As Midterms Approach, Prepare for Market Volatility

Here’s the lay of the land. The Senate is currently divided between 51 Republicans and 49 Democrats (including two Independents who caucus with the Democrats). A change of two seats in favor of the Democrats will give Democrats control of the Senate under the leadership of Chuck Schumer of New York.

Of the 100 Senate seats, 35 are up for election in 2018. Those 35 Senate seats are currently divided among 24 Democrats, two Independents who caucus with Democrats and nine Republicans. Simply put, the Democrats have more turf to defend and potentially more to lose.

Twenty of the 35 seats are considered safe for the incumbent party; those seats will not change parties and will not affect the balance of power in the Senate.

The remaining 15 seats consisting of 10 Democratic and five Republican incumbents are close in the polls and will determine the balance of power. Six of those 10 Democratic seats are leaning Democratic. Three of those five Republican seats are leaning Republican. One Democratic seat is leaning Republican. The remaining five seats, of which three are Democrats and two Republicans, are too close to call.

The close races are Arizona and Nevada (both now Republican) and Missouri, North Dakota and Montana (now Democratic). The Democrats would have to win all five of those close races while keeping all of their current seats to gain control of the Senate.

The Democratic control scenario is extremely unlikely to happen.

The one Democratic seat leaning Republican is Heide Heitkamp of North Dakota. The latest polling (Oct. 4) shows Republican challenger Kevin Cramer ahead of Heitkamp by 12 percentage points. Heitkamp’s vote against the confirmation of Brett Kavanaugh doomed her chances.

North Dakota is a pickup for the Republicans. This means that the Democrats would have to go five for five in the close races and score an upset in one of the “leaning Republican” states such as Tennessee or Texas. But Republicans in those states are ahead by 14 points (Blackburn in Tennessee) and eight points (Cruz in Texas) respectively.

In short, the Democrats have no likely or clear-cut path to Senate control. Investors can safely conclude that the Senate will remain Republican with a slightly larger majority of 52-48 or even 53-47 once the close races are decided.

The House of Representatives is a different story. All 435 seats are up for election in the midterms on Nov. 6. Republicans currently control the House by 236 seats to 193 for the Democrats with six vacancies that will be decided in the upcoming election. The Democrats will have to hold all of their existing seats (including the two Democratic vacancies) and pick up 23 currently Republican seats to gain control of the House.

Of the 435 seats up for grabs, 368 (191 Democrats and 177 Republicans) are considered safe for the incumbent party or lean heavily in favor of the incumbent. That leaves only 67 seats that lean slightly either way or are too close to call. The Democratic pickup of 23 seats will have to come from that group of 67 seats in order to win control of the House.

Put differently, if the Democrats win 27 of the 67 toss-ups while Republicans hold 40, the Democrats will take control of the House when the 27 wins are combined with the 191 safe seats.

Predicting the outcome of those 67 close elections is extremely difficult because important indicators such as polling, likely turnout and enthusiasm are changing by the day. The vast majority of polls and pundits are predicting a Democratic victory in the House. But those predictions must be taken with more than a grain of salt. Here’s why:

• Most major pollsters are associated with media outlets such as ABC, NBC, TheWashington Post, TheNew York Times and others who heavily favor the Democrats. Their polling methods can skew the outcome in favor of Democrats by sampling all voters (instead of “likely” voters) and by oversampling Democrats in general and African-American Democrats in particular.

Also, small samples can produce larger margins of error. These were the same mistakes the pollsters made in 2016 when they predicted Hillary Clinton would be elected president with a likelihood of between 70–90%. The pollsters who were wrong in 2016 will likely be wrong again because they have done little to improve their models or balance their methodology

• The quality of polls and the final election results depend entirely on turnout. Pollsters make assumptions about millennial, Hispanic, female and African-American turnout and likely voting patterns that are incorrect. Liberal pollsters routinely overestimate millennial and African-American turnout. They also overestimate the so-called “gender gap.”

Focusing on the fact that more women support Democrats ignores the fact that more men support Republicans and the two factors tend to cancel out. Women are more independent-minded than the liberal pollsters assume and male turnout will be greater than the same pollsters assume. Finally, Hispanic voters seem to be splitting 70-30 for Democrats instead of the 80-20 pro-Democratic split the pollsters assume. Once the polls are adjusted for all of these factors, the Republican showing will be much stronger than the media project.

Finally, let’s look at some recent polling data from actual bellwether races. Here are six races (shown by state and district number) to watch on election night and in the weeks ahead to get a feel for how the overall House election will turn out: PA-8, NC-9, IL-12, FL-26, CA-10 and CA-45.

The Pennsylvania 8th District has no polling data but leans Democratic. The North Carolina 9th District is Democratic +4. The Illinois 12th District is Republican +1. The Florida 26th District is Republican +3. The California 10th District is Democratic +5. The California 45th District is Democratic +7.

While these data clearly favor Democrats, a few words of caution are in order. Four of the six districts have polling results within the poll’s margin of error. When that information is put in the context of the polling critique above, the races may be closer than they seem.

The other caution is that these data are between five–10 days old. Given the dynamic nature of these midterm elections and recent trends toward Republicans, the North Carolina 9th District and the California 10th District may produce surprise victories for Republicans.

The bottom line is that Democrats are slightly favored to take control of the House of Representatives.

But the election is much closer than headlines and polls make it appear. When polling deficiencies and dynamic surges in turnout are taken into account, the election will be close and Republicans may hold onto the House, if just barely. Since all of these trends are still in play, close attention needs to be paid over the next two weeks before final forecasts of the outcome can be made with confidence.

If the Senate and House both remain in Republican hands, expect more of the same. The Senate will continue to confirm Trump-appointed conservative judges to the federal courts and perhaps a justice to the Supreme Court should another vacancy arise.

Even with a narrow majority in the House, party discipline will enable a Republican House to work with a Republican Senate and the White House to increase defense spending, pursue bilateral trade negotiations and isolate China on the global scene. Trump will continue his efforts to build “the wall” and tighten immigration enforcement.

If the Senate remains in Republican hands (as expected) and the House is controlled by the Democrats (a close but likely outcome as of today), investors should expect radically different results.

With Nancy Pelosi as speaker of the House, Adam Schiff as chair of the House Permanent Select Committee on Intelligence and Maxine Waters as chair of the House Financial Services Committee, the House will engage in a frenzy of investigations, hearings, subpoenas and other actions with the sole purpose of removing Trump from office or paralyzing his administration.

Chief among these efforts will be hearings aimed at impeaching Donald Trump.

Trump will respond in kind and effectively go to war with the Democratic-controlled House. Trump thrives on such controversy and will use the impeachment effort to energize his own campaign for reelection in 2020.

The result will be a paralyzed government unable to pursue effective fiscal policy, domestic policy or international relations. While the impeachment wars are raging, the 2020 presidential campaign will go into full swing, which will politicize the environment ever more.

The hardball politics and bitterness that suffused the Kavanaugh confirmation will be back with full force except the dysfunction will last for two years, not two months.

All of this will be highly negative for U.S. stocks and bonds. It’s not that markets will choose sides. It’s more the case that markets despise uncertainty, and the political dysfunction described above will produce the greatest political uncertainty since the Cold War and Watergate.

Investors can prepare for this outcome now by reducing equity allocations and increasing allocations to cash and gold. Then be prepared to stay up late on election night to see how events transpire.

Regards,

Jim Rickards
for TheDaily Reckoning