INVESTMENT STRATEGY RESEARCH

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1 INVESTMENT STRATEGY RESEARCH November 1, 2018 Mulling Over The Mid Terms RBC Capital Markets, LLC Lori Calvasina (Head of U.S. Equity Strategy) (212) Sara Mahaffy, CFA (Associate) (212) Key Takeaways: The mid-term elections will take place on Tuesday, November 6 th. We revisit and refresh our views on the event (previously published in our last Macroscope) in light of the recent sell-off in the US equity market. Passage of the event, which will coincide with the wind down of S&P 500 reporting season, could help stabilize the equity market near term assuming a Democratic sweep does not occur. We view a split Congress as a neutral to positive short-term event for the stock market, a Republican sweep as a short-term positive, and a Democratic sweep as a short-term negative (though we are admittedly a bit less concerned about an adverse reaction than we were a few weeks ago given recent declines in the S&P 500). The main sector trade that seems clear to us around the event is Health Care, where we view a Democratic sweep as a potentially negative short-term catalyst for the sector and risk to our overweight view. Equity investors have been expecting a split Congress. According to our latest RBC US Equity Investor Survey, conducted during the last week of September, most US equity investors have been expecting a split Congress after the mid-terms (Exhibit 1). Very few have believed that a sweep by either party is probable. There has also been a clear consensus on the implications for the US equity market under the different outcomes. A majority have viewed a split Congress as a neutral for stocks (Exhibit 2). Meanwhile, most have viewed a Republican sweep as a bullish event for the market, and a Democratic sweep as bearish event. Beyond the market implications, there wasn t much too much agreement in what investors said they would buy and sell under the three potential outcomes (Exhibit 3). One exception many of our respondents said they would be sellers of Health Care under a Democratic sweep. Carlos Torres (Associate) (212) carlos.torres@rbccm.com We are staying prepared for all three outcomes. We think the consensus view that control of Congress will be split after the midterms is probably correct. As of October 31 st, Fivethirtyeight.com s model indicated that the Democrats had an 86% chance of winning the House, while the Republicans had the same chance of keeping the Senate. These forecasts firmed up for both chambers recent weeks. Nevertheless, in 2016 s Presidential election we learned that it pays to be prepared for any outcome, especially the one that seems highly unlikely. We confess that, despite the polling data, it wouldn t entirely surprise us to see one of the two parties emerge with control of both chambers. Both Republicans and Democrats have gotten more energized, with the generic ballot hitting new highs recently for both Democrats and Republicans (Exhibit 4). Momentum in the generic ballot has shifted several times over the past few months. In the past few weeks, as stocks have sold off and Trump s disapproval rating has risen, Democrats have recaptured the momentum and widened their lead, but not by much (Exhibit 5) Disseminated: Nov 1, :45ET; Produced: Oct 31, :07ET Priced as of prior trading day's market close, EST (unless otherwise noted). All values in USD unless otherwise noted. For Required Conflicts Disclosures, see Page 14.

