US midterm elections were broadly in line with expectations: the Democrats captured the House but Republicans retained control of the Senate. While markets were volatile as the votes were counted, the lack of a major surprise limits the net market response. The outlook for trade policy and the Fed will be unchanged. Major spending cuts and further tax cuts are both unlikely, while there could be some talk of an infrastructure package.
The Democratic Party recaptured control of the House of Representatives for the first time since losing it in the 2010 “Tea Party” wave but the Republican Party easily kept control of the Senate. So from 3 January 2019, Congress will revert to the historically common situation of being split between the two parties.
This outcome was our base case, with an 85% probability, given consistent polling favouring Democrats nationally and the fact that the mixture of Senate seats being contested (just 35 of 100) tilted very heavily in the Republicans’ favour (2020 is a different story).
The Democratic party gained at least 26 seats in the House, with an additional 15 seats yet to be called while Republicans strengthened their slim Senate majority by 2 seats.
What comes next?
Retaking the House allows the Democrats to set the legislative agenda. But deep partisan divide seems likely to ensure many proposals passed by a Democrat-controlled House are blocked by a Republican-controlled Senate before ever reaching the president’s desk. Signature legislation thus faces a tough uphill battle. Trump’s agenda is not necessarily crippled but it will certainly face headwinds.
Extending last year’s tax cuts (Tax Cuts 2.0), a key priority for Republicans is very unlikely with Democrats running the House.
Further deregulation in various sectors such as energy and banking will likely rely exclusively on executive order and is likely to be smaller in scale.
Infrastructure is likely to be revived, long favoured by Democrats and Trump, though they remain very far apart on key details. Democrats prefer federal spending to drive capital works while the administration has pushed for private sector participation. Any infrastructure push needs to overcome a Republican-led Senate too. Fiscal deficits approaching $1trn will arguably check any meaningful infrastructure spend as well.
It is an open question how key fiscal deadlines will be dealt with going forward. Congress averted a government shutdown before the midterms by passing a short term funding bill that expires 8 December 2018, raising yet again the prospect of a partial shutdown then. The debt limit is currently suspended, but due to be reinstated on 1 March 2019 at the prevailing stock of public debt, probably around $22 trillion, up more than $1 trillion since the suspension on 9 February 2018. Funding the government and raising the debt ceiling to avoid default has been typically less fraught when Democrats have been in charge of the House, but they may be less willing to compromise after their midterm victory.
Aside from economic issues, House Democrats are sure to launch multiple select committees to investigate Trump’s finances and Russian collusion even more aggressively.
President Trump will still have great leeway to pursue his trade policies, with little need to consult Congress on e.g. China tariffs. Over decades, Congress has delegated substantial powers over trade to the president. This year’s tariffs on both metals and a wide range of goods imports from China did not require Congressional approval. Trump’s protectionist agenda enjoys a sympathetic ear with Democrats too and is unlikely to meet any meaningful resistance from a Democrat led House. The outcome of the Trump-Xi summit at the Buenos Aires G20 at the end of November will be much more significant. Trump has tasked US officials with drafting terms of a potential deal and officials in both China and the US have sounded hopeful albeit cautious.
Congress is likely to vote on ratification of the revised NAFTA deal early next year and will need to win some Democrat support if it is to pass the House; that is no sure thing with Democrats reportedly seeking even stronger provisions to protect US labour interests.
The Fed will brush aside any questions of politics and will proceed with a December rate hike. Trump will likely continue to periodically criticise the Fed for raising interest rates and cast doubt about Chair Powell.
The US economy is in good shape; the labour market is close to full employment and inflation is near the Fed’s 2% target. The outcome of the midterm elections does not materially impact the US growth outlook either way and thus shouldn’t alter the USD’s medium term trend. Fed tightening will remain a key pillar of support for the USD going forward.