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With only days to go, the wild 2022 midterms continue apace. From Democrats funding “MAGA Republicans” in primary races, to former President Trump trying his hand as kingmaker, to sacrosanct Democrat seats and governorships at risk of being flipped (we’re thinking of you New York), it’s clear that this is not your father’s election cycle.

Given that midterms have historically favored the minority party and given that President Biden has very high unfavorable ratings, the Republicans entered this election season as the presumptive favorites. This was reflected in the consensus view that the Republicans would retake the House, but the path to Republican victory in the Senate was seen as more difficult given that only 34 seats are in play, and of those 21 already reside in Republican hands. In addition, as recently as September Democrats appeared poised to defend, and potentially pick-up, seats in the Senate.

However, as James Carville taught us back in 1992; “It’s the economy, stupid.” 30 years later, it appears that this is still the case as inflationary concerns and fears of a recession dominate the conversation and the polls. The result is that the Republicans have the momentum going into Tuesday, and our base case is that they will gain control of the House and the Senate. Further, if coveted “undecideds” continue to shift red, it’s quite possible that Republicans pick up 35-40 seats in the House and may end with as many as 53, or even 54, seats in the Senate.

While this scenario will be seen as a major shift in Washington, we expect a relatively muted reaction from financial markets. A return to a divided government is typically interpreted favorably by markets, but in the current environment we do not expect any type of political comity to emerge that might drive policy. Instead, we would expect an end to Democratic legislative priorities and a Republican Congress that is more interested in positioning the party for 2024 than it is in sponsoring legislation that could make it past the Resolute desk.

As a result, we think it is unlikely that the two parties will find common legislative ground even in areas where there may be some agreement – like tech regulation or certain areas of healthcare reform. Said differently the D.C. dysfunction will get worse before it gets better, which may well lead to government agencies using regulatory power to push Democratic agenda in the absence of congressional control (for example, a more aggressive SEC under Gary Gensler).

With that as a backdrop, market attention will quickly shift from politics back to inflation and the likelihood of a recession. So if asked, perhaps Carville would remind us that for the markets later this year and into 2023 – It’s the Fed, stupid.