Goldman: Divided Government Could Hurt Small-Cap Stocks

With the Democrats likely to take over the House, legislative gridlock may have a Wall Street impact, study shows.

Odds appear strong that the Democrats will capture control of at least the House of Representatives this fall. If so, expect small-cap stocks not to perform as well with a divided government, according to a Goldman Sachs analysis.

Using data from 1979 through this year, the investment house indicated that small stocks gained 21.8% annually under a united government—where a single party controls the White House and both chambers of Congress—but that showing was more than halved under divided rule, to 9.5%.

This conclusion, in Goldman’s mid-year investment outlook, didn’t spell out any difference of performance under Democrats or Republicans.

By Goldman’s reckoning, large-cap stocks also had a fall-off under divided rule, to 10.8% from 16.4%. But the firm termed that difference not statistically significant.

Either way, divided government often means that legislative initiatives are bogged down. During Barack Obama’s presidency, he passed Obamacare and fiscal stimulus packages during his first two years, when his Democratic Party had complete dominance of both ends of Pennsylvania Avenue. Obama’s program ground to a halt once the Republicans, as the result of his first mid-term election, seated a majority in January 2011. 

By the same token, GOP President Donald Trump got through tax cuts, a Supreme Court justice (and maybe two), and a military spending increase in his first two years.

Perhaps the difference between large and small stocks is that big corporations have the financial heft to better weather legislative stalemates. (Think government shutdowns.)

Bonds, however, did better with a divided Washington, 8.8% versus 3.6%. Maybe that reflects a lack of significant government spending growth due to gridlock. Higher federal outlays may hike inflation, which harms bond prices.

Right now, Goldman noted, polling data show that there’s a 60% chance that the Democrats will wrest the House majority away from the Republicans in the upcoming mid-term elections. But surveys also say that the Democrats have only 30% odds of taking over the Senate. The Senate numbers may reflect that more Democratic seats are up for grabs this time, a number of them in Trump-supporting states. The 60% poll applies to the House.

Goldman also pointed out that early congressional polling results often came out differently when the actual voting occurred.

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