Three Themes That Matter More Than the Midterms

This year hasn’t followed the average pattern. U.S. equities remained well above the typical midterm-year path as other forces, including resilient corporate earnings and AI-linked investment, played a more important role.

The break from historical trends offers an important lesson: Political developments may contribute to volatility, but election-cycle averages are not an investment thesis, and there are more influential factors than politics guiding markets in midterm years and beyond. Instead of being distracted by the midterms, investors should focus on central bank policy, rates and the AI boom, three themes that have shaped markets this year and will continue to do so long after polls close.

The most important man in Washington isn’t on the ballot this year

For markets, the center of gravity in D.C. isn’t the White House or the Capitol. It’s the Federal Reserve.

Fed Chairman Kevin Warsh took his first steps to quell inflation last month when the Federal Open Market Committee voted unanimously in favor of a 25-basis point hike. Warsh has taken a different approach from his predecessors, minimizing communication in the hope that the market will price in the correct level of rates instead of taking its cue from the central bank.

After deciding to keep rates flat at the first and second meetings of his chairmanship, Warsh changed course after delivering a hawkish speech at Jackson Hole in which he promised to rein in inflation that’s remained stubbornly above the Fed’s 2% target for several years.

After Warsh’s comments during the last Fed meeting, we see the potential for one or two additional hikes between now and September 2027. October’s decision is scheduled for the week before the midterms, and the Fed typically does not engage in hikes so close to an election. Even if they keep rates steady at their next meeting, future Fed decisions will be key in determining the rate of inflation and the direction of the U.S. economy.

The new rate regime requires caution

Even without the level of forward guidance it’s used to, the market’s done plenty to contain borrowing. The recent sell-off in bonds put Treasury yields at multi-decade highs, making debt more expensive for borrowers ranging from large corporations to first-time homebuyers.

Several factors could be contributing to the run-up in yields, from historic levels of government debt to heavy issuance by technology companies looking to finance AI infrastructure.

While all those scenarios are plausible, we’re more focused on the effect of the bond sell-off: A return to the rate regime we saw prior to the Global Financial Crisis. Exhibit 2 shows that much of the increase in yields on longer-dated debt has occurred in real yields, or yields minus expected inflation. That means markets see more of a case for resilient economic growth and greater compensation for investors holding longer-maturity bonds versus an environment where inflation remains higher.

EXHIBIT 2: REAL YIELDS ARE DOING THE HEAVY LIFTING

The upshot for investors is that it’s important to build a balanced portfolio that can handle rates moving sharply in either direction.

The AI boom has a love-hate relationship with inflation

Undergirding all the discussion around inflation, rates and even politics is the way AI is fundamentally reshaping the global economy.

As demographics shift and much of the workforce ages out, we see AI helping to keep productivity resilient. That could help to contain inflation in the future. While the full effect of AI on the economy and productivity is far out, its impact is already felt in markets. The Magnificent Seven%7% technology stocks that dominate the S&P 500 are all exposed to the theme somehow, whether it’s Tesla’s bet on robotics and autonomous vehicles or chipmaker Nvidia’s development of a computation financing platform.

For now, spending on chips, data centers and infrastructure hungry for energy is contributing to pressure on limited inputs including semiconductors, electricity demand and construction costs. As illustrated by Exhibit 3, mammoth issuance by so-called “AI hyperscalers” is one potential contributor to the sharp move higher in bond yields.

EXHIBIT 3: AI IS TAKING OVER THE BOND MARKET

Constructing more data centers is quickly falling out of political favor. An NPR/PBS News/Marist Poll conducted in September found that 58% of registered voters surveyed believe that the construction of datacenters nationwide will have a negative impact on the country. Voters were even more agitated by the idea of data centers being built in their communities, with 65% opposed to it regardless of their political affiliation.

Election outcomes that reward candidates advocating for tighter restrictions on construction could increase the risk to data-center-exposed companies and influence infrastructure policy ahead of the 2028 general election. Given long project lead times, the more significant question is whether political resistance constrains capital spending and the pace of broader AI diffusion from 2028 onward, rather than materially changing investment that is already committed.

Investor playbook: Focus on the themes that can move markets

Our positioning continues to reflect the economic and earnings backdrop rather than the election calendar. We see monetary policy, the rate environment and the AI boom as themes that will continue to influence markets long after the election is over, and we favor remaining invested instead of allowing headlines to interfere with fundamentally grounded investing decisions.