Citigroup Interpretation: How will the midterm elections affect the U.S. stock market at the end of the year?

TL;DR ·Citigroup believes that the expectation of the Democratic Party regaining control of both houses of Congress has been largely reflected in market sentiment. If the Republican Party unexpectedly retains the Senate, it could provide a catalyst for a rise in U.S. stocks by the end of the year. ·The previous optimism regarding healthcare relative to financials and banks has mostly been realized; if the Republican Party retains the Senate, it may further support the performance of financial stocks. ·Local elections may impact data center approvals, slowing down the deployment of new computing power, but a slowdown in construction pace may also alleviate the pressure of concentrated financing. ·If the Democratic Party wins more than 53 seats in the Senate and more than 235 seats in the House of Representatives, the market may begin to factor in the risk of corporate tax increases in 2028; entering 2027, budget, debt ceiling, and deficit financing will also become important variables.

Whether U.S. stocks can gain new upward momentum by the end of the year, Citigroup is focusing on the changes in policy expectations brought about by the midterm elections. If the Republican Party unexpectedly retains the Senate, it may boost market sentiment and provide support for financial stocks; if the Democratic Party achieves a larger-than-expected majority, the market may begin to factor in the risk of corporate tax increases in 2028, putting pressure on valuations.

In a U.S. equity strategy report released on October 30, Citigroup pointed out that the expectation of the Democratic Party regaining control of both houses of Congress has been largely reflected in current market sentiment. Therefore, the gap between the results and expectations will be key in influencing stock price reactions.

Citigroup expects that the direct impact of this election on corporate fundamentals will be relatively limited, but changes in policy expectations may drive sector rotation and affect overall valuations. Financial regulation, healthcare budget negotiations, and local policies affecting AI data center construction are among the areas worth paying attention to.

Finance and Healthcare: Previous Trades Realized, Next Focus on Policy Changes

Citigroup previously recommended a positive outlook on healthcare relative to financials and banking sectors. As market expectations for the Democratic Party winning both houses of Congress heat up, this relative value trade has mostly been realized.

The potential support for the healthcare sector mainly comes from budget negotiations. Citigroup believes that if the Democratic Party regains control of the House of Representatives, it may seek to restore some of the healthcare spending cuts, including reversing some of the cuts in the Inflation Reduction Act (OBBBA). Even if the two houses of Congress are controlled by different parties, related demands may still enter budget negotiations.

However, the change in control of the House of Representatives does not necessarily mean that spending will increase; the specific outcome still depends on negotiations between the two parties.

Financial stocks are more sensitive to the Senate results. The leadership of Senate committees can influence the regulatory agenda and policy atmosphere, and the Senate also has the confirmation power over Federal Reserve personnel appointments. Based on this, Citigroup judges that if the Republican Party retains the Senate, financial stocks may receive tactical support.

This judgment is premised on the fact that the market has already largely factored in the expectation of a Democratic victory. If the Republican Party performs better than expected, financial stocks may rise with adjustments in policy expectations, providing support for overall market sentiment by the end of the year.

Entering 2027, the impact of fiscal policy may further expand. The Democratic Party may seek to restore healthcare spending, while the Republican Party may push for increased defense spending, bringing budget, debt ceiling, and deficit financing back into focus.

For the stock market, spending expansion has a dual impact: fiscal stimulus may support the economy and corporate revenues, while larger deficits and financing needs may also increase market concerns. The ultimate impact needs to be assessed in conjunction with the scale of spending, sources of funding, and negotiation outcomes.

AI Construction: Approvals May Slow, Financing Pressure May Alleviate

The impact of the midterm elections on AI trades may also be transmitted through gubernatorial and local elections.

Citigroup expects that if the Democratic Party expands its advantage at the state and local levels, data center construction may face more resistance. Land use zoning, site selection, and permit approvals may all affect project construction progress, thereby slowing down the deployment of new computing power.

Texas is highlighted as an observation target in the report. The results of various levels of elections in the state, as well as subsequent policy changes, may influence market judgments on local data center construction. For investors, the policy environment of the project location will become an important factor in assessing AI infrastructure investments.

However, Citigroup's concerns about the long-term fundamentals are relatively limited. Its judgment is that policy resistance is more likely to extend the time for computing power to come online rather than lead to the cancellation of overall planned capacity.

A slowdown in construction may also bring another impact: the demand for funds is spread over a longer time, thus reducing the pressure of concentrated financing in the short term. Therefore, while delayed approvals may affect the revenue realization time of some projects, it may also alleviate market concerns about overly concentrated spending on AI infrastructure.

This means that changes in local policies may have different impacts on companies in the AI supply chain. Project distribution, production time, and financing arrangements will determine which companies face more significant pressure.

U.S. Stock Valuations: Beware of 2028 Corporate Tax Increase Expectations

For the overall U.S. stock market, Citigroup's longer-term focus is on corporate taxes.

If the Democratic Party gains a significant advantage in this election, it may improve its political prospects for 2028, prompting investors to adjust their judgments on future post-tax profits in advance. Citigroup points out that raising corporate taxes aligns with the Democratic Party's policy priorities during the 2024 campaign, so the market may begin to factor in related risks before the policy actually occurs.

The continuity of Senate seats gives this election a longer-term impact. Senators serve six-year terms, and the seats won in this round will extend beyond 2028. Citigroup notes that most of the seats the Democratic Party will face re-election for in 2028 are located in relatively safe states for the party, and if they achieve a larger majority this time, their foundation for maintaining control of the Senate will be more solid.

The observation criteria provided by Citigroup are: the Democratic Party winning more than 235 seats in the House of Representatives and more than 53 seats in the Senate. In its scenario analysis, such results may increase the probability of the Democratic Party simultaneously controlling the White House and both houses of Congress in 2028, thereby intensifying market concerns about corporate tax increases.

This risk still belongs to long-term policy expectations and does not mean that corporate tax rates will change immediately after the midterm elections. However, for stock valuations, adjustments to future post-tax profit expectations can be reflected in prices in advance.

At the same time, the Republican Party retaining the Senate remains a realistic possibility. The report points out that the polling gaps in several key Senate races are still within the margin of error, and small yet consistent polling deviations could change the outcomes in multiple states.

Therefore, Citigroup presents two main scenarios for U.S. stocks: if the Republican Party retains the Senate, it may lead to better-than-expected results, supporting the year-end market; if the Democratic Party achieves a larger-than-expected majority, it may cause the tax risk for 2028 to enter market pricing earlier, putting pressure on valuations.

After the election, the financial regulatory agenda, healthcare budget negotiations, data center approvals, and the fiscal arrangements for 2027 will determine whether these expectations can translate into actual profit changes.