2 Our thoughts on a Split Congress. The knee jerk reaction of the stock market to a split Congress is tough to gauge. Near-term, we suspect it would be a neutral event for stocks (most investors have been expecting a split and have viewed it as a neutral event for the market) or a positive event (passage of the event would remove an element of uncertainty for markets, and would be viewed by many as preferable to a Democratic sweep). A negative reaction in the short term is plausible. Investors tend to rely (at least initially) on historical playbooks around these kind of events. In the past, having a divided government with a Republican President has been one of the worst performance backdrops for stocks (Exhibit 10). But we doubt this scenario would be too much of a negative catalyst for the stock market given the dramatic declines that have already occurred since September. Any drawbacks for the market under this scenario are likely priced in, and have probably contributed to the profit taking a de-risking that has contributed to recent equity market weakness. Our thoughts on a Republican sweep. In the short-term, we think that a Republican sweep could be bullish for the stock market. The S&P 500 has been moving mostly in tandem with Republican sentiment in recent years (Exhibit 7), and most investors have viewed a Republican sweep as a bullish event. Further government stimulus/tax cuts would remain a possibility in the eyes of investors. The historical playbook could also feed a bullish short-term reaction. In the past, the US equity market has performed better under a Republican Congress than a Democratic or split one, and better under united government than divided government. We think any optimism under a Republican sweep could be short lived, however. A sweeping victory could embolden the Trump administration on trade. We also have doubts about whether a second round of tax cuts would really be a priority for the Republicans ahead of the 2020 elections, since tax cuts have not appeared to be motivating Republican voters. According to the results of a late October NPR/PBS Newshour/Marist poll, just 11% of voters (and only 10% of Republicans) said that the tax cuts were the most important factor in their vote, while 45% of all voters said the tax cuts were more likely to push them to vote for Democrats. Our thoughts on a Democratic sweep. We continue to view a Democratic sweep as a potentially bearish event for the stock market in the short term. Republican sentiment (which moves in sync with stocks, and has been at all-time highs) would likely take a hit if Republicans lose both chambers, most investors have viewed it as a bearish event, and hopes for any further stimulus would be off the table. We think investors would also start to worry about drug pricing coming back on the legislative agenda (a rare issue that Trump and the Democrats agree on), damaging confidence in one of the defensive sectors that has served as a safe haven and alternative to the FANG trade in recent months (big cap Health Care). Indeed, the late October Marist poll noted that 28% of Democrats viewed Health Care as the top voting issue, and an issue that overwhelmingly pushed them to vote for their party. The historical playbook is also on the side of a bearish market reaction to a Democratic sweep. Historically, the equity market has performed worse under Democratic Congresses than Republican ones, and under divided governments than unified ones. We also think investors will begin to worry about the possibility of a Democratic Presidency returning in Concerns about impeachment proceedings could also rise. On this point, it s important to keep in mind that even if Democrats win all of the open seats in the Senate in this year s mid-terms, they would still only hold 58 seats (there are 23 seats in Democratic control that are not up for election this year, and 35 total that are in play). That would not be enough to remove the President from office, as the threshold for conviction is two-thirds of the 100 votes in the Senate. Interestingly, in our September investor survey there was no consensus on market reaction to impeachment without conviction (Exhibit 13). Our respondents were split between those who viewed it as a neutral event, and those who viewed it as a bearish event. Interestingly, while November 1,

3 stocks were generally resilient around the Clinton impeachment the S&P 500 did briefly fall 9% peak to trough ahead of the actual proceedings (Exhibit 16). Admittedly, we are less concerned about a negative market reaction to a Democratic sweep than we were a few weeks ago, before equities tumbled. We suspect some of the pain for markets under this scenario has already been priced in. Some of the biggest Policy overhangs on the stock market won t get fixed by the midterms. While some investors have viewed a Democratic sweep as a potential check on the Presidency, we think it is important to keep in mind that Congress doesn t have much of an ability to control trade policy, where the Oval Office has wide reaching powers to act unilaterally. Whatever happens with the mid-terms, we expect the President to keep pushing his trade agenda. Republican victories will send the message that the President s agenda resonated well with voters. Republican defeats will send the message that the President needs to fight harder for his base ahead of the 2020 Presidential election. Similarly, both major political parties in the US (and governments around the world) appear to have an appetite to increase regulation on big cap Tech/social media something we suspect will take significant time to play out. What if we don t know the result on November 7 th? If enough races are too close to call on Tuesday night, and control of Congress hangs in the balance, we think it could weigh on an equity market that has already felt fragile. The best example we have of this in recent history is the 2000 election when both the Presidency and control of Congress were unresolved for roughly a month. At the time, the equity market was already tumbling, and it continued to fall while the results were being determined (Exhibit 11). Thoughts from RBC industry analysts. Our Banks and Biotech teams have spent the most time digging into the implications of the midterms for their stocks (access their reports here and here). Several other teams have also provided us with some interesting insight into how to think about their coverage under the different scenarios. Our Banks team believes that the Banks are prepared to weather any outcome, as the regulatory fate of the industry is now in the hands of the regulators, and most are already in place and are pro business. Elsewhere in Financials, our Insurance analyst has also noted that insurers could benefit under a Republican sweep from the possibility of favorable retirement plan and flood insurance reforms. A Democratic sweep could be a challenge for annuity writers if fiduciary rule legislation were resurrected. Our Biotech team has pointed out that drug pricing has been a key campaign issue in many states in the current election cycle. They view a split Congress as best case scenario for their stocks as a divided House and Senate would make implementation of President Trump s blueprint for drug-pricing reform especially challenging. Under a Republican sweep, they believe the environment of low impact policy changes would continue. Under a Democratic sweep, they see increased risk of adverse policy changes. Elsewhere within Health Care, our med tech analyst notes that his names would be viewed as a safe haven if the Democrats sweep, and that Health Care reform staying in place would also be good for volumes. Within the Energy/Utilities arena, our Utilities analyst has noted that a Republican sweep could be a positive for EXC (the largest owner of nuclear generation assets, which the Trump administration is looking to protect). A Democratic sweep could be positive for NEE, the largest developer of renewable assets in the US. Our Refining analyst believes that a Republican sweep would be supportive of Refiners generally. November 1,

