Whether U.S. stocks can gain new upward momentum by year-end, Citi is looking to policy expectation changes brought by the midterm elections. If Republicans unexpectedly hold the Senate, it could boost market sentiment and provide support for financial stocks; if Democrats achieve an unexpectedly large majority, the market may price in the risk of a 2028 corporate tax increase in advance, weighing on valuations.
In a U.S. equity strategy report released on October 30, Citi pointed out that the expectation of Democrats retaking both chambers of Congress has been largely reflected in current market sentiment. Therefore, the gap between results and expectations will be key to stock price reactions.
Citi expects the direct impact of this election on corporate fundamentals to be relatively limited, but changes in policy expectations may drive sector rotation and affect overall valuations. Financial regulation, healthcare budget negotiations, and the impact of local policies on AI data center construction are areas worth watching.
Financials and Healthcare: Previous Trades Have Played Out, Next Step Is Policy Changes
Citi previously recommended favoring healthcare relative to financials and banks. As market expectations of Democrats winning both chambers of Congress increased, this relative value trade has largely played out.
Potential support for the healthcare sector mainly comes from budget negotiations. Citi believes that if Democrats retake the House, they may seek to restore some cut healthcare spending, including reversing some of the cuts in the One Big Beautiful Bill Act (OBBBA). Even if the two chambers of Congress are controlled by different parties, related demands may enter budget negotiations.
However, a change in House control itself does not necessarily mean spending will increase; the specific outcome still depends on negotiations between the two parties.
Financial stocks are more sensitive to the Senate outcome. Senate committee leadership can influence the regulatory agenda and policy climate, and the Senate also holds confirmation authority over Federal Reserve-related personnel appointments. Based on this, Citi judges that if Republicans hold the Senate, financial stocks may receive tactical support.
The premise of this judgment is that the market had previously priced in a Democratic victory to a significant extent. If Republicans perform better than expected, financial stocks may rise as policy expectations adjust, providing support for overall market sentiment toward year-end.
Entering 2027, the impact of fiscal policy may further expand. Democrats may seek to restore healthcare spending, while Republicans may push for increased defense spending, and the budget, debt ceiling, and deficit financing will return to focus.
For the stock market, spending expansion has a two-way impact: fiscal stimulus may support the economy and corporate earnings, while larger deficits and financing needs may also increase market concerns. The ultimate impact needs to be judged in light of spending scale, funding sources, and negotiation outcomes.
AI Buildout: Approvals May Slow, Financing Pressure May Also Ease
The impact of the midterm elections on the AI trade may also be transmitted through gubernatorial and local elections.
Citi expects that if Democrats expand their advantage at the state and local levels, data center construction may face more resistance. Land-use zoning, site selection, and permitting approvals could all affect project construction timelines, thereby slowing the commissioning of new computing capacity.
Texas is a particular observation target highlighted in the report. The results of races at different levels in the state, as well as subsequent policy changes, may affect the market's assessment of local data center construction. For investors, the policy environment where a project is located will become an important factor in evaluating AI infrastructure investment.
However, Citi's concerns about long-term fundamentals are relatively limited. Its judgment is that policy resistance is more likely to lengthen the timeline for computing capacity coming online rather than cause planned capacity to be canceled outright.
A slowdown in construction may also bring another effect: funding needs spread over a longer period, and the pressure of short-term concentrated financing declines accordingly. Therefore, although approval delays may affect the timing of revenue realization for some projects, they may also ease market concerns about AI infrastructure capital spending being too concentrated.
This means that local policy changes may have differing impacts on companies across the AI supply chain. Project distribution, commissioning timelines, and financing arrangements will determine which companies face more obvious pressure.
US Equity Valuations: Beware of Expectations for a 2028 Corporate Tax Increase
For the overall US equity market, Citi's longer-term focus is corporate tax.
A significant Democratic advantage in this election could improve the party's political prospects for 2028, prompting investors to adjust their expectations for future after-tax corporate profits in advance. Citi noted that raising corporate taxes aligns with the Democrats' policy priorities from the 2024 campaign, so the market may begin pricing in related risks before policy changes actually materialize.
The durability of Senate seats gives this election longer-term implications. Senators serve six-year terms, and seats won in this cycle will extend beyond 2028. Citi noted that most Democratic seats up for reelection in 2028 are in states relatively safe for the party, and if Democrats achieve a larger majority this time, their foundation for maintaining Senate control will be more solid.
Citi's observation thresholds are: Democrats winning more than 235 House seats and more than 53 Senate seats. In its scenario analysis, such an outcome could raise the probability of Democrats controlling both the White House and Congress in 2028, intensifying market concerns about corporate tax increases.
This risk remains a forward-looking policy expectation and does not mean corporate tax rates will change immediately after the midterm elections. But for equity valuations, adjustments to future after-tax profit expectations can be reflected in prices in advance.
At the same time, Republicans holding the Senate remains a realistic possibility. The report noted that polling margins in several key Senate races remain within the margin of error, and a small but consistent polling bias could change outcomes in multiple states.
Therefore, Citi outlined two main scenarios for U.S. equities: Republicans holding the Senate could deliver better-than-expected results and support year-end market performance; Democrats achieving an unexpectedly large majority could bring 2028 tax risks into market pricing earlier, putting pressure on valuations.
After the election, the financial regulatory agenda, healthcare budget negotiations, data center approvals, and the 2027 fiscal arrangements will determine whether these expectations translate into actual earnings changes.
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