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Executive Summary Chart 1Quant Model Prediction Vs. Past Outcomes Complementing the US Political Strategy Quantitative Presidential And Senate Election Models, we introduce our Quantitative House Of Representatives Election Model. Our House election model measures the expected change in seats that will be won or lost by the incumbent party (Democratic Party) in the midterm election. The model predicts that Democrats will lose 21 seats, giving up control of the House and resulting in political gridlock from 2023 to 2025 even if the Democrats somehow hold onto the Senate. The “Blue Sweep” policy setting is effectively over. In a last ditch effort, Democrats will look to pass a budget reconciliation bill before the election. Post-midterm, financial markets will see gridlock as a marginal positive in 2023, as long as inflation levels off. In the very near term, however, US equities still face formidable hurdles that should warrant investors taking a defensive position. ​​​ Asset Initiation Date Return Long DXY (Dollar Index) 2022-02-23 6.1% Bottom Line: Stay tactically defensive until US election risk subsides and global macro risks stabilize.     The 2020 US election was hotly contested and future elections, like the upcoming 2022 midterm election, will be closely watched by investors. BCA’s US Political Strategy has introduced two quantitative models over the past year that aim to predict both the Presidential election in 2024 and the Senate election in 2022.  In this report we introduce our House election model, so that we now provide readers with a quantitative model-based estimate for all three major US elections. With the 2022 midterms scheduled for November 8, our House model provides valuable insight into control of Congress in 2023-24. In the 2020 election the Democrats held onto the House while winning the Senate and the White House – the so-called “Blue Sweep.” But the Democrats lost 13 House seats while the GOP gained 14, leaving a mere five-seat margin for President Biden today (221 versus 208 seats today, with six vacancies). In 2022, markets expect Republicans to take control of the House and Senate given the well-established pattern that the president’s party performs badly in midterm elections.1 Our House model agrees, and points to the Democrats losing 21 seats later this year. The Model And Variables Our House model uses a simpler modelling approach than our Presidential and Senate models. Unlike those two models, we do not predict any state level outcomes, nor do we assign a probability to any predictions. For starters, House elections do not occur at the state level but rather at the level of congressional districts. Secondly, we are primarily interested in the overall control of the House rather than individual elections. Therefore our model predicts the number of seats the incumbent party will lose or gain (seat swing), and hence its control of the House.  Our model is based off a simple linear regression. Uniquely, in our suite of three models, our House model does not include any economic variables. Rather, the model is based off three independent political variables that explain our dependent variable. Due to data constraints on one of our independent variables, our sample size is limited to 20 observable House elections, from 1982-2020. Our model is defined as: Change In House Seatsi= β0+β1Var1i+β2Var2i+β3Var3i+εi Change In House Seats. This is the dependent variable in the model and what we aim to predict. A negative change means the incumbent party will lose seats while a positive change means the incumbent party will win seats. Congressional approval (Var1). This variable measures the public’s approval rating on “how congress is doing its job.” We take the average net approval rating (approval less disapproval) in an election year. A positive net rating supports the incumbent party in gaining seats while a negative rating does the opposite.  Generic congressional ballot (Var2). The generic congressional ballot asks people which party they are likely to vote for in Congress in a given election. We take the average net support rate in an election year (that being whichever party leads the other in congressional ballot polling). The larger the president’s party’s deficit on the generic ballot rate, the more House seats it tends to lose. Defending House seats (Var3). The last independent variable is inspired by work from Sabato’s Crystal Ball.2 This measures the number of House seats defended by the incumbent president’s party in an election year. The more seats to defend, the more seats tend to be lost. One variable we omitted is presidential approval. Readers might find this surprising as presidential job approval ratings have tended to correlate reasonably well with House seats gained and lost in midterm elections. Our reason for excluding this variable is that three explanatory variables explain a high degree of variation in the dependent variable. Combined, our three variables explain more than 80% of the variation in the dependent variable. This is more than satisfactory from a statistical standpoint and keeps the model simplistic in nature. Democrats To Lose The House As it stands, our election model predicts that Democrats will lose control of the House in 2022 (Table 1). The Democrats are predicted to lose 21 seats. This prediction is based off