Weekly Update ​29 October 2018

Forward-looking highlights from Geoquant’s high-frequency political risk intelligence platform

US midterms update + market implications

United States: Split Congress still most likely; accelerated Political Risk adds to bear market momentum

Following on our 10 September analysis, GeoQuant indicators continue to suggest the upcoming US midterm elections will result in a split Congress, with the incumbent Republicans losing the House of Representatives but retaining control of the Senate. We also find some preliminary evidence that US Political Risk may add to bear market momentum. In sum:

• Government Instability Risk is now projected to be (just) higher than during the 2016 elections, signaling worse outcomes for the incumbent Republicans than in early September. Nonetheless, the level is still too low to suggest the Democrats will take the Senate along with the House.
• That said, the risk level increases significantly if we “stress” our models by upweighting the influence of (already elevated) Social Polarization and Political Violence risks, suggesting these factors could push a surprise “blue wave” over both the House and the Senate.
• Overall US Political Risk is clearly accelerating going into the midterms, and we find a loose but potentially compelling link between higher Political Risk and recent corrections in the S&P 500.
• There is a much firmer (negative) correlation between our US Regulatory Risk indicator and the S&P500, with the former projected to increase in 2019. This suggests politics may help further current momentum toward a bear market.

U.S. Government Instability Risk and the Election

The graph below shows how US Government Instability Risk has tracked higher going into next week’s vote than we anticipated on 10 September, noted with the dashed line. Whereas we previously projected Government Instability Risk would come in below the level achieved during the landmark 2016 election, it is now projected to be just higher on 6 November 2018. [Note again that both risk levels are higher than during the 2014 midterms, where the incumbent Democratic Obama administration lost the Senate to the GOP.]

This trend re-affirms our view that the incumbent GOP will lose at least one chamber of Congress to the Democrats, with the House clearly most vulnerable; indeed, contrary to conventional wisdom, higher Government Instability Risk suggests the Democrats now have greater odds of taking the House than they did in September. It also suggests that the Democrats are now better placed to take the Senate as well — although we continue to believe that outcome is unlikely due to the GOP’s institutional advantages in critical Senate races. Note that projected Government Instability Risk on 6 November now scores 40.2, still below the 40.32 threshold we set for changing our “split Congress” prediction, which we maintain.

Interestingly, if we stress our US models by increasing the weight of Social Polarization Risk and Political Violence Risk — both clearly elevated given recent events in the run up to the midterms — Government Instability Risk does surpass the 40.32 threshold on 6 November, hitting a score of 41.48 [NB: In the graph below, the “stressed” risk model is represented by the solid line, while the default GeoQuant model is represented by the dashed line].

Given that risk score is now slightly below the equivalent “stressed” risk score for the 2016 election, this is no analytical silver bullet indicating a surprise Democratic sweep. But it does indicate that if such a sweep does happen, high/ sometimes violent social polarization will be a key driver just as in 2016.

Market Implications

While U.S. social polarization and political violence hasn’t exacerbated the recent equity market sell-off (it very rarely does in the U.S.), there is some speculation that the Trump administration’s equity-boosting deregulatory push and pro-cyclical fiscal stimulus have run their course. And indeed, we find some evidence for that in our U.S. Regulatory Risk indicator, which is projected to bounce up in 1H 2019.

Given that U.S. Regulatory Risk is negatively correlated with the S&P 500 daily close over the past 6 years (r = -0.39; higher risk, lower close and vice-versa), this suggests post-election politics may add to the bear market momentum.

In addition, we note an interesting relationship between our top-line US Political Risk indicator and recent (i.e. 2018) sell-offs in the S&P 500, including last week’s. Per the graph below, note that while the relationship between top-line U.S. Political Risk and the S&P 500 close is actually positive over the past 6 years (r = 0.19), that relationship has turned negative (and more strongly negative, r=-0.39) since the Trump election. What’s more, while pre-Trump S&P corrections (Aug 2015, Jan 2016) preceded a run-up in Political Risk, the 2018 corrections (Feb 2018, Oct 2018) have occurred after Political Risk already began to accelerate. See below; food for thought . . .