Michael Hartnett sees 10% downside or more if prediction markets are right about midterms

Prediction markets see a 64% probability of the Democratic Party sweeping Congress in the midterm elections next month.

The rising probability of the Democratic Party taking control of both houses of Congress in the midterm elections poses a "meaningful" threat to risk appetite, said Michael Hartnett, Bank of America's chief equity strategist. He posited that if the Democrats were to win both the House and the Senate, U.S. stocks could plummet more than 10%.

And more than just the stock market SPX would feel the effects, he said.

Hartnett said he would expect the dollar DXY and U.S. Treasury yields TLT to fall and international stocks to outperform, as they would no longer be undermined by wars, whether trade or military. The probability of a Democratic sweep has been rising and stands at 64% at betting-market sites, up from less than 50% a month ago. A scenario in which the Republican Party loses the House but maintains power in the Senate is currently priced at 28% by prediction markets.

There is a 64% probability of a Democratic sweep in the midterm elections, versus a 28% chance of a divided Congress, according to Polymarket.

According to Hartnett, this would represent "an electoral shift from populist capitalism to populist socialism." Both taxes and regulation would likely increase, and the upshot of that would be negative for company earnings.

In a strategy note to clients on Friday, Hartnett outlined his view that Democratic Party policies to counteract inflation could challenge the K-shaped wealth boom that has seen spending by higher-income Americans and accelerated asset-price appreciation for that group. In his opinion, it could also endanger the artificial-intelligence capital-expenditure boom.

More important, however, would be the loss of political capital for President Donald Trump, Hartnett said. Full control of Congress by the Democrats would hinder Trump's ability to force governments, corporations and resources into supporting his policies of resource monopolization and AI supremacy over China.

If the Republicans were to hold on to the Senate, though, Hartnett said stock prices could increase by more than 5%, as the legislative gridlock would be what he called a Goldilocks scenario: The AI capex boom would continue unabated, and the dollar's exceptionalism could persist.

The most bullish scenario is a Republican Party sweep that would prompt a jump of 10% or more in stocks and sustain or further boost the AI trade. Betting markets are giving such an outcome only a 9% chance, however.

Outside the U.S., Hartnett highlights the potential allure of Latin American markets, especially after the market-friendly outcome of the first round of Brazilian elections. The recent political shifts in Latin America have put right-wing governments in place in 11 of the region's 20 countries, with a combined population of 420 million.

Markets, judging from reactions like the 13% spike in the Brazilian benchmark Bovespa index BR:BVSP this week, seem to be embracing a shift toward fiscal consolidation, lower rates and business-friendly policies. Hartnett points out that even with Brazilian stocks at all-time highs, Latin American stocks ILF as a whole are still 35% below the record set in 2008.

Latin American stocks are still 35% below their all-time high.

The rightward trend is also being seen beyond in Latin America. In Europe, Germany, Italy and France are being joined in shifting that way by Spain, where the death of an 87-year-old woman came to epitomize the housing crisis, and where fresh elections have been called for Nov 29. At present, a center-right party is leading in the polls, and according to Hartnett, this may represent a very early but nonetheless positive signal for European bonds, if fiscal conservatism and pro-growth policies emerge.

In the very short term, Hartnett said that while investors may be waiting for 6% yields to buy Treasury bonds, he would be "nibbling" away already at U.S. 40-year bonds and indirect yield plays like small caps RUT and real-estate investment trusts VNQ .

-Jules Rimmer