Headed for a showdown

Bottom Line

The final sprint to the critical midterm election November 3 is on. We are now less than a month away, and early voting has already begun in many states. The consensus view is Democrats will regain a majority of the House of Representatives and Republicans will maintain control of the Senate with a 50-50 tie that Vice President Vance could break if necessary.

Historically, investors love divided government. A split Congress generates fiscal policy checks and balances between the two parties, theoretically keeping legislation in the middle of the political fairway. But the degree of the split is crucial.

In the past, when a Republican is in the White House and each party claims one of the two chambers on Capitol Hill, the S&P 500 has rallied nearly 14% annually on average over the past 90 years. But if the entire Congress swings to Democrats, stocks have returned an average of less than 5%.

With stocks soaring to a new record high this week, and benchmark 10-year US Treasury yields hitting a 24-year high of 5.36%, we think the latter could surprise investors and spark a fourth-quarter air pocket in share prices.

What’s the problem? The fundamentals of the US economy are in good shape, with GDP growth surging, the labor market solid, and consumer spending and manufacturing both at their strongest points in four years. Yet, business and consumer confidence have plunged, and President Trump’s poll numbers across the board and on a variety of issues are deeply under water.

This divergence begs explanation. Why do most Americans dislike President Trump, even though the labor market is solid, many are spending money like there’s no tomorrow, and equity investment portfolios have doubled over the past four years? Is it style over substance? 

Solid economic fundamentals Recently, nominal second-quarter US GDP growth was revised up from 1.5% quarter-over-quarter (q/q) to a final gain of 2.2%, while the core private domestic final sales component was revised up from 4.2% q/q to a final gain of 4.6%, marking the strongest quarter in more than three years. The Atlanta Fed’s GDPNow tracking estimate is forecasting nominal growth of 3.7% q/q in the third quarter, which will be flashed just before the midterms on October 29.

Nonfarm payrolls have grown by an average of 87,000 jobs over the past seven months through September, compared with only 10,000 jobs last year. Household employment added 406,000 and 569,000 jobs in September and August, respectively, driving the unemployment rate for less-educated workers down to a 34-year low of 4.3% last month, with highly educated workers at a 15-month low of 2.5%. The four-week moving average for initial weekly jobless claims at 198,000 is now at a four-year low.

Back-to-School (BTS) spending rose by 6.0% year-over-year (y/y) through August, a four-year high, and we expect Christmas spending to rise by 5-5.5% y/y. The ISM manufacturing Index has been above 52 in expansion territory in each of the past nine months for the first time in four years.

Core CPI retail inflation has declined from a 40-year high of 6.6% y/y in September 2022 to a five-year low of 2.4% in August 2026, and core PCE inflation has eased from 5.6% y/y in September 2022 to 3.0% in August 2026. In its recent Summary of Economic Projections (SEP) in September, the Federal Reserve now expects core PCE to hit its long-standing 2% y/y target by year-end 2029.

Affordability on the ballot The conflict with Iran is hugely unpopular with voters of all stripes. It has been a thorn in the side of the US economy since the US and Israel attacked the country eight months ago. There is no end in sight, and it is driving prices for crude oil, gas and diesel sharply higher. Rising energy prices have had a deleterious impact on other costs, such as food and travel. In part to counter this development, the Fed raised interest rates by a quarter point last month, its first hike in three years. It is projecting at least two more hikes over the next six months. The tightening in policy has driven mortgage rates up to a two-year high of 7.5%, making buying a house even more out of reach for the average family.

President Trump’s poll numbers miserable across the board His metrics are dreadful on several key issues: overall job (38.4% approval); direction of the country (32.2%); the economy (33.7%); inflation (27.3%); and military action in Iran (32.5%). That’s not a winning hand. It’s an opportune time for the Democrats.

Business and consumer confidence falling Today’s preliminary University of Michigan Consumer Sentiment Index for October hit a five-month low of 46.3, marginally above May’s record low of 44.8, largely due to concerns about inflation. Broken down by political party, self-identified Republicans respondents are relatively optimistic, with an upbeat sentiment reading of 84.0. In contrast, Independents and Democrats are decidedly pessimistic, with dour sentiment readings of 38.9 and 37.3, respectively. According to Gallup, Independents are now the largest voting bloc in the country, accounting for 45%. Democrats and Republicans each account for 27%.

What about the polls? Perhaps due to oversampling, some pundits think the polls consistently overstate Democratic performance. That would suggest that a half dozen battleground states in the Senate are running within many expert’s margin of error. Republicans have a significant edge in campaign fundraising, and they also have a stronger ground game. But did they wait too long to spend their cash advantage, as voters’ negative opinions may now be cast in stone?