current values of our independent variables as calculated and shown below. For the number of defending House seats, we allocate two of three vacant seats to the Democrats to defend.3 This adds up to 224 seats. Table 1Quant Model Predicts A Democrat Loss For this report, we are only concerned with election outcomes pertaining to midterm elections. In this regard, our model’s prediction is in line with historical outcomes for the president’s party (Chart 1). That is, the president’s party almost always loses House seats in a midterm election. While our model does not provide any probability measure for the predicted outcome, it is in line with market expectations that Democrats will lose the House later in the year. Currently, market implied odds for the Democrats to retain the House are just 16%, as opposed to 87% for Republicans to gain control (Chart 2). Most other private forecasts for the House also point to Democrats losing control.4  Chart 1Quant Model Prediction Vs. Past Outcomes Chart 2Republicans Overwhelmingly Favored To Take The House Back Testing Our Model Chart 3In-Sample Back Testing Results Our House model performs well during in-sample back testing. For in-sample testing, we test our model over our entire sample period (1982-2020) but show results for midterm election outcomes only. Our model correctly predicted the direction of seat change (positive or negative) for 80% of outcomes, missing the direction of seat swing for just the 1998 and 2002 midterm elections (Chart 3). The latter two elections are the only two in the post-WWII period in which the president’s party gained seats and this was due to exceptional circumstances (i.e. the Dotcom Bubble and the September 11, 2001 terrorist attacks). During this same test, when our model correctly predicted the directional change in seat swing, it only over-predicted the change once (in 1986), highlighting a more conservative forecast over time. In 2022, given the stagflationary economic backdrop and President Biden’s weak approval rating, the voting public may very well punish the Democrats harder in November than our model expects. Chart 4Out-Sample Back Testing Results During out-sample back testing, we look at a sample period of 2002-2018, comprising of just five midterm elections. Our model correctly predicts the direction of seat swing in 80% of the midterm elections, just like our in-sample testing showed (Chart 4). 2002 is again a standout election where our model incorrectly predicted the direction of seat swing. Closing In On Election Day The midterm election is approximately five months away. Our Senate model predicts the Democrats will lose control of the Senate. Our House model suggests Democrats will lose the lower chamber too. This view is in line with the consensus across markets, forecasters, and historical outcomes. Given the poor showing by Democrats in the 2020 House election, this House prediction will be hard to change. The Senate race could still see some surprises, such as via the Supreme Court. But all in all the “Blue Sweep” of 2020 is already over. The headwinds against the president’s party have gained even more momentum in the context of high inflation, falling consumer confidence, and low real wages. These factors were not measured in our model, but they do form a basis for voting intentions in elections. Coupled with President Biden’s low approval ratings, in general and in specific policy areas like the economy, the Democratic party will need to pull off  a political “Hail Mary” to retain the Senate, let alone the House, later this year. Investment Takeaways President Biden and the Democrats may look to the 1934, 1962, 1998, and 2002 elections for proof that the ruling party can perform well in the midterms. But 1998 was a period of nearly unprecedented peace and prosperity, while 2002 came in the wake of a historic attack on the homeland. The 1934 election reinforced a crisis-era government and as such could serve as a model for Biden, but today’s situation is not as dire as the Great Depression. The 1962 analogy is perhaps the best, since Biden, like President Kennedy during the Cuban Missile Crisis, could conceivably benefit from an escalating showdown with Russia this fall. But Kennedy’s Democrats still lost a net of four seats in the House that year – and Kennedy’s approval rating was above 60% while Biden’s is barely 40%. COVID-19 was an unprecedented shock that continues to play out across the economic and political environment in the US. But while the Republicans suffered from the pandemic itself, the Democrats now own the stagflationary aftermath. Democratic enthusiasm should revive a bit from now until the election, but it would take a massive shock to reverse the general trend. There is a strong correlation between opinion polling in the beginning of the year and the midterm election results. Facing a shellacking, Democrats will make one last-ditch effort to pass a budget reconciliation bill before the election. Given the energy crisis in Europe, there is potential for Biden’s renewable energy subsidies to be repackaged into a general “energy security” bill that drops the former hostility to fossil fuels. This could be matched with limited tax changes, including the 15% minimum corporate tax rate that Biden negotiated with other countries. Otherwise US fiscal policy will virtually freeze even if the Senate stays in Democratic