Post-mid-term US equities will be shaped by policy, not rerating

 US equity returns are likely to depend more on policy decisions than valuation changes after Democrats gained control of Congress in the US mid-term elections, according to Steven Blitz, managing director of global macro and strategy and chief US economist at GlobalData.TSLombard.

“Rerating is not the equity market’s major problem going forward, policies are,” Blitz wrote.

He expects the new Congress to provide a constraint on the administration, but not to control its agenda.

For markets, he said, policy from the administration and the Federal Reserve, alongside geopolitical events, will matter more than the election result itself.

Historical patterns suggest the party winning a mid-term election does not determine equity-market direction.

“In four of the six mid-terms beginning 2002, the market continued in the same direction after the election that it was heading in before,” Blitz said.

In 2018, the market fell 9% from election day to year-end. Blitz attributed the decline to Federal Reserve tightening rather than Democrats gaining 41 House seats.

The market also fell 3.9% from election day to year-end in 2002, despite the Bush administration adding eight House seats and two Senate seats.

Volatility has shown no consistent pattern around mid-terms. The VIX averaged 21.9 before elections and 19.5 afterwards. Blitz described the difference as “a statistical difference with no meaning”.

On valuations, Blitz said the market appears fairly priced relative to bonds and the nominal economy.

The S&P 500 trades at a forward price-to-earnings ratio of 21, representing an earnings yield of 4.78%. This implies that prices would double in 15 years.

Average annual nominal economic growth was 5.7% over the past decade, a rate that would double GDP in 13 years. A 10-year zero-coupon bond yield of 4.9% suggests capital would double in 14 years.

“The 10Y is not yet cheap enough to pull money from stocks,” Blitz wrote. He noted that sector indices are similarly priced, although valuation gaps are wider among the 20 largest companies by market capitalisation. “The equity market is fairly valued,” Blitz concluded.