The US midterm elections are tomorrow, and with large implications for US policy and markets, the stakes are high.

After the 2016 election, equities rallied sharply and bond yields rose, as investors anticipated fiscal stimulus and looser regulatory policy from the Republican-controlled federal government. While the Presidency is not on the ballot this November, the GOP may lose control of one or both chambers of congress. As shown below, the Democrats need to flip only 24 seats in the House or 2 seats in the Senate to wrest control of one chamber.

The consequences of tomorrow's election could have wide-ranging effects: GOP officials have mentioned the possibility of additional tax cuts if they retain control, though the details are sparse. Alternatively, some commentators have suggested that if Democrats make gains, they could work together with President Trump to pass a major infrastructure spending package.

Overnight, in reports from both SocGen and Deutsche Bank, analysts review what the polls and betting markets indicate about the likely outcome of the election, what the main issues under discussion are, and what the possible market implications will be.

Here are the key things to look for:

House of Representatives

Typically, the opposition party tends to gain seats in midterm elections. Over the last 150 years, there have been only four instances where an incumbent president has actually seen his party gain seats. These have often been the result of special circumstances. For example, President Bush's popularity increased after the September 11 attacks ahead of the 2002 midterms. In 1998, the Democrats gained seats but did not take back legislative control. In 1934, amid the Great Depression, the Democrats benefited from the popularity of President Roosevelt's New Deal program. In 1902, the size of the House of Representatives was expanded, so while the incumbent Republicans did gain nine House seats, their majority actually shrank by 16 seats.

Furthermore, as Deutsche Bank notes, historically, the “generic ballot,” which asks voters which party they plan to vote for without narrowing the question based on candidate or district, has been a strong predictor of the eventual House election outcome. As shown below, a 1pp gain in the generic ballot is associated with around a 0.98pp increase in eventual seat share. Republicans tend to outperform their generic polling margin, scoring a 3% majority even if the generic poll is tied, on average. For this cycle, the generic poll shows a 9.1pp Democratic lead (taking the average of the ten most recent polls), which would equate to around a 5.8% or 42 seat majority. This Democratic lead in the generic ballot has been fairly steady over the last 18 months. It widened slightly at the end of last year, but has remained in the same range throughout 2018.

Another closely tracked predictor of midterm House election results has been the Presidential approval rating. President Trump’s current approval, at around 42%, is notably above its trough last fall around 36% and near the highs of his Presidency, but it also implies a Democratic House victory. Based on the historical relationship, his current polling would equate to around a 37 seat loss for the GOP. Note, however, that the relationship is more uncertain when a President's approval rating is below 50%, with the actual outcomes more dispersed.

Senate

The Senate will be tougher to predict. Since only a third of the chamber is up for reelection every two years - unlike the House where every member faces reelection every two years – it is harder to infer powerful trends from historical experience. This cycle, the election map looks very favorable to the Republicans. Of the 35 seats being contested, 26 are currently held by Democrats. Of those Democratically-held seats, 10 are in states that voted for Donald Trump in 2016. In contrast, Republicans are only defending eight states, and only one of those voted for Hillary Clinton.

Betting odds

Betting odds and professional modeling confirm these expectations. The chart below shows the betting market-implied odds from PredictIt (an online betting website) and the model output from fivethirtyeight. Taken together, they indicate around a 75% chance that the Democrats take control of the House and around an 80% chance that the Republicans retain control of the Senate.

Looking at just 538's model, Democrats have an 86% chance to win control of the House, and Republicans have an 85% chance to retain the Senate.

What are the key issues?

Some of the major themes from the last two years of political discourse continue to dominate the campaign rhetoric. Using Google trends data on internet searches, healthcare, trade, and immigration are the top issues in the public consciousness. In contrast, two major areas of potential pro-growth fiscal expansion – tax reform and infrastructure – barely feature. The Mueller investigation, which sparked market volatility in May 2017 when it was started, has the potential to resurface at some point but the public does not seem overly interested in the topic.

According to SocGen, four key economic issues are at stake: A Democrat majority or split Congress can influence key fiscal issues. The relevant themes we examine are tax cuts, government spending, regulatory reform, and trade policy.

Tax reform : Even with a Democrat-controlled Congress, Trump holds veto power and can easily protect the tax cut legislation. There is unlikely to be any change to the tax reform legislation. Congress is considering extending individual tax cuts that expire in 2025, but prospects there are mixed. A Democratic Congress, or a Democrat majority in just one house of Congress, would materially reduce the chances that congress in 2019-20 would approve making the individual tax cuts permanent.

: Even with a Democrat-controlled Congress, Trump holds veto power and can easily protect the tax cut legislation. There is unlikely to be any change to the tax reform legislation. Congress is considering extending individual tax cuts that expire in 2025, but prospects there are mixed. A Democratic Congress, or a Democrat majority in just one house of Congress, would materially reduce the chances that congress in 2019-20 would approve making the individual tax cuts permanent. Government spending: Current law requires a spending cut in FY20 (fiscal years begin in October, and FY20 begins October 2019). Can a Democratic Congress work with Trump to raise spending caps for FY20? The easy answer is yes. A Republican Congress passed increased spending caps with significant support for the Democrats. Trump has an incentive to maintain defense spending and avoid the hard cuts required in current rules. Democrats will want to avoid painful cuts to non-defense programs. It might not be easy, but there is plenty of room to negotiate a bipartisan outcome.

