Maintaining perspective during the U.S. midterms

To an already crowded list of topics competing for investors’ attention, we can add the rapidly approaching U.S. midterms elections slated for the first Tuesday in November. Given the host of hot-button issues – along with the endless campaign coverage – we can understand why some investors believe such events could potentially represent an inflection point in financial markets.

While recognizing that elections indeed have consequences, we believe investors should maintain the perspective that what matters most for financial outcomes is compounding returns over longer horizons. Implicit in this mindset is that the secular drivers of returns play out over multiple election cycles. Of greater relevance than any particular cycle’s flagship issue is the policy framework that governs how economies function, enable capital formation, meet customer demand and generate profits.

Regardless of the temperature of campaign rhetoric, change within this framework tends to be incremental, which is one reason why the U.S. and other similarly governed countries tend to be destinations for investment capital.

Looking at the full cycle

In the stock market, we say that equities follow earnings. The historic investment hyperscalers make in artificial intelligence (AI) infrastructure today is done so with the aim of growing earnings over the next decade and even longer. When allocating capital over such horizons, management teams factor in potential changes in the macroeconomic cycle and regulatory environment. Similarly, investors also consider these changes when assigning a risk premium to a particular security.

With demand trailing AI compute capacity, and companies and governments considering deployment of this technology a strategic priority, we believe hyperscaler earnings growth will remain a considerable driver of aggregate corporate profits over the remainder of the decade. Importantly, we are already seeing a dispersion of AI-related earnings as end users begin to register productivity gains.

Within this context, the data-center backlash that’s become part of several state and local political campaigns may impact the when, where, and for how much of this buildout, but it won’t, in our view, materially slow it down.

Sticker shock

Another key issue across jurisdictions is affordability, with the cost of energy being a major driver. High energy prices are inextricably linked to geopolitical developments. But even a reaction at the ballot box to higher prices may not greatly impact policy, as the U.S. system affords the executive branch significant power in executing foreign policy.

We largely share the consensus view that high energy prices will eventually recede. But the duration of the energy shock and its leaching into core prices, coupled with AI’s potential to be inflationary before it is disinflationary, is likely to be at the forefront of many voters’ minds.

Prices have already had a policy impact, but on the monetary side. In response to persistently above-target inflation, the Fed raised rates in September for the first time since 2023. Influencing the cost of capital is a major policy lever, but one largely insulated from the U.S. electoral calendar. With forward-looking markets expecting possibly up to three more hikes before mid-2027, the Fed may make inroads on its price-stability mandate, but at a cost of higher interest rates causing companies and households alike to reconsider big (and sometimes small) purchases. Providing the Fed latitude is a remarkably resilient U.S. economy.

Learning to love gridlock?

Mid-term elections tend to be unfavorable events for the party in power. That doesn’t bode well for a Republican Party in control of the White House and both branches of Congress. Democrats gaining control of the House of Representatives – with a remote shot at winning the Senate – would represent a return to a split government. As seen in Exhibit 1, this has been the governing arrangement for nearly 65% of the past half century.

Given the U.S.’s economic growth over this period, equities generated similar returns (just over a 50 basis-point difference) under unified or split control of Washington. Higher volatility during years with split control may have been caused by policy uncertainty, but a counterargument is that split government potentially insulated voters – and the economy – from some of the most ambitious intentions of a single party. In short, gridlock may be good.

Preparing for an AI-enabled and deglobalizing world

In this – or any – election cycle, we believe investors need to maintain this long-term view. We think AI has the potential to reset U.S. economic and corporate earnings growth on a higher trajectory. While high energy prices due to conflict in the Middle East could eventually fall, we caution that this is yet another byproduct in the trend toward deglobalization.

Collectively, these forces are likely to be inflationary and add volatility to markets. As we discussed earlier this year, corporations, government borrowers, and investors must accept that we have entered a higher-cost-of-capital regime. Exacerbating this development is fiscal profligacy on the part of both U.S. political parties, as well as most governments in Western Europe.

While that may diminish the luster of longer-duration fixed income products, in our view, it presents an opportunity for investors to conduct rigorous analysis to determine which management teams and governments can deliver in meeting these higher-return thresholds.

IMPORTANT INFORMATION

Artificial intelligence (“AI”) focused companies, including those that develop or utilize AI technologies, may face rapid product obsolescence, intense competition, and increased regulatory scrutiny. These companies often rely heavily on intellectual property, invest significantly in research and development, and depend on maintaining and growing consumer demand. Their securities may be more volatile than those of companies offering more established technologies and may be affected by risks tied to the use of AI in business operations, including legal liability or reputational harm.

Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.