US Midterms Near, Global Economy Hangs in Balance

With the US midterm elections just over a month away, historical patterns suggest a challenging period for the stock market. However, the market has shown unusual resilience to rising bond yields and oil prices, with the VIX index indicating low investor concern. One explanation is the expectation of strong earnings growth, while another points to the approaching midterms.

Historically, midterm election years are difficult for stocks, but the month leading up to the vote has often seen gains. In nine of the last 11 midterm elections, the S&P 500 rose in the month prior to voting. The only exception was in 2018 under Donald Trump, when the index fell. This year's performance may follow the historical pattern or again diverge, as it did in 2018.

In 2018, Trump's tax cuts boosted corporate profits and a strong economy, aided by tech stocks, pushed the market to new highs. However, rising bond yields due to strong growth led the Federal Reserve to raise interest rates, causing investor fears of further monetary tightening. Trump's criticism of the Fed and escalation of the trade war with China, including reports of new tariffs just before the vote, contributed to a market downturn of about 4.5% in the month before the elections.

Republicans are currently trailing in the polls, with Democrats holding a significant lead in national congressional intent. While this doesn't guarantee Democratic control, it suggests a serious threat to the Republican majority in the House of Representatives and potential losses in Senate races. The key question for investors is how much Trump prioritizes these election outcomes.

Unlike in 2018, when he was campaigning for re-election, Trump is now in his final constitutional term. He has stated he does not care about the midterms, suggesting a potential focus on core policy objectives, such as confronting Iran, over Republican electoral success. This stance, coupled with the significant polling deficit, may make concessions less appealing for him.

If Trump does not back down from his stance against Iran, Tehran may feel compelled to escalate. Iranian oil exports have dwindled, and its currency has hit record lows. The commander of Iran's army issued a stark warning: "If Iran cannot trade, if Iran cannot live, no one will be able to trade or live." Iran faces a choice between escalation or defeat, with escalation appearing to be the more rational option given its current position.

Recent diplomatic activity, including Benjamin Netanyahu's visit to the UAE and a visit by the UAE's Vice President to Saudi Arabia, suggests a US-led effort to unite regional partners against Iran. Tehran's attempts to gain support from Gulf states may be countered by US efforts to draw them in a different direction. If Iran perceives its diplomatic efforts are failing, it may resort to aggressive actions, potentially impacting oil prices.

Beyond the Middle East, Europe and China are approaching a critical juncture in their trade relations. The EU aims to curb import surges from China that have widened its trade deficit and pressured its manufacturers. An upcoming European Council summit could signal the start of a major trade dispute.

Concerns also exist regarding artificial intelligence (AI). While Trump has previously warned of potential bans on Chinese AI models, his recent statements suggest a belief that the US can maintain its lead without immediate action. However, the rapid advancement of AI in China, coupled with potential conflicts with Iran, could lead to a delayed confrontation with China, further increasing risks for investors.