hands. Taxes will no longer be able to rise from 2023 but spending will not be subject to cuts. Heading into 2024, gridlock will be reinforced by our presidential quant election model’s slightly higher odds of Democrats retaining the White House, which we think are underestimated at present. Hence Biden is lined up to retain veto power even if Democrats squander the House and Senate in 2022, as long as his administration avoids a recession. Financial markets will see gridlock as a marginal positive in 2023, as long as inflation levels off. In the very near term, however, US equities still face formidable hurdles that will keep us on the sidelines. Global growth is wobbly. Global supply chains remain constrained, affecting growth outcomes and adding to elevated price levels. China’s zero-covid policy and the absence of a credible plan for US-China tariff reduction and economic re-engagement continue to weigh on sentiment. Fed rate hikes are still generating uncertainty. The Middle East is unstable and likely to bring additional energy supply disruptions. Lastly, the Russia-Ukraine war has yet to come to a ceasefire and Russia is likely to reduce energy supplies to Europe in retaliation for Germany’s energy ban and NATO enlargement. With this backdrop in mind, we remain tactically defensive. We see the potential for improvement after the US election brings a reduction in policy uncertainty – as long as geopolitical risks and inflation also stabilize.   Guy Russell Senior Analyst GuyR@bcaresearch.com   Statistical Appendix Some clients may be curious to read through our model’s estimated regression coefficients as well as conditional forecasts given certain levels of our independent variables. These are discussed herein: Regression Coefficients As mentioned earlier, our model is estimated exclusively by political variables. The beta coefficients for the three explanatory variables are shown below alongside their t-statistics and p-values. All three of these variables tested statistically significant at 5% and 10% levels. The regression’s R-squared value is 0.8183, meaning that the explanatory variables help explain 81.83% of the variation in the dependent variable (Table A1). Clients can recreate the model’s prediction by multiplying the current level of each variable as it stands today by that variable’s respective beta coefficient and adding the constant at the end of the equation. Be sure to follow the methodology explained earlier in the text if such an exercise is of interest. Also, conditional forecasts can be created by holding certain parameters constant should clients want to better understand what differing levels of the three explanatory variables may imply for the change in House seats. Table A1Regression Coefficients Conditional Forecasts We will create simple conditional forecasts for two explanatory variables. Let’s start with the net congressional approval variable. Forecasts will be generated with data intervals calculated over the course of President Biden’s first term in office so far. The lowest net congressional approval rating was -67 ppt and the highest was -25 ppt. We will use 10 ppt intervals between -20 ppt an -70 ppt. Shading indicates the current level for the variable input. Table A2Conditional Forecasts In Table A2, we hold our other explanatory variables constant at their prevailing levels while we assume differing levels for the net congressional approval variable. We will apply this method to conditional forecasts using the net generic congressional ballot. Table A2 shows us that a more negative net congressional approval rate suggests the president’s party will lose more House seats. Of course, the Democrats cannot lose a fraction of a seat (only whole seats), but this conditional forecast illustrates the point of the variable’s impact on the overall outcome. Table A3Conditional Forecasts Changing to the net generic congressional ballot, our conditional forecast for values ranging from -2 ppt to + 5 ppt are shown in Table A3. This range shows the high and low of the net generic congressional ballot through President Biden’s first term in office. Shading indicates the current level for the variable input. Like before, the results in Table A3 shows us that a more negative net generic congressional ballot suggests the president’s party will lose more House seats. Again, the Democrats cannot lose a fraction of a seat. But the results in Table A3 show that changes in House seats are more sensitive to changes in the net generic congressional ballot variable compared to the net congressional approval variable. This is due to two reasons: The net generic congressional ballot variable is a strong predictor of House election outcomes. It’s larger beta value indicates it’s high degree of sensitivity for the dependent variable, implying that it is the most important variable in our model, and that changes to it have the largest impact on the modelled outcome, that is predicted changes in House seats.   Footnotes 1     See The American Presidency Project. "Seats in Congress Gained/Lost by the President's Party in Mid-Term Elections," October 29, 2018. presidency.ucsb.edu 2     See Kyle Kondik, “The Kinds of Seats that Flip in Midterms,” Sabato’s Crystal Ball, May 11, 2022, UVA Center For Politics, centerforpolitics.org. 3    For our 2022 prediction, we allocate vacant House seats evenly between Democrats and Republicans. For example, if there are six vacant seats, each party will be allocated three seats to defend on top of the House seats that they already occupy. If there are an odd number of vacant seats, for example three, each party will receive one seat added to their count, then the incumbent party will receive the remaining seat. 4    See fivethirtyeight.com, 270towin.com and racetowh.com, among others. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment​​​​​​​ Table A4CPolitical Capital: The Economy And Markets​​​​​​​

