Midterms and Markets: A 2022 Guide for Investors

A historic U.S. midterm election is fast approaching. Whether Republicans prevail in one or both chambers, or in the unlikely event that Democrats retain control in Washington, the implications could be significant for markets and key equity sectors, including defense, tech and industrials. Here’s a look at the election scenarios and how investors should consider preparing.

For months, the midterms have appeared likely to break in favor of Republicans in one or both chambers. Two key reasons: 

• Historically, voters have generally not favored the political party in power. Going back to 1922, the party of the sitting president has lost, on average, 30 seats in the House of Representatives and four in the Senate in midterms. Even if Democrats perform better than the historical averages would suggest, their narrow control of both chambers of Congress means they could still easily lose both bodies.  

• Democrats may face a more competitive landscape than Republicans. As of mid-September, of all the seats up for election in the House, 34 races were considered competitive for Democrats, compared with just 11 for Republicans. In the Senate, meanwhile, three contests were seen as toss-ups for Democratic incumbents running in traditional GOP strongholds, versus two likely toss-ups for Republicans in states that tend to break for the GOP.

Of course, when planning ahead, investors should leave room for scenarios that go against current consensus—in this case, the possibility that Democrats retain control of Congress. Indeed, a narrow path to Democratic victory may be emerging. While Republicans held solid polling leads through August, Democrats in recent weeks were slightly favored to win the Senate and have been polling ahead of Republicans, on average, by very thin margins in the House.

So, what would a Republican or Democratic victory mean for investors? Let’s look at two scenarios: 

In the unlikely event that Democrats retain control of both legislative chambers, they would likely continue to pursue President Biden’s policy priorities from the last session. These include additional fiscal stimulus for expanded access to healthcare and housing aid, as well as increased support for lower-income families and children. These spending priorities could lead to revived tax proposals aimed at high earners, who narrowly avoided increases to individual income taxes, capital gains taxes and other wealth-related taxes earlier this year.

In addition, we would expect Democrats to intensify regulatory scrutiny of the financial and technology industries, likely increasing businesses’ compliance costs and weighing on their stocks in the near term. That said, our analysis of past regulatory trends shows such headwinds tend to dissipate within a couple years, with equities in affected sectors rallying back to outperform the broader market.

On the other hand, if Republicans win one or both chambers, investors may want to brace for more gridlock—whether between a GOP-controlled legislative branch and a Democratic White House or within a split Congress. Such divided-government scenarios could make it harder to implement major spending initiatives or policy changes over the next two years.

However, even in a more divided government, there could be room for bipartisan cooperation on a number of key policy priorities, with the potential to create new opportunities and risks for investors over the next two years or more. We suggest watching these areas, in particular:

• Increased defense spending: As war in Europe continues, look for bipartisan agreement on potential hikes in federal military spending, as the U.S. seeks to catch up with foreign adversaries. From 2000 to 2020, China boosted annual defense spending by 513%, while U.S. spending rose just 64%, spurring the Biden administration to cite Chinese military growth as a new benchmark for future U.S. military spending. Watch the performance of U.S. aerospace and defense stocks, which have a strong positive correlation with U.S. defense outlays.

• Robust cybersecurity investment: A dramatic ramp-up in cybersecurity threats from abroad, including China, Russia and North Korea, is heightening U.S. government vigilance. Morgan Stanley expects federal spending on cybersecurity to increase over time as cyber-related threats mount, creating a bullish environment for cybersecurity stock valuations.

• Supply-chain “reshoring”: Concerns about inflation-fueling supply disruptions are adding momentum to a broader trend of returning, or “reshoring,” manufacturing to the United States. Federal efforts to strengthen domestic production, such as investments in the U.S. semiconductor industry, are expected to grow. In 2022 and 2023 alone, Morgan Stanley researchers expect capital investment in U.S. factories to increase 7.5%. U.S. semiconductor companies, in particular, could benefit from federal legislation that would incentivize more manufacturing at home. 

Find out more in Morgan Stanley’s report “US Policy Pulse, Midterms Developing on the Margins.” Your Morgan Stanley Financial Advisor can share a copy of the report and help you understand how you may want to position your portfolio for a new policymaking environment. 

• In the unlikely event that Democrats retain control of both the House and the Senate in the 2022 midterm election, how might it impact markets in the years ahead?

• If the federal government becomes more politically divided following the 2022 midterms, how could it affect different sectors of the equity market?