Preparing investors for mid-term fever

Below is a commentary I wrote that was first published by Business Insider on September 7. To read the story on BusinessInsider.com, visit https://read.bi/2wSdaWj.

To learn more about how investors can expect markets to react following the US mid-term elections, read the UBS CIO's latest ElectionWatch report at https://bit.ly/2CqTUVQ.

Investors are likely to find themselves tired of rhetoric, short on patience and disappointed with the consistent flood of commentary on the mid-term Congressional elections this fall. However, as many have learned since the fall of 2016, with the longest-ever bull market approaching 3,500 days, investing based on personal reactions to electoral results often leads to suboptimal results. Further, research has shown that political bias can significantly hamper investors' ability to make prudent investment decisions - especially if they allow political disappointment to morph into investment pessimism or fear.

Now, roughly two months from Election Day, it's a good time to consider how the composition of the 116th Congress may impact investors' decision-making. Here are four potential electoral outcomes and what they could mean for markets (note that these scenarios should not be interpreted as support for any political party or candidate).

First, a "red tide," in which Republicans expand their majority. While this outcome is improbable in our view, it would likely be supportive for risk assets. Substantial Republican gains would also set the stage for party leaders to address deficit concerns through major initiatives like entitlement reform, which would support stocks, the US dollar and US Treasuries. Conventional wisdom, however, is that Republicans will probably lose at least a few seats.

A second but still unlikely outcome is the "status quo": Republicans keep a reduced majority in both chambers of Congress. This result would likely support stocks in the short term but hinder attempts to address the deficit, putting downward pressure on US Treasuries and the US dollar.

Third, and far more likely in our view, is the "historical norm": the non-incumbent party - in this case the Democrats - picks up a modest majority in the House, while Republicans hold onto the Senate. Should this happen, expect legislative gridlock to put renewed pressure on the dollar and Treasuries.

Probably the biggest red herring for investors in this outcome is the possibility that a Democrat-controlled House impeaches President Trump. It's important to acknowledge that unless a Republican Senate voted to remove the President - unlikely, in our view - there would still be few immediate implications for US policy and hence for markets (which didn't blink after the House impeached President Clinton in 1998).

What happens in a fourth scenario in which Democrats gain sizable control of the House and a majority in the Senate? A so-called "blue wave" is much less likely than the "historical norm," though worth considering as it may carry the most uncertainty for investors. In this scenario we expect DC gridlock to worsen and more last-minute dealmaking over issues like the debt ceiling. During the debt ceiling crisis in 2011, the S&P 500 dropped nearly 20% in just a few weeks. Market shocks like this become more possible when extreme gridlock prevents policymakers from acting swiftly and decisively.

Today, the investors I speak with are most concerned with the impact of global trading policies on the economy and markets, and want to know what impact mid-term changes could have. In fact, in UBS's most recent Investor Watch Pulse survey of US business owners and investors, most had very strong views on the topic and favored fighting back against unfair trade practices, even if they find a full-blown trade war unpalatable.

They're right to be concerned about the potential effects of a trade war on market stability and growth, but when it comes to questioning how any potential mid-term changes could impact the simmering dispute, the short answer is not much. Trade will remain the most powerful economic issue regardless of who controls Congress, since President Trump's policies will continue to be the most important variable. In other words, investors should keep a close eye on where trade is heading, but shouldn't expect the mid-terms to heavily sway the debate.

With mid-term fever inevitably set to descend on the country, wealth managers and financial advisors must help investors cut through the noise, prepare them for any resulting volatility, and keep them focused on their longer-term goals. Emotional decision-making rarely leads to optimal outcomes. Instead, advisors must encourage investors to stay the course with their financial plans and to tactically take advantage of excessive market reactions.

Goals-oriented investors with a financial plan and a prudent financial advisor will know what to listen to, what to disregard and how to react when the election results come in.