With the US midterm elections approaching, Wall Street bets on a divided Congress—will markets see a mild respite?

As the US midterm elections enter their final stretch, Wall Street is increasingly viewing a "divided Congress" as the baseline scenario and believes this outcome might be the relatively moderate policy result given the current market environment.

According to Bloomberg, investors generally expect Democrats to take back the House in November while Republicans maintain control of the Senate, albeit with a narrow margin. The market believes that this setup will reduce the odds of rapid major policy implementation, forcing both parties into gridlock or compromise on more issues, thereby easing policy uncertainty.

Stuart Kaiser, head of U.S. equity trading strategy at Citigroup, stated in a client report, "A ‘divided government’ will 'force both sides into gridlock or seek compromise', making policy choices more moderate, 'allowing the stock market to focus on corporate and economic fundamentals.'"

Meanwhile, the market is also preparing in advance for volatility around the election. The futures market linked to the Chicago Board Options Exchange Volatility Index (VIX) indicates that demand for S&P 500 volatility protection in early November has risen significantly.

A Divided Congress May Be the Market’s “Optimal Outcome”

Historical data supports Wall Street’s optimism. According to research compiled by Carson Investment Research, since 1950, during times when a Republican president is in office while each house of Congress is controlled by a different party, the S&P 500 has seen an average annual gain of 13.7%; in comparison, when Congress is wholly controlled by either party, average gains are only 8.3% for the Republicans and 4.9% for the Democrats.

Stifel’s chief Washington policy strategist Brian Gardner said, "Investors are expecting a divided Congress. If this becomes reality, with Democrats taking the House though not by a landslide, I think we may see a relief rally."

Artificial intelligence has also become one of the most watched topics in these midterm elections. As investor sentiment around data center buildouts continues to run high, the market is facing the growing regulatory risks confronting this core technology that has driven the U.S. stock bull run over the past four years.

Under a divided government, the possibility of disruptive policy changes in AI, defense, and healthcare will be sharply reduced, which is precisely why the market considers this scenario the “most positive outcome.”

If One Party Sweeps, Markets May Face High Volatility

However, the high market consensus on a divided Congress is itself a potential risk—should the eventual result diverge significantly from expectations, equities could experience sharp swings.

A Democratic sweep of both chambers is not impossible. While Trump remains the Republican Party’s largest mobilization force, his record-low approval ratings are becoming a major drag. Republicans are counting on a midterm campaign push, informally dubbed "Trumpapalooza", to avoid repeating the party’s setbacks during Trump’s first term.

According to Bloomberg, a team led by Bank of America strategist Michael Hartnett noted last month that if the GOP performs strongly and Texas Governor Greg Abbott is re-elected, it will clearly boost AI-related trades; conversely, if Democrats win the Senate and Abbott loses, the stock market will be at risk of a 'sharp correction.'

Phil Wool of Rayliant analyzed that a Republican sweep would benefit sectors likely to gain from further regulatory easing, with energy and financials among potential winners; a Democratic “blue wave,” by contrast, could strengthen renewables and healthcare service providers.

Institutions Position Early, Long-Term Strategies Still Prevail

While the market is preparing for the election outcome, not all institutions believe the midterms are sufficient to change long-term investment strategies.

Omar Aguilar, CEO of Schwab Asset Management, said that although political outcomes always make clients anxious, most election results have limited real impact on the market’s long-term trajectory. He acknowledges that certain sectors may see increased short-term volatility, but argues this should be viewed as an opportunity to adjust portfolios, not a sign to overhaul overall strategy.

"Clients are indeed watching, just as they do when oil is at $100," Aguilar said. "But does this mean they have to change their strategy? Our advice is always: no, just stay the course."