ANALYSIS-Political gridlock may help US stocks, but inflation remains in control

By Saqib Iqbal Ahmed

NEW YORK, November 16 (Reuters)Shared control of the U.S. Congress after the midterm elections could give equities a tailwind at the end of a battered year, but inflation and the Federal Reserve are likely to remain the main market drivers, investors said.

Republicans were projected to win a majority in the House of Representatives on Wednesday, paving the way for two years of a divided government as President Joe Biden’s Democratic Party keep control of the Senate.

“For the economy and the markets, it’s policy that determines outcomes, rather than politics,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments. A divided government “makes major political changes unlikely, and this political stability tends to reassure investors.”

Historically, stocks have done better under a divided government when a Democrat is in the White House: S&P 500 average annual .SPX returns have been 14% in a divided Congress under a Democratic president, according to data since 1932 analyzed by RBC Capital Markets. That compares to 10% when Democrats controlled the presidency and Congress.

On a sectoral basis, a Democratic-led Senate could prove favorable to utilities, consumer discretionary and healthcare, as well as clean energy, wrote John Lynch, chief investment officer of Comerica Wealth. Management, in a note released Tuesday.

Sectors whose recent performance may have been helped by expectations of a better Republican performance, including energy, biotech, financials and defense, could take a breather as investors reassess the degree of tax and regulatory benefits going forward, Lynch said.

A divided government could prevent Democrats from pushing through several major fiscal packages, including $369 billion in spending on climate and energy policies and the enactment of a windfall tax on oil and gas companies, UBS analysts wrote. Global Wealth Management earlier this month.

Some worried that such spending could help prop up inflation at a time when the Fed stepped up monetary tightening to push consumer prices down to their highest levels in decades.

On the other hand, bottling carries its own set of risks, including a potential stalemate on breeding the US debt limit next year that could disrupt the economy at a time when Fed rates may still be at their peak.

While a divided Congress may reduce the risks of a deadly fight against the debt ceiling, “we’ll be sleeping with one eye open,” said Goodwin of New York Life Investments.

Still, macro concerns and monetary policy have buoyed markets throughout the year, and investors believe that trend isn’t likely to change any time soon.

The S&P 500 is up more than 10% from its October low, with temperatures colder than expected inflation data last week and tuesday producer price index the results bolster hopes that the Fed could temper its rate hikes sooner than expected. The index is still down nearly 17% this year as of Wednesday’s close.

“Inflation matters more than anything else right now,” said Michael Antonelli, managing director and market strategist at Baird.

Indeed, fund managers polled Nov. 4-10 in BofA Global Research’s latest survey cited continued high inflation as the market’s top “tail risk.”

Some investors are also counting on stocks to get a boost from seasonal trading patterns: November and December saw the second- and third-largest average monthly percentage gains for the S&P 500 since 1950, according to the Stock Trader’s Almanac.

However, much of this increase in seasonality may depend on whether the period is in a bear market – defined as when stocks have fallen 20% or more from their most recent high.

In the last five instances where the November-December period has occurred in a bear market, the S&P 500 has averaged a two-month decline of 2.2%.

“When we talk about a generally positive end of the year, that is the case in bull markets. If you look at bear markets, there is no evidence of seasonality at the end of the year,” said Antonelli said.

(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and Leslie Adler)

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