IN A break from recent form, advance opinion polls proved to be correct this week when the Democratic “blue wave” took control of the House of Representatives and the Republican “red wall” added to that party’s Senate majority in the US midterms. A divided Congress has implications for political and economic policy that will be of major determinant to financial returns over the next few years.

Looking back to earlier in 2018, the US economy really didn’t need the fiscal boost included in the US budget, given that we were already 10 years into an economic recovery. Historically, the financial markets have exerted some discipline on errant spending by politicians, but given the extraordinary monetary stimulus undertaken after the financial crash it is taking longer than in previous cycles for markets to revert to their normal functioning.

For the past few years government yields had been low enough that any increase had been interpreted as vindication of the strength in the economic recovery, but attention has switched to the monetary cycle and whether the interest-rate-setting Federal Open Market Committee will overshoot on its tightening path. In my opinion it was predominately the reappraisal of the monetary policy cycle that caused equities to fall significantly in October. Trump might not care what happens in the bond markets but it is clear that he is obsessed with the performance of the US equity bourses.

Perhaps paradoxically, the policy paralysis that will beset Congress is actually constructive for sentiment. There is less uncertainty over changes to regulatory regimes, which should encourage investment, and a much lower probability of further fiscal stimulus. The Democrats may vainly try to rescind Trump’s tax cuts, but there is zero chance of that passing through a Republican controlled Senate.

On the flipside there are also increased risks from the proverbial blue wave crashing against the red wall. The US has a debt ceiling rule that limits the total quantum of debt that can be issued and that has been raised over 75 times since it was introduced in 1917. The limit is currently suspended but will be reinstated in March 2019 and is likely to be raised by August 2019 otherwise a Federal shutdown will ensue. The Democrats will use this as leverage and, inter alia, President Trump will not get to build his wall on the Mexican border.

Constitutionally not all policy has to pass through Congress and Trump will use executive privilege on the tariffs front to raise the level of his rhetoric on foreign nations and increase trade war tensions. Trade frictions could knock 0.3 to 0.5 per cent off global growth but are unlikely to completely derail the cycle.

Meanwhile, on this side of the Atlantic we have Italian fiscal discipline to worry about, not to mention untangling ourselves from a bloc we’ve been part of since 1973 (you didn’t think you could get through an article without Brexit being mentioned, did you?). Globally, economic growth remains solid and developed world labour markets are seeing wage inflation increase, suggesting most other central banks should join the Federal Reserve in tightening monetary policy.

The financial markets have adjusted to anticipate some interest rate rises, but still not enough. In most Western Government bond markets you are virtually guaranteed a negative real return (the return adjusted for inflation) over the next 10 years. The US Treasury market has much higher nominal yields, and a real yield over 1%, due to it leading the economic cycle. I view the US bond market as the least bad option for taking bond exposure presently. Strategically rates are still some way from peaking in the US and completely out of whack in Europe. The time to aggressively buy fixed income has not come yet, but those that despise the asset class need to be wary of its influence on all other markets, especially equities.

The US mid-term elections make a further fiscal stimulus improbable. Political headline risk will increase in the US. A combination of an advanced monetary cycle, voter frustration and continued headlines emanating from the US for the rest of Trump’s term will lead to heightened volatility. But with volatility comes opportunity.

Phil Milburn is a fund manager at Liontrust Asset Management.