Executive Summary First IG, Then HY Corporate bonds are following the 2018 roadmap. Investment grade underperformed Treasuries as interest rate expectations rose from low levels, then junk joined the selloff once rate expectations moved above estimates of neutral. Inflation is too high for the Fed to abandon its tightening cycle, as it did in 2018/19, but the Fed will move more slowly than what is priced in the curve for 2022. Underlying economic growth is stronger than it was in 2018 and corporate balance sheets are in better shape. That being the case, even a modest dovish surprise from the Fed will be sufficient for corporate bond returns to form a bottom. Municipal bonds are attractively priced versus both Treasuries and credit, and state & local government balance sheets are in excellent condition. Stay overweight.   Bottom Line: We maintain our cautious stance on corporate bonds for the time being, but are now on upgrade watch. Signs of peaking inflation and/or dovish signals from the Fed could cause us to increase exposure in the relatively near term. Stay tuned.  Feature The similarities between recent market action and what occurred in 2018 are striking. Back in 2018, the Fed was in the process of lifting the policy rate back toward estimates of neutral. The yield curve flattened as a result, and investment grade corporate bonds responded to the removal of policy accommodation by underperforming duration-matched Treasuries (Chart 1). Chart 1The 2018 Experience Despite the Fed’s actions, high-yield initially performed well in 2018. That is, until the market started to believe that the Fed would over-tighten. Recession fears increased in late 2018 as near-term rate expectations surpassed estimates of neutral and high-yield sold off sharply, giving back all of its gains from earlier in the year and then some. Now let’s turn to the present day (Chart 2). Once again, investment grade corporates underperformed Treasuries as near-term rate expectations moved higher and the yield curve flattened. For its part, high-yield performed well during the early stages of the interest rate adjustment but returns plunged once 12-month forward rate expectations moved above survey estimates of neutral. Chart 2First IG, Then HY What’s Different This Time? While we think the 2018 roadmap is a good one, it’s important to consider the differences between 2018 and today before drawing any firm conclusions about future credit market performance. The first obvious difference is that the Fed had already been lifting rates for some time in 2018. In fact, the fed funds rate was above 2%. Today, the Fed is still in the early stages of its tightening cycle and the fed funds rate is only 0.83%. We think this difference is less significant than it initially appears because the level of the fed funds rate itself is less important than the perceived restrictiveness of monetary policy. Today, the market is priced for the fed funds rate to hit 3.18% in 12 months, higher than at any point in 2018 (Chart 3). We also see that the Treasury slope beyond the 2-year maturity point is about as flat today as it was in 2018 (Chart 3, bottom panel). This strongly suggests that the market perceives monetary policy as about as restrictive today as it was in late 2018. The second difference we identify is that inflation is much higher today than it was in 2018 (Chart 4). This is potentially bad news for future credit market performance. High inflation gives the Fed a strong incentive to keep lifting rates even if risky assets sell off. In 2018, the Fed reversed course on its tightening cycle once broad financial conditions tightened into restrictive territory. That’s an easy decision to make when inflation is close to 2%. It’s much more difficult to do with inflation where it is now. Chart 3Monetary Conditions Are Similar Chart 4Inflation Is Much Higher … High inflation makes it unlikely that the Fed will pull a 180 on its tightening cycle. But on the flipside, today’s strong underlying economic growth means that a complete reversal on rate hikes is probably not necessary to avoid a recession. Just look at the labor market. Labor market utilization, as measured by both the unemployment rate and the prime-age employment-to-population ratio, is in a similar place today as it was in 2018 (Chart 5). However, despite a tight labor market, job growth is running at a much stronger pace this year. Nonfarm payroll gains have averaged 523 thousand during the past three months. In 2018, in a similarly tight labor market, monthly job growth averaged just 191 thousand. Now turn to housing, arguably the most important channel through which interest rates impact the economy. In a prior report we identified that the 12-month moving average of housing starts dipping below the 24-month moving average is a good indicator for the end of a Fed rate hike cycle.1 In 