4 Most Expect The Mid Terms To Produce A Split Congress Exhibit 1: September 2018 RBC US Equity Investor Survey - How Likely Are Each of the Following? A strong majority of our survey respondents has believed it is unlikely or very unlikely that either party will win both chambers in the mid-term elections this November. 100% 80% 60% 40% 20% 75% 12% 13% 8% 25% 67% 71% 19% 10% At the margin, there has been a little less conviction about the chances for a Democratic sweep. 0% Republicans win both chambers In the midterm elections Democrats win both chambers In the midterm elections Split Congress in the midterm elections Likely or Very Likely (51-100%) Unlikely or Very Unlikely (0-49%) Source: RBC US Equity Strategy Republican Sweep Seen As Bullish, Democratic Sweep Seen As Bearish, Split Seen As Neutral Exhibit 2: September 2018 RBC US Equity Investor Survey - What are the Implications for US Equities For Each of the Following? Most have believed that a Republicans sweep would be bullish for stocks, while a Democratic sweep would be bearish. A slim majority believe that the most widely anticipated outcome a split Congress would be neutral for the stock market. Nearly a third view it as a bullish event. 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 73% 24% 3% Republicans win both chambers In the midterm elections 4% 18% 78% Democrats win both chambers In the midterm elections 29% 58% 13% Split Congress in the midterm elections Very Bullish or Bullish Neutral Very Beairsh or Bearish Source: RBC US Equity Strategy November 1,

5 What Equity Investors Said They Would Buy & Sell Under Different Midterm Election Outcomes Republican Sweep: Industrials/Defense, Health Care and Financials/Banks made the most appearances on the buy list. We suspect that Defense might gather fewer fans under this scenario if we took our poll today based on the market s reaction to recent news of potential DoD budget cuts. Democratic Sweep: HC/Pharma/Biotech, Financials/Banks, and Tech made the most appearances on the sell list. Split Congress: Less consensus on what to do in this scenario. Exhibit 3: September 2018 RBC US Equity Investor Survey - What Would You Buy; What Would You Sell? Republicans Win Both Chambers In The Midterm Elections Democrats Win Both Chambers In The Midterm Elections Split Congress In Midterm Elections What Would You Buy? Industrials/Defense (15), Health Care (9), Financials/Banks (8), Everything (5), Energy (5), Consumer/Education (4), Cyclicals (3), Tech (3), US Equities (3), Value (2), US Small Cap (2), Growth (2), Inflation Protection (1), Big Mergers (1), Old Economy (1), Gold (1), Emerging Markets (1), Momentum (1), Domestic (1), US (1), Quality (1), Defensives (1), Nothing Different (1) Nothing (8), Consumer Staples (6), Utilities (6), Defensives (5), Infrastructure (5), HC / Hospitals (4), Growth (3), Bonds (3), Emerging Markets (3), International (2), REITs (2), Financials/Banks/Insurance (2), Metals (2), Quality (2), Safety (2), beneficiaries of regulatory friction (1), Renewables (1), Gold (1), High Dividend Stocks (1), Industrials (1), Tech (1), Telecom (1) Tech/FANG (7), Growth (5), Nothing Different (5), Industrials (4), Emerging Markets (4), Energy (3), Financials/Banks/Insurance (3), Health Care (3), Nothing (3), US Equities (2), Infrastructure (2), Small/Mid Cap (2), International (2), Materials/Chemicals (2), Real Economy Cos w/ Dividends & Decent Balance Sheets (1), Everything (1), Domestic (1), Cyclicals (1), Value (1), Europe (1), Momentum (1), Quality (1), Defensives (1) What Would You Sell? Utilities (8), Tech (5), Nothing (3), Defensives (3), REITs (3), Emerging Markets (3), Nothing Different (3), Bonds (3), Growth (2), Staples (2), Value (1), High Yield US Stocks (1), International (1), Gold (1), Expensive Stocks (1), US Equities (1), Industrials (1), Low Growth (1), MLPs (1), Financials (1), Housing (1), Clean Energy (1), Telecom (1) Health Care/Biotech/Pharma (14), Financials/Banks (7), Tech (7), US Equities (5), Everything (4), Cyclicals (4), Energy (3), Growth (3), Equities (2), Value (2), Nothing Different (1), Old Economy (1), Coal (1), Retail (1), Momentum (1), Expensive Stocks (1), Social Media (1), Industrials (1), Education Stocks (1), MLPs (1), Utilities (1) Nothing Different (10), Nothing (5), Tech (3), Consumer Staples (3), Utilities (2), Defensives/Bond Proxies (2), US Equities (2), Industrials (2), Bonds (1), Everything (1), Emerging Markets (1), REITs (1), Value (1), Value Traps (1), Low Growth (1), Equities (1), Housing (1), Autos (1), Chemicals (1) Source: RBC US Equity Strategy November 1,

