Bank of America and Morgan Stanley have warned that the outcome of the US midterm elections could significantly influence equity markets, with a Democratic sweep potentially weighing on stocks and AI infrastructure sentiment, while continued Republican control could support risk appetite and investment.
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, Michael Hartnett, Bank of America’s chief equity strategist, said, according to MarketWatch.
If Democrats win control of both the House of Representatives and the Senate, US stocks could fall by more than 10%, Hartnett said.
The effects would extend beyond equities.
He expects the US dollar and Treasury yields to decline, while international stocks could outperform as geopolitical tensions ease and foreign markets become less exposed to trade and military conflicts.
The probability of a Democratic sweep has increased in recent weeks.
Prediction markets put the odds at 64%, up from less than 50% a month earlier, while the possibility of Republicans losing the House but retaining control of the Senate stands at 28%, according to Polymarket.
A Republican sweep, meanwhile, has a 9% probability priced into betting markets.
Hartnett described a Democratic victory in both chambers as “an electoral shift from populist capitalism to populist socialism.”
He expects higher taxes and increased regulation under such a scenario, potentially weighing on corporate earnings and investor sentiment.
In a strategy note to clients on Friday, Hartnett argued that Democratic policies aimed at tackling inflation could challenge the K-shaped economic boom, in which higher-income households have benefited disproportionately from stronger spending power and rising asset prices.
The policy shift could also put pressure on the artificial intelligence capital-expenditure boom, which has become an important driver of US equity market performance.
Trump’s political influence could shape market sentiment
Hartnett said the potential loss of political capital for President Donald Trump could be more consequential than the immediate impact on corporate taxation and regulation.
A Democratic takeover of Congress would constrain Trump’s ability to advance his policy agenda, including efforts to consolidate US control over strategic resources and maintain American supremacy in artificial intelligence relative to China.
The outcome could also affect investor expectations for government support of the AI industry, trade policy and the broader business environment.
However, Hartnett outlined several scenarios in which Republican strength could support equity markets.
If Republicans lose the House but retain the Senate, stocks could rise by more than 5%, he said. Legislative gridlock would create what he described as a Goldilocks scenario, allowing the AI capital-expenditure boom to continue while preserving the dollar’s exceptionalism.
A Republican sweep would be the most bullish outcome for US equities, potentially driving gains of 10% or more and sustaining or strengthening the AI trade.
Prediction markets, however, assign that outcome only a 9% probability.
The range of potential outcomes highlights how the midterm elections could influence not only corporate earnings expectations but also the regulatory environment and the direction of capital spending.
Morgan Stanley sees risks for AI infrastructure
Morgan Stanley shares Hartnett’s concerns about the implications of the midterm elections for the AI investment cycle, particularly the construction of data centres and the infrastructure needed to support expanding computing capacity.
Ariana Salvatore, head of public policy research at Morgan Stanley, said a Republican sweep would likely be the most constructive outcome for AI infrastructure sentiment.
“Now, that’s because investors would likely expect fewer regulatory constraints ahead. As well as a greater likelihood of active support for permitting reform, additional power generation, and development on federal land,” she said.
A Republican victory in both chambers could therefore support expectations for continued investment in data centres, electricity generation and related infrastructure by reducing uncertainty around permits and regulatory requirements.
Salvatore said a divided government would represent something closer to the status quo.
Such an outcome would preserve questions about the durability of the AI infrastructure build-out, although political gridlock in Washington would leave many substantive decisions at the state and local levels.
A Democratic sweep would be the least constructive outcome for sentiment, she said, as investors could anticipate greater scrutiny of the sector and tighter restrictions on new projects.
“Now, importantly, that doesn’t mean that we expect a nationwide data center moratorium, as I said. Rather, investors could interpret Democratic outperformance as increasing the probability of tighter local restrictions in the near term, and potentially much more federal scrutiny after the next 2028 elections,” she said.
The distinction is important for investors because the risks may emerge through local permitting decisions, power availability and regulatory scrutiny rather than a blanket federal prohibition on data centre construction.
Hartnett starts buying long-dated Treasury bonds
In the near term, Hartnett said investors may be waiting for US Treasury yields to reach 6% before buying bonds more aggressively.
However, he is already beginning to increase exposure to some long-duration assets.
He said he would be “nibbling” at US 40-year bonds, alongside indirect yield-sensitive investments such as small-cap stocks and real estate investment trusts.
The approach suggests that Hartnett sees opportunities in assets that could benefit if yields decline, even as the midterm elections introduce uncertainty into the outlook for US equities.
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