2018, our housing starts indicator was barely positive. Today, it is extremely elevated (Chart 5, bottom panel). Chart 5… But Growth Is Much Stronger The key point is that with employment growth and housing starts trending at much better levels than in 2018, we can conclude that the Fed has a fair amount of scope to tighten policy before threatening to push the economy into recession. The upshot for corporate bond markets is that the threshold for Fed capitulation is also different. While a full backtracking away from rate hikes was necessary to avoid a recession and spur corporate bond outperformance in 2018, both the economy and financial markets likely require less of a Fed reversal today. The final difference we identify between 2018 and today relates to the health of corporate balance sheets (Chart 6). Compared to 2018, nonfinancial corporations are carrying much less debt as a percentage of net worth, have significantly higher interest coverage and are benefiting from net ratings upgrades. Much like with the labor market and housing indicators, there’s every reason to believe that corporations are better equipped to handle higher interest rates today than they were in 2018. Chart 6Balance Sheets Are Healthier The Way Forward If we look back at Chart 1, we see that the 2018 roadmap is for the Fed to abandon its tightening cycle, leading to a sharp drop in near-term rate expectations and a V-shaped bottom in excess corporate bond returns. We won’t get such a swift Fed reversal this year, but there are strong odds that the Fed will lift rates by less than what is currently discounted in the market between now and the end of 2022. As we noted in last week’s Webcast, we expect the Fed to deliver two more 50 basis point rate hikes (in June and July) before shifting to 25 bps per meeting increments in September once it’s clear that inflation is trending down (Chart 7).2  We also see potential for relief at the long-end of the yield curve, where 5-year/5-year forward Treasury yields have room to fall back toward survey estimates of the long-run neutral rate (Chart 8). Chart 7Rate Expectations Chart 8Yields Above Fair Value It’s also worth noting that corporate bond valuations have improved markedly during the past few weeks. The 12-month breakeven spread for investment grade corporates is back above its historical median, and the junk index is priced for a 6.3% default rate during the next 12 months (Chart 9). Investment grade and high-yield index spreads are also now well above their respective 2017-19 averages, as is the spread differential between high-yield and investment grade (Chart 10). Chart 9Corporate Bond Valuation Chart 10Favor HY Over IG The bottom line is that we are slowly turning more positive on corporate bonds. Falling inflation will cause the Fed to tighten by less than what is expected this year, and it will soon become apparent that – as was the case in 2018 – the US economy is not close to tipping into recession. Spreads also present an increasingly attractive opportunity. That said, with the Fed still poised to deliver 100 bps of tightening within the next two months, we are not yet ready to abandon our relatively cautious corporate bond allocation. We maintain our underweight (2 out of 5) allocation to investment grade corporate bonds and our neutral (3 out of 5) allocation to high-yield, but we are now firmly on upgrade watch. Signs of peaking inflation and/or signals that the Fed will pivot to a hiking pace of 25 bps per meeting could cause us to increase our recommended corporate bond exposure in the relatively near term. Stay tuned. Seek Refuge In Municipal Bonds While we wait for clearer signs of a bottom in corporate credit, investors can more confidently deploy capital in the municipal bond market. Municipal / Treasury yield ratios have jumped in recent weeks, and they are now back above post-2010 averages across the entire yield curve (Chart 11). Long-maturity municipal bonds are even trading at a before-tax premium relative to US Treasuries (Chart 11, top 2 panels). Municipal bonds are also trading at above-average yields relative to credit rating and duration-matched corporate bonds (Chart 12). This is despite the recent back-up we’ve witnessed in corporate bond spreads. Chart 11Muni / Treasury Yield Ratios Chart 12Munis Cheap Versus Credit Not only are munis attractively priced versus both Treasuries and corporates, but state & local government balance sheet indicators show that municipal credit quality is sky high (Chart 13). Tax revenues have accelerated since the pandemic, but state & local governments have remained cautious about spending their windfalls. Despite being flush with cash, state & local governments have re-hired only a small fraction of the employees that were let go during the pandemic (Chart 13, panel 2). The result of this lack of spending is that state & local government net savings are the highest they’ve been in years (Chart 13, panel 3). Chart 13State & Local Government Health Bottom Line: Municipal bonds are attractively valued versus both Treasuries and investment grade corporates, and state & local government balance sheets are in superb condition. Investors should overweight municipal bonds in US fixed income portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 2 https://www.bcaresearch.com/webcasts/detail/537 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns