Capital Ideas^™

In a year when soaring inflation, the war in Ukraine and a bear market have commanded headlines, the U.S. midterm elections risked becoming an afterthought. But now the election is coming back into focus. And with good reason. Capital Group political economist Matt Miller believes 2022 could be one of the more consequential midterm elections in U.S. history.

“Make no mistake, every move in Washington this year has been carefully calculated with the midterms in mind,” Miller says.

But while control of the U.S. Congress may be at stake, do midterm elections have any effect on equity markets?

To find out, we examined more than 90 years of data and found that the answer is yes, markets have behaved differently during midterm election years. Here are five things you need to know about investing in this political cycle.

Midterm elections occur at the midpoint of a presidential term and usually result in the president’s party losing ground in Congress. Over the past 22 midterm elections, the president’s party has lost an average 28 seats in the House of Representatives and four in the Senate. Only twice has the president’s party gained seats in both chambers.

Why is this usually the case? First, supporters of the party not in power usually are more motivated to boost voter turnout. Also, the president’s approval rating typically dips during the first two years in office, which can influence swing voters and frustrated constituents.

“The Senate remains a toss-up, but history suggests we will see a backlash against the party in power that will result in Republicans taking back control of the House,” Miller says. “As far as investors are concerned that would end any chance for ambitious Democratic legislation the next two years."

Since losing seats is so common, it’s usually priced into the markets early in the year. But the extent of a political power shift — and the resulting policy impacts — remain unclear until later in the year, which can explain other trends we’ve uncovered.

Our analysis of returns for the S&P 500 Index since 1931 revealed that the path of stocks throughout midterm election years differs noticeably compared to all other years.

Since markets typically rise over long periods of time, the average stock movement during an average year should steadily increase. But we found that in the first several months of years with a midterm election, stocks have tended to have lower average returns and often gained little ground until shortly before the election.

Markets don’t like uncertainty — and that adage seems to apply here. Earlier in the year there is less certainty about the election’s outcome and impact. But markets have tended to rally in the weeks before an election, and they have continued to rise after the polls close. So far, 2022 has been another example of a midterm election year with lacklustre returns, although the impact of politics has been minimal compared to that of inflation and rising rates.

Despite the uncertainty, investors shouldn’t sit on the sidelines or try to time the market. The path of stocks varies greatly each election cycle, and the overall long-term trend of markets has been positive.

Elections can be tough on the nerves. Candidates often draw attention to the country’s problems, and campaigns regularly amplify negative messages. Policy proposals may be unclear and often target specific industries or companies.

It may come as no surprise then that U.S. market volatility is higher in midterm election years, especially in the weeks leading up to Election Day. Since 1970, midterm years have a median standard deviation of returns of nearly 16%, compared with 13% in all other years.

“I don’t think this election will be any different,” says Chris Buchbinder, a portfolio manager on Capital Group U.S. Equity Fund^TM (Canada) “There may be bumps in the road, and investors should brace for short-term volatility, but I don’t expect the election results to be a huge driver of investment outcomes one way or the other.”

The silver lining for investors is that markets have tended to rebound strongly in subsequent months, and the rally that has often started shortly before Election Day hasn’t been just a short-term blip. Above-average returns have been typical for the full year following the election cycle. Since 1950, the average one-year return following a midterm election was 15% in U.S. dollar terms. That’s more than twice the return of all other years during a similar period.

Of course every cycle is different, and elections are just one of many factors influencing market returns. For example, over the next year investors will need to weigh the impacts of a potential U.S. recession and global economic and geopolitical concerns.

There’s nothing wrong with wanting your preferred candidate to win, but investors can run into trouble if they place too much importance on election results. That’s because, historically, elections have had little impact on long-term investment returns.

In 2020, many investors feared the “blue wave” scenario, or Democratic sweep. But despite these concerns, the S&P 500 rose 42% in the 14 months following the 2020 election (from November 4, 2020, through January 3, 2022) in U.S. dollar terms.

Going back to 1933, markets have averaged double-digit returns in all years that a single party controlled the White House and both chambers of Congress. This is just below the average gains in years with a split Congress, a scenario which many believe is a strong possibility this year. Even the “least good” outcome — when the president’s opposing party controls Congress — notched a solid 7.4% average price return.

What’s the bottom line for investors?

Midterm elections — and politics as a whole — generate a lot of noise and uncertainty.

Even if elections spur higher volatility there is no need to fear them. The reality is that long-term equity returns come from the value of individual companies over time. Smart investors would be wise to look past the short-term highs and lows and maintain a long-term focus.