6 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Both Republicans & Democrats Are Energized, With The Generic Ballot At New Highs For Both Exhibit 4: 2018 Generic Congressional Vote: Democrats vs Republicans Republicans started to improve in the generic ballot in 2Q after the steel tariffs were announced in mid March Democrats Republicans Source: RBC US Equity Strategy, Real Clear Politics Exhibit 5: 2018 Generic Congressional Vote: Democrats vs Republicans Spread We ve seen several shifts in momentum recently. Democrats gained ground in late August. Republicans got the momentum back in September. The gap has shifted in favor of the Democrats again in late October Source: RBC US Equity Strategy, Real Clear Politics November 1,

7 Republican Sentiment Has Hit A New High & Has Been Mostly Moving In Sync With Stocks Exhibit 6: Bloomberg Consumer Comfort Index: Democrats vs Republicans Since 2016, sentiment among Democrats & Republicans has diverged Republicans Democrats Source: RBC US Equity Strategy, Bloomberg We are keeping a close eye on Republican sentiment, which has been closely correlated with the S&P 500 since the 2016 Presidential election. It hit another new all-time high this Fall, and could turn lower (a negative for stocks) if Republican lose any control in the mid terms. Exhibit 7: Bloomberg Consumer Comfort For Republicans vs S&P Republicans S&P Source: RBC US Equity Strategy, Bloomberg November 1,

8 2018 Hasn t Been The Typical Mid Term Election Year For The Stock Market Exhibit 8: Average & Median S&P 500 Performance During Election Cycles Since 1928 While stocks tend to rise during mid term election years, gains tend to be far below those seen in other years of the Presidential cycle. 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 16.9% 12.8% 9.5% 7.1% 7.1% 5.9% 6.2% 4.8% Election Year Year 1 Year 2 / Midterm Year 3 Average Median Source: RBC US Equity Strategy, Bloomberg Exhibit 9: S&P 500 Performance During Mid Term Election Years Stocks tend to fall from April to September, before rising again during the 4th quarter. We aren t looking for a year-end rally based purely on the passage of the midterms, however. In 2018, the market has not followed the typical midterm path month to month. Generally, this year stocks have done the opposite of what is normally expected in most months Typical Path: Average During Mid Term Years Between Source: RBC US Equity Strategy, Bloomberg November 1,

