If the Democrats win the House, will the markets turn red?

Will investors panic if Democrats take control of the US House of Representatives after next week's midterm elections?

Posted Updated

Paul R. La Monica
, CNN Business
(CNN) — Will investors panic if Democrats take control of the US House of Representatives after next week's midterm elections?

Various political experts and pollsters are predicting that there is an extremely high chance Democrats will take control of the House. In fact, CNN's The Forecast is currently estimating that Democrats wind up with a 17-seat majority in the House.

Some market experts blame the recent bout of volatility on Wall Street, in part, on growing expectations that Democrats may win the House.

The big fear? Emboldened Democrats might talk more about dialing back President Trump's signature tax cuts -- or, at the very least, not extending the cuts for individuals, which are set to expire in 2025.

It's unclear if Democrats would be able to actually kill the tax cuts, which they say are a giveaway to the rich and have caused the deficit to balloon, especially since they are probably not going to win a majority in the Senate.

Trump, who has touted the tax cuts as a boon to corporations and regular Americans, also has the executive power of a presidential override.

No more tax cuts in addition to Fed rate hikes may roil market

Still, any uncertainty could be troubling for stocks, particularly since there are already worries about continued interest rate hikes from the Federal Reserve possibly slowing the economy down.

"If the Democrats try and roll back Trump's tax cuts, he will be sitting there with the veto pen," said Hugh Johnson, chief investment officer of Hugh Johnson Advisors. "But just the talk of monetary and fiscal restraint at the same time could be cause for trouble for the markets."

in other words, you could have the Fed hiking rates at the same time that Democrats, who will already have an eye on the 2020 elections, likely talking more about a need for responsible spending and keeping debt levels in check.

At the very least, a Democrat-controlled House would be far less inclined to pass any new tax cuts -- even if they don't repeal any of the existing ones.

Trump goes on the offensive ahead of midterms

That's potentially a killjoy situation for the market. With that in mind, it's no wonder that President Trump is starting to tweet about what he feels are the perils of a Democrat victory in the House combined with rate hikes.

Trump tweeted Tuesday that "the Stock Market is up massively since the Election, but is now taking a little pause - people want to see what happens with the Midterms. If you want your Stocks to go down, I strongly suggest voting Democrat."

And he followed that up with a tweet quoting Wells Fargo market strategist Scott Wren saying that if the Fed "backs off" on rate hikes, the stock market would go back up.

Still, even if Democrats don't wind up pushing aggressively on taxes, there's the possibility that a divided government will lead to more gridlock. Although Wall Street often prefers it when Washington isn't doing much, this time might be different.

Lewis Alexander, US chief economist at Nomura, wrote in a report last week that a Democratic victory in the House will make it unlikely to "generate much in the way of positive economic policymaking."

He wrote that the new USMCA trade agreement (i.e. the NAFTA replacement) could still get ratified. But Alexander said he was "skeptical that a House led by the Democrats will be able to work with President Trump to pass an infrastructure bill."

Would gridlock be bad for the markets or business as usual?

Hopes for a major rebuilding of the nation's infrastructure was something that both President Trump and his Democratic challenger Hillary Clinton agreed on, although there were different opinions about what should be prioritized and how a plan would be funded.

Alexander suggested that "a Democrat House will be reluctant to support initiatives that Trump could use to advance his reelection chances in 2020. In this context, business sentiment may deteriorate over the months immediately after the election."

There is a danger to that strategy. Playing the obstructionist card could hurt Democrats if the economy cools and Trump blames inaction in the House for that.

That's why Jason Pride, chief investment officer of Glenmede, points out that Democrats could "cater to Trump's more populist agenda on things like infrastructure spending and drug pricing."

That would mean a victory for Trump but it's something Democrats could also take credit for.

Still, one strategist thinks history will repeat itself if the Democrats win the House. As long as the economy doesn't fall off a cliff, Wall Street will likely cheer gridlock in Washington once again.

"The economy is still doing well, so nothing is really needed on the policy front," said Leah Traub, partner and portfolio manager with Lord Abbett, in a report.

"Markets will trade more on the U.S. and global economic outlooks rather than anything to do with what's happening—or not happening—in D.C.," she added.

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