What midterm election results could mean for the market outlook

Review the latest Weekly Headings by CIO Larry Adam.

Key takeaways:

• Composition of the House is likely to shift, while the Senate is a toss-up
• Items such as government funding and the debt ceiling will need to be addressed
• Fundamentals will remain the driver of the market in the long term

As the days grow shorter and the nights longer, Americans will turn their clocks back, shifting from daylight saving time to standard time. But the clocks won’t be the only thing changing. Americans will also head to the polls, with the potential to reshape Congress in the 2026 midterm elections. More than 46 million voters have already cast their ballots, surpassing the total early vote in 2022. And with affordability top of mind, inflation and gas prices moving higher and a majority of Americans believing the economy is headed in the wrong direction, both polls and betting markets point to a potential shift in the balance of power. With the outcome likely to shape Washington’s legislative agenda, below we outline our election base case, what to watch for on election night and what the results could mean for the market outlook.

Is a shift in power likely?

If there is one constant in Washington, it is change. Since 2000, only one election has left the balance of power unchanged. Our base case is no different: Democrats flip the House (our policy team assigns a 90% probability), while the Senate remains a toss-up. With Democrats needing four seats to take control, key races to watch include Texas, Michigan, Maine and Alaska. Beyond Washington, however, the 36 gubernatorial races may prove just as consequential. With data center policy largely set at the state level, these races could shape the direction of AI policy, with important implications for investment, economic growth and equity markets.

Is a blue wave in the cards?

Midterms have often produced wave elections, with the party out of power picking up a significant number of seats. In 2010, Republicans flipped 63 House seats; in 2018, Democrats flipped 44. Could we see a similar tsunami-like shift this year? We don’t think so. While Democrats have built a sizable lead in the Generic House Ballot (+9), the number of truly competitive districts has dwindled. As a result, we expect Democrats to pick up closer to 20 seats, roughly in line with the historical average. Still, if a bigger wave begins to build on election night, we’ll be watching races such as VA-02, VA-07, and key Iowa and Kentucky districts for early signs.

What are the policy implications?

Coming off one of the least productive Congresses in modern history, the outlook for major legislation remains limited. Still, several must-address issues loom. Congress will need to pass appropriations bills or a continuing resolution to fund the government beyond December 12 and avoid a government shutdown, while also raising the debt ceiling, expected to become binding sometime next year. Spending priorities, particularly healthcare and defense, will likely be key areas of negotiation. But even if legislative activity remains subdued, policy risk will not disappear. The president retains broad authority over trade through executive action, making tariffs a potential source of economic and market volatility over the next 24 months. Geopolitical and military decisions, particularly in the near term, could also remain an important source of uncertainty, with much of that decision-making resting with the president.

What is the impact on the economy and markets?

When we rank the fundamental drivers of the markets, politics comes in eighth out of 10. Why? Because fundamentals such as GDP growth, earnings, valuations and monetary policy ultimately matter more. But this cycle could be slightly different. The growing number of data center moratoriums could have broader implications given AI’s increasing contribution to investment, economic growth and earnings. With that in mind, here is how the election could shape our market outlook:

• Economy: Historically, economic growth has been a bit slower under divided government. Annualized GDP growth has averaged 2.8% under divided government versus 3.7% under one-party control. Notably, 10 of the 13 recessions since 1945 have occurred during periods of divided government. One reason may be that unified governments have an easier time passing large fiscal packages, leaving less policy flexibility under divided government if the economy weakens. For now, we are maintaining our 2027 GDP forecast of 2.3%. However, we will be watching whether data center delays or moratoriums slow the momentum in capex spending and create downside risk to growth.
• Equities: Similar to the economy, S&P 500 returns have historically been slightly stronger under unified government, averaging approximately 9.5% annualized versus 8.2% under divided government. But the more compelling trend is what happens after midterms. Regardless of which party wins, the S&P 500 has gained an average ~15% in the 12 months following a midterm election and, remarkably, has been positive after every midterm since 1942, a streak spanning 21 consecutive elections. Combined with a constructive earnings backdrop, that history leaves us comfortable with our 12-month S&P 500 target of 8,450. However, beyond 2028, rising populism fueled by widening income inequality could bring higher capital gains, dividend and corporate tax rates, creating a longer-term headwind for equities.
• Fixed income: The election outcome does not change our outlook for the Federal Reserve, where we expect just one hike in December over the next 12 months, or for interest rates, with a 12-month 10-year Treasury yield target of 4.5% to 4.75%. With the deficit running near $2 trillion, the bid-to-cover ratio remains a key gauge of investor appetite for US Treasuries, and we expect demand to remain healthy at approximately 2.5x.

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