Regulatory reform: Regulatory reform is primarily in the domain of the various financial regulators that have varying independence from the President, and who operate very independently from Congress. Yes, Congress confirms leadership for these agencies, but most of the appointees are already in place. Trump has appointed new leaders to most of the financial regulatory bodies. The Treasury has provided a thorough game-plan for discussion and refinements of the Dodd-Frank legislation. A repeal is not in the cards. The US Treasury, along with the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency (OCC), and others are reviewing various portions of the financial regulations in an effort to reduce burdens.

Regulatory reform is primarily in the domain of the various financial regulators that have varying independence from the President, and who operate very independently from Congress. Yes, Congress confirms leadership for these agencies, but most of the appointees are already in place. Trump has appointed new leaders to most of the financial regulatory bodies. The Treasury has provided a thorough game-plan for discussion and refinements of the Dodd-Frank legislation. A repeal is not in the cards. The US Treasury, along with the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency (OCC), and others are reviewing various portions of the financial regulations in an effort to reduce burdens. Trade policy: The president enjoys great latitude in setting trade policy. The actions taken in 2018 were done without the consent of Congress. The current Republican Congress at times has criticized Trump for trade policies. A Democratic Congress in 2019 might be more vocal criticizing Trump’s trade-policy initiatives, but there is no obvious power they can exert over the president on trade. New efforts for Congress to write legislation that would clarify or strengthen their hand would require presidential approval. The veto threat would likely remain an effective tool for the president. A Democratic majority in either or both houses of congress could disrupt approvals of trade agreements. The first agreement to consider would be the new USMCA (to replace NAFTA). While approval could be seen as giving Trump a victory, the alternative – pulling out of NAFTA without a replacement – is not a good alternative. The emphasis on more production from higher-paid North American labour is a union and labor win that the Democrats would be unwise to reject

Key Risks

Risk of greater partisanship: The risks from even greater partisanship include government shutdowns, constitutional challenges, and potential impeachment hearings. All this uncertainty could affect decision-making. For an aged business expansion, uncertainty might be more damaging.

Government shutdowns threat : Trump has already threatened to shut down the government to push Congress to pass immigration reform and build a wall on the US-Mexican border. To force action with a Democratic majority in Congress, he may be using this tool more frequently. The uncertainty and disruptions can plague markets and the economy. Moreover, the debt limit could be another avenue to exert pressure. Trump has shown the will to fight.

: Trump has already threatened to shut down the government to push Congress to pass immigration reform and build a wall on the US-Mexican border. To force action with a Democratic majority in Congress, he may be using this tool more frequently. The uncertainty and disruptions can plague markets and the economy. Moreover, the debt limit could be another avenue to exert pressure. Trump has shown the will to fight. Impeachment is an additional consideration: A Democratic House of Representatives would likely want a more determined examination of impeachment. The investigation overseen by Robert Mueller will remain at work, regardless of the election outcome. If Republicans maintain their majority in the Senate, the chances of a guilty verdict are lower. This uncertainty for financial markets and the economy could meaningfully intensify with a Democrat-led Congress. But with the economy now in the later stages of a business cycle and the positive effects of fiscal stimulus ebbing, we would not take comfort in a benign outcome either.

Market Reaction

In order to assess the medium-term market impact of the midterms and recommend trade ideas, SG economists, strategists and analysts have worked under three different scenarios according to the election outcome.

Scenario 1: Gridlock - GOP Senate and DEM House (most likely): Markets would fear that economy would be more vulnerable from now on with the absence of any further economic stimulus in the event of economic slowdown.

Markets would fear that economy would be more vulnerable from now on with the absence of any further economic stimulus in the event of economic slowdown. Scenario 2: Blue Wave - DEM Senate and DEM House: Markets would stir on speculation of a lame duck presidency and potential impeachment proceedings. Potential upside risk on Infrastructure.

Markets would stir on speculation of a lame duck presidency and potential impeachment proceedings. Potential upside risk on Infrastructure. Scenario 3: Red Wave - GOP Senate and GOP House (least likely): The least expected scenario for the market, which would probably trigger a short-lived risk-on environment. Trade tensions and Fed tightening will quickly be back in the market focus

SocGen's US economist has provided potential policy outcome stemming from these three potential elections outcomes:

Meanwhile, Deutsche Bank's equity strategists believe that the environment is ripe for an equity rally into year end. Markets have historically rallied around midterm elections, though this is equally due to historic coincidence (growth has tended to be strong around elections) as the actual elections. They expect this scenario to repeat, as growth looks strong, positioning is light, and Democratic gains could act as a check on the president’s trade war policies. On the other hand, some Democratic politicians have expressed support for President Trump's trade war, so they may actually support an escalation against China.

On the FX side, the bank's strategists do not expect a significant change for the dollar or for EM FX. In the event that the Republicans retain full control, risk assets would likely rally and the dollar would rally. If the Democrats surprisingly gain control of both chambers, uncertainty and volatility would likely rise and probably weaken the dollar in at least the short-term.