time it was a big deal was during President Barack Obama’s first term. The US lost its prized perfect AAA credit rating from Standard & Poor’s as a result of the debt ceiling drama. The stock market plunged more than 5% after the downgrade occurred in August 2011.

“This election result is less about what might be done versus what might not be done to help the economy during a downturn,” Dent said. “We are concerned about the division of the government leading to randmanism about the debt limit and the potential for a government shutdown. We haven’t had to deal with that for a long time.”

But at the end of the day, political headlines are often just noise for the markets. Ameriprise chief market strategist Anthony Saglimbene said on a conference call last week about the midterms that stocks have historically rallied after elections, regardless of which party controls the White House and Congress.

The midterms can also take a “back seat” to other macro issues. Saglimbene noted that “growth, profits, inflation and interest rates” matter more to investors in the long term. He admitted that election results could lead to more volatility in the short term, but that the market is already pricing in a strong likelihood of divided government.

Politically induced market and economic volatility is the last thing that consumers, investors or the Fed need, given that inflation has proven not to be transitory as Fed Chair Powell had predicted for much of 2021.

It is clear that higher prices for raw materials and other raw materials, freight and other transport costs and labor costs will not disappear anytime soon.

Steve Cahillane, CEO of cereal and snack giant Kellogg ( K ), even said on the company’s latest earnings call last week that the idea that “inflation was going to be transitory was always patently ridiculous.”

We will get a better sense of how persistent inflation is on Thursday after the government reports the consumer price index (CPI) from September.

Economists polled by Reuters forecast overall prices rose 0.7% last month, up from a 0.4% increase in September. That is likely to push year-on-year prices, which rose 8.2% in the last 12 months through September, even higher as well. The continued strength of the labor market will also put more pressure on prices.

“The labor market is robust and inflation is spreading to the service sector as well,” said Troy Gayeski, investment strategist at FS Investments.

This may lead to more concerns that the economy may be heading towards a so-called stagflation environment, a period where stagnant growth occurs together with high inflation. If that happens, the Fed will likely keep interest rates higher for longer.

“We will leave this inflation/stagflation situation eventually,” Gayeski said. “But it’s not like the Fed is going to quickly cut interest rates back to zero. It’s going to be very cautious.”

Monday: China trade data; revenue from BioNTech (BNTX), Take-Two (TTWO), Ryanair (RYAAY) and Lyft (LYFT)

Tuesday: United States midterm elections; earnings from DuPont (DD), Norwegian Cruise Line (NCLH), Lordstown Motors, Disney (DIS), Occidental Petroleum (OXY), News Corp (NWS), IAC (IAC), AMC (AMC) and Novavax (NVAX)

Wednesday: China inflation data; revenue from DR Horton (DHI), Weibo (WB), Hanesbrands (HBI), Capri Holdings (CPRI), Roblox, SeaWorld (SEAS), Wendy’s (WEN), Redfin (RDFN), and Beyond Meat (BYND)

Thursday: US CPI; US Weekly Jobless Claims; revenue from Nio (NIO), Ralph Lauren (RL), Tapestry (TPR), WeWork, Six Flags (SIX), Yeti (YETI) and Warby Parker

Friday: US bond market closed for Veterans Day; UK GDP; US U. of Michigan consumer sentiment; earnings from SoftBank (SFTBF)

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