How will the US midterm elections affect the financial markets?

2018 has been a busy year in the markets. Traders have had to navigate global geopolitical risks, including trade tensions, NAFTA negotiations (now USMCA: United States Mexico Canada Agreement), Trump's legal woes, the run on the Turkish Lira, Brexit and more.

However, it seems the biggest risk to markets is yet to come - the 6 November US midterm elections. That's because the balance of power in Washington has meaningful implications for domestic policy and foreign relations. This results in a global impact across all markets.

Before we look at the possible impact of these elections on the market, let us first understand the situation.

Your guide to the US midterm elections

You have probably already guessed that these midterm elections take place two years into a presidential term. On 6 November, American voters will take to the polling stations to choose new members of Congress. This is the part of the US government which makes laws and is made up of two chambers: the House of Representatives and the Senate.

Currently, both houses are controlled by the Republican Party, which back US President Donald Trump. With control of both houses, it has been much easier for Trump to pass policies. However, if the Democrats can win control of the House of Representatives, which they think they can, then they can block or delay the President's plans.

Essentially, every seat is up for grabs in the House of Representatives as they are elected to two-year terms.

There are 435 seats in the House of Representatives. On the Republican side, 150 of those seats are considered to be solid (they will be voted to remain in the party), 52 are likely to remain in the party, and 38 could potentially swing to the Democrats. On the Democratic side, 182 seats are solid, 10 are likely, and 3 are up for grabs.

Who is going to win and how will that affect the markets?

Historically, it does not look good for Trump. The party with a President in the White House has lost an average of 32 seats in the House of Representatives in every midterm election since the American Civil War in 1861.

President Trump has also been through a roller coaster year, full of scandals and sinking popularity ratings. In fact, Trump is one of the most unpopular presidents of modern times, with approval ratings around the 40% mark.

So how will this affect markets? Let's take a look

US midterm elections and the markets

As the elections draw closer, contentious issues like immigration, race relations and foreign policy will certainly make the headlines. However, when analysing the market's reaction it is important to try and focus on the economic considerations.

However, that is easier said than done. That's because markets like foreign exchange can move from headline to headline. In this instance it can be useful to look at some statistical evidence on possible market gains or losses.

Research from Keith Parker, an analyst at UBS investment bank, has noted that the S&P 500 stock market index has rallied an average of 14.5% from the end of August to the end of March around midterm elections. This is highlighted in the chart below.

Source: UBS via MarketWatch

The chart above shows the performance of the S&P 500 around US midterm elections, which is the blue line, against all other years in the brown line. The research suggested that September would result in a choppy performance. In fact, as the four hour chart of the S&P 500 index shows below, September was indeed a choppy month with quite a few swings in the market:

Source: Admiral Markets MT5 SP500, H4 - Data range: from 22 August 2018 to 9 October 2018 - performed on 29 October 2018 at 2:29 PM GMT

Now let's zoom out and look at the 12 month chart of the S&P 500 index:

Source: Admiral Markets MT5 SP500, Daily - Data range: from 29 June 2017 to 29 October 2018 - performed on 29 October 2018 at 2:31 PM GMT

The UBS research suggested that a midterm rally would start early October but, in fact, the market dropped during this period. Of course, statistical evidence is only a bias and we must take into consideration other factors that are happening in the markets. However, the outperformance of a midterm election year relative to a normal year lasts until around March the following year, according to UBS. So, there is still some room to breathe towards the upside it seems.

The real question is, if the stock market is to continue to push higher, how can it be traded? Let's take a look.

Trading the S&P 500 index over midterm elections

Traders can use simple price action patterns and support and resistance levels to help identify possible turning points in the market.

Source: Admiral Markets MT5 SP500, Daily - Data range: from 29 June 2017 to 29 October 2018 - performed on 29 October 2018 at 2:40 PM GMT

In the above chart the S&P 500 has rejected a diagonal support line (yellow), otherwise called a trend line. It has also formed a popular price action reversal pattern called a 'pin bar'.

Let's say a trader entered a 5 lot buy position on the high of the bar at 2692.39, with a stop loss at the low of the bar 2627.48. If the trade triggered the entry price and then went to hit the stop loss then the trader has risk managed their position to a loss of USD 324.55.

However, if the trader did rally higher to the next swing high point at 2821.52, formed on 17 October, then the possible profit would be USD 645.65

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.