The markets are hoping for gridlock in the US midterms

Gridlock is good. The midterms in the US will almost certainly deliver it, for whatever happens in the Senate, according to FiveThirtyEight there is only a 16 per cent likelihood of the Democrats retaining control of the House.

Polls get things wrong, but let’s assume they can’t be that wrong this time. Midterms are mostly about politics but they also have an economic spin-off. For the rest of the world, that spin-off is what matters. So, viewed from the UK and Europe, what does this mean?

The first thing to get out of the way is why financial markets like gridlock – why should they want governments to be unable to do very much? The best explanation is that neither companies nor markets like disruption. The planning horizon for any large corporation ranges up to 10 years, maybe more, and that is far longer than the political cycle in any regular democracy.

True, if there is some disaster – the pandemic is an example – companies are just like the rest of us. They want action. The giants also want to game regulation to their advantage, for big wealthy companies have quite different priorities from smaller, poorer ones. But as a general rule, it is easier to plan if government policies are stable.

Gridlock is a horrid word, but stability is a nicer one. To over-simplify a bit, having Congress controlled by a different party from the presidency is likely to provide that.

Next, there is a remarkable phenomenon in the US financial markets, in that equity prices often fall in the run-up to the midterms, then shoot up afterwards. Some research by Strategas, a US brokerage and advisory firm, shows that the S&P500 index has not fallen in the 12 months following the midterms since 1946, and “with stocks up one-year from the low every time since 1962, and by an average of 31.6 per cent”.

Since the beginning of this year, the S&P500 has fallen just about 20 per cent, so if the next 12 months conform to type, all the ground lost in the current bear market should be regained at the latest by the end of next year. Actually, the average recovery usually gets going in October, ahead of the vote, with November and December very strong months.

There is a further element at work, the Federal Reserve. The Fed always matters, but right now is one of those moments when it is particularly important. It is committed to getting inflation back to 2 per cent, and that drive to do so dominates global markets. But there are signs that the turning point in inflation, at least in the US, if not in Europe, is in sight.

The survey of inflation expectations carried out by the New York Fed (one of key constituent banks of the Federal Reserve System) shows that these have fallen to 5.4 per cent a year from now and 2.2 per cent five years out.

There is no point in trying, from this side of the Atlantic, to unpick the complex interactions that will determine US monetary policy in the coming months. What is worth saying is that insofar as loose fiscal policies have pushed up overall demand – and hence added to inflationary pressures – over the past two years, a gridlocked Congress will, at the margin, lead to a tighter fiscal stance.

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So the Fed will not have to compensate to the same extent in the future as it has in the past for this source of inflation. That does not mean lower interest rates right now, but it does mean lower rates in the future than would otherwise be the case.

The sources of inflation in the UK and Europe have a different balance from those in the US. Here, these are mostly rising energy costs and only partly strong pressures of demand. In the US, they are mostly the pressure of demand, with higher energy prices secondary.

In addition, the strong dollar has helped the US hold down import costs, whereas the weak pound and euro have had the reverse effect. So you cannot read across whatever is happening to US financial conditions and apply them directly to the UK and Europe. But there are links.

If the midterms set a recovery in US equities in motion, that at the margin must help UK and European share prices too. If we all get sight of a peak in US interest rates, that might well cap the rise of the dollar, which in turn would help contain inflation here.

Calmer times ahead? In US politics – maybe not. But in terms of economic conditions in the US, the answer is probably yes. A bit of calm would be more than welcome over here too.