9 Stock Market Gains Most Robust When Congress Is United Or Controlled By Republicans Exhibit 10: Median & Average S&P 500 Returns Under Different Governments Compositions Median and average S&P 500 returns tend to be higher when Congress is controlled by Republicans, than when Congress is controlled by Democrats or when there is a split Congress. Years when the government is united tend to be better than years when the government is divided. Having a divided government with a Republican President is one of the worst scenarios from a performance perspective. United vs. Divided Congress Average S&P 500 Return Median S&P 500 Return % Times Up # of Instances Republican Congress 14% 14% 71% 17 Democratic Congress 8% 11% 70% 56 Split Congress 7% 12% 67% 12 United vs. Divided Government Average S&P 500 Return Median S&P 500 Return % Times Up # of Instances United Government 10% 12% 73% 41 United Republican Government 16% 14% 86% 7 United Democratic Government 9% 12% 71% 34 Divided Government 7% 9% 66% 44 Divided Government w/ Republican Preside 5% 4% 67% 30 Divided Government w/ Democratic Presid 13% 12% 64% 14 Source: RBC US Equity Strategy, Haver, Includes years since 1933 S&P 500 Performance When The Election Outcome Is Unclear Exhibit 11: S&P 500 Performance Around 2000 Presidential Election We looked at S&P 500 performance around the 2000 election, in the event that it is unclear who has control of the Senate and/or House after the midterm elections. The 2000 election occurred in the midst of a broader S&P 500 pullback. Resolution did not put an end to the selloff. From November 7 th to December 13 th, the incremental drop in the S&P 500 was 5% Election Day Source: RBC US Equity Strategy, Bloomberg US Supreme court ruling / Gore conceded election November 1,

10 Few Have Expected Trump To Make An Early Exit From The White House Exhibit 12: September 2018 RBC US Equity Investor Survey - How Likely Are Each of the Following? There has been a strong consensus that Trump will finish out his first term, and that he will avoid impeachment altogether. 100% 80% 60% 40% 20% 0% 95% 2% 3% 5% 8% Trump resigns before his 1st term ends 88% Trump leaves office involuntarily (impeachment & conviction, or 25th amendment) 15% 19% 66% Trump is impeached by the House, but not convicted by the Senate (stays in office) Likely or Very Likely (51-100%) Unlikely or Very Unlikely (0-49%) Source: RBC US Equity Strategy A Trump Exit Has Been Seen As Bearish For Stocks Exhibit 13: September 2018 RBC US Equity Investor Survey - What are the Implications For US Equities For Each of the Following? A Trump exit from the White House (voluntary or involuntary) has also been seen as bearish for stocks (by a slim majority if voluntary & a solid majority if involuntary). There s been no consensus on the impact of impeachment without conviction our respondents were split b/tw those in the neutral & negative camps. 70% 60% 50% 40% 30% 20% 10% 0% 36% 53% 11% 8% Trump resigns before his 1st term ends 26% 66% Trump leaves office involuntarily (impeachment & conviction, or 25th amendment) 3% 50% 48% Trump is impeached by the House, but not convicted by the Senate (stays in office) Very Bullish or Bullish Neutral Very Beairsh or Bearish Source: RBC US Equity Strategy November 1,

