Politics will be front and center as a catalyst in the first week of the new year

Traders work on the floor of the New York Stock Exchange.

NYSE

Stocks exit 2020 with strong gains and are riding a tailwind, but already in the dawn of the new year, the market could face its first big challenge.

The final outcome of the 2020 election plays out Tuesday, when voters in Georgia will pick their senators and decide which party controls the U.S. Senate.

With President-elect Joe Biden heading to the White House and a Democratic-controlled House of Representatives, Wall Street has been comfortable with the view that Biden and the Democrats could not succeed with tax hikes and more progressive policy changes while Republicans hold the Senate.

The runoff election for the two Senate seats Tuesday is widely expected to result in one or both of the incumbent Republican senators retaining their seats. But Democrats are close in the polls and should they win, each party would have 50 seats with Vice President-elect Kamala Harris the tie breaker.

“Georgia is the most important thing to the Biden presidency for the next two years,” said Ed Mills, Washington policy analyst at Raymond James. “It’s going to determine what is the legislative agenda and who can get confirmed by the United States Senate.”

Sen. David Perdue is being challenged by Democrat Jon Ossoff, while GOP Sen. Kelly Loeffler is running against Democrat Raphael Warnock. None of the candidates had more than 50% of the vote in the Nov. 3 election, so Georgia law requires a runoff election between the two leading candidates for each seat.

“It’s a binary event,” said Mills, adding it’s of growing interest to markets. “The general sense for the market is that Republicans are well positioned to maintain their majority in the Senate. But I think the 2020 election as well as the 2016 election and to some extent, the 2018 election has humbled us … The Senate outcomes, in particular, seem to be less predictable than almost any other elections.”

Mills said the results may take several days to determine, adding to the uncertainty the event could hold for markets. According to an RBC investor survey, 88% expect Republicans to maintain control, and most say that is a positive for the stock market.

“The market tends to shoot first and ask questions later. There will certainly be a reaction if Democrats win both those seats,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. Strategists say there could be a relief rally if Republican incumbents see a clear victory.

“That totally dominates [trading] because it’s about do we have status quo or do we have Democrats controlling all parts of Washington and what that means for spending and taxes,” Boockvar said. “I think you could see the worries about taxes overwhelming any thoughts on the benefits of more spending” by Democrats.

By the numbers

A year of extreme volatility ended with a big win for stocks, as the pandemic steered the course for markets. The S&P 500 was up about 16%. That gain comes after a 33% decline early in the year, followed by a powerful more-than 65% rebound. Technology was the big winner for the year, and the Nasdaq was up more than 43%.

Besides the runoff vote, the market will be watching a stream of data in the coming week, including the important December jobs report Friday. That could show fewer than 100,000 jobs were added as the spreading virus impacted hiring and layoffs. There were 245,000 jobs created in November.

There is also ISM manufacturing data Tuesday, and a number of Fed speakers, including Vice Chairman Richard Clarida on Friday.

The virus itself could also be a factor for stocks.

Conventional wisdom for the coming year has been that vaccines will be widely distributed, and by the second half things will start to get back to normal and the economy will pick up. But the initial distribution has been slow, and far short of the 20 million targeted for December by President Donald Trump’s task force.

In that recent RBC survey, three quarters of investors were optimistic about vaccine distribution with 80% expecting a majority to be vaccinated by the end of 2021. “We suspect that the positive outlook for the stock market and the economy would deteriorate if expectations for a smooth vaccine rollout are not met,” RBC strategists wrote.

They also noted that nearly 60% of the investors surveyed believe high stock market valuations are problematic.

“This suggests to us that any threat to the economic and earnings recovery story could spark profit-taking. On this point, it is worth noting that the vaccine was the No. 1 issue keeping investors up at night, closely followed by monetary policy and excessive optimism on the recovery,” the strategists noted.

Chris Rupkey, chief financial economist at MUFG Union Bank, said investors will also be watching the formal acceptance of the Electoral College vote Wednesday. Strategists expect the vote count to confirm Biden’s presidency.

However, Missouri Sen. Josh Hawley says he will challenge the certification, and several House Republicans have already vowed to contest the election at that time. If one House member and a senator jointly object to a state’s slate of electors, the two houses of Congress must separately debate and vote on the objection.

Strategists see little chance of any impact on the election outcome, but there could be fireworks. Trump has been claiming since the election that there was fraud but multiple courts failed to find any truth to the claims.

Rupkey said investors are not taking into account enough potential for political risk from the deep animosity between the two political parties.

“I think the additional stimulus and hopes for additional stimulus, and infrastructure spending in 2021, I don’t know that that is such a slam dunk, because of the issue of political instability,” he said.