11 What Equity Investors Said They Would Buy & Sell Under Different Presidential Scenarios The consensus on what to buy and sell in these scenarios is rather low. Bonds, defensive sectors, gold, and Emerging Markets were mentioned multiple times as things investors would buy if Trump left office (voluntarily or involuntarily) of if Trump was impeached but not convicted. Exhibit 14: September 2018 RBC US Equity Investor Survey - What Would You Buy; What Would You Sell? Trump Resigns Before His 1 st Term Ends Trump Leaves Office Involuntarily (Impeachment & Conviction or 25 th Amendment) Trumps Is Impeached But Not Convicted (Stays In Office) Source: RBC US Equity Strategy What Would You Buy? Nothing Different (6), Bonds (5), Gold (4), Defensives (4), Utilities (3), Emerging Markets (3), Health Care (2), International (2), Nothing (2), Financials/Banks/Insurance (2), Growth (2), Metals (2), Quality (2), Tech (1), NAFTA tied cos (1), Guns (1), Cash (1), Oil (1), Agriculture (1), Defense (1), Safety (1), Consumer Staples (1), Materials (1), Risk Off Assets(1) Gold (6), Nothing Different (6), Utilities (5), Bonds (4), Defensives (4), Cash (3), Financials/Banks/Insurance (3), Emerging Markets (3), Nothing (2), Health Care (2), Growth (2), Quality (2), Tech (1), REITs (1), Telecom (1), NAFTA tied cos (1), Guns (1), International (1), MXNRUB FX Rate (1), Oil (1), Safety (1), Staples (1), Metals (1), Materials (1), Risk Off Assets (1) Nothing Different (6), Utilities (4), Bonds/Fixed Income (4), Growth (3), Nothing (3), Defense (3), Emerging Markets (3), Cash (2), Gold (2), Health Care (2), Quality (2), Tech (1), Everything (1), NAFTA tied Cos (1), International (1), Oil (1), Chemicals (1), Banks (1), Staples (1), Materials (1), Risk Off Assets (1) What Would You Sell? Industrials/Defense (6), Nothing Different (4), Nothing (4), Equities (3), Tech (3), Everything (2), Energy (2), Health Care / Pharma (2), US Equities / US (2), Growth (2), Financials (2), Bonds (1), Oil (1), Cyclicals (1), Banks (1), Defensives (1), Momentum (1), USD (1), Overleveraged (1), Low Growth (1), Housing (1), Autos (1), Chemicals (1), Expensive Stocks (1) Industrials/Defense (5), Growth (4), Nothing Different (4), Nothing (4), Equities (3), Tech (3), Financials/Banks (3), Energy (2), Health Care / Pharma (2), US Equities (2), Bonds (1), Utilities (1), Everything (1), Real Estate (1), Cyclicals (1), Defensives (1), Momentum (1), USD (1), Overleveraged (1), Low Growth (1), Housing (1), Autos (1), Expensive Stocks (1) Nothing (5), Nothing Different (5), Equities (3), Industrials/Defense (3), Growth (2), Tech (2), US Equities (2), Financials (2), Health Care (1), Bonds (1), Everything (1), Energy (1), Real Estate (1), Cyclicals (1), Defensives (1), Momentum (1), Expensive Stocks (1), Low Growth (1), Housing (1), Autos (1), Chemicals (1) November 1,

12 Dec-70 Mar-71 Jun-71 Sep-71 Dec-71 Mar-72 Jun-72 Sep-72 Dec-72 Mar-73 Jun-73 Sep-73 Dec-73 Mar-74 Jun-74 Sep-74 Dec-74 Mar-75 Jun-75 Sep-75 Dec-75 A Tale of Two Impeachments: A Derailment Around Nixon, A Speed Bump Under Clinton Exhibit 15: S&P 500 Performance Around Nixon Impeachment Process Around Watergate/Nixon s resignation, the S&P 500 peaked on Jan 11, 1973 and hit its low 270 trading days later on Oct 3, The S&P 500 ultimately fell 48% peak to trough Watergate break-in Impeachment process initiated by House of Representatives Nixon Resigns Source: RBC US Equity Strategy, Bloomberg Exhibit 16: S&P 500 Performance Around Clinton Impeachment Process The S&P 500 fell 9% peak to trough ahead of Clinton s impeachment proceedings, but rallied back quickly Clinton gives sworn deposition denying affair Clinton impeached by House Clinton acquitted of charges by Senate House voted to proceed with impeachment proceedings Source: RBC US Equity Strategy, Bloomberg November 1,

13 Small/Large Trade Mostly Trending With Trump s Polling Numbers Exhibit 17: Small/Large Relative Performance vs Trump Favorability In 2016 and 2017, Small Cap performance vs. Large Cap was closely tied to Trump s favorability in the polls, with Small Caps leading when Trump s favorability was up. Tax reform explained the relationship in 2017, the dollar/trade explains the link in early/mid In mid September, the trade diverged from the polling data as investors started to view trade as more of a threat to global growth with the potential to bring about the end of the economic cycle. We still acknowledge the possibility that Small Caps could rally more on a Republican sweep than Large Caps as surprised investors could be inclined to pull out the November 2016 playbook, and Small Cap valuations are attractive vs. Large Caps. But our confidence has been lowered given the recent breakdown in this relationship Small Rel to Large Source: RBC US Equity Strategy, Bloomberg, Russell Real Clear Politics Trump Favorable Poll Average November 1,

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