Democrat sweep adds new twist to markets’ Iran, AI, and debt worries

A sweeping Democratic victory in the US midterm elections has introduced an unexpected twist to markets grappling with several challenges, including the ongoing Iran war and the AI boom that has fueled growth and inflation. While the initial market reaction was modest, with equities higher in Europe and the dollar recovering, investors are bracing for further volatility. The two main areas of concern are the direction of the Iran war, which has driven oil prices up by 70% this year, and the debate over US fiscal spending.

If the President, Donald Trump, escalates the conflict in the Middle East following the election, it could negatively impact both stocks and bonds. As oil prices remain above $100 a barrel, fuel costs for consumers and businesses are increasing. Central banks are wary of a broader price surge, which may require higher interest rates.

Central banks are also vigilant about the potential spill-over into a price surge, necessitating higher interest rates. The US central bank has been failing to meet its inflation target for over half a decade. Euro zone inflation rose to a three-year high at 4% in October due to high energy costs, and it is expected to continue rising, reinforcing expectations for a December rate hike by the European Central Bank.

Geopolitical risks remain high as President Trump retains control over foreign policy. The US capture of Venezuelan President Nicolas Maduro and Trump's tariff threats to European allies over Greenland earlier this year have also caught investors off guard. Analysts expect significant foreign policy noise in the final two years of the Trump presidency.

Concerns have arisen that rapid AI sector growth might be hindered by regulatory scrutiny following the Democratic win. Opinion polls suggest that Democratic voters favor more control over AI, and investors anticipate the Democratic-controlled Congress to apply more scrutiny to the sector. Despite initial wobbles, world stocks recovered and were higher, while US stock futures rose after falling by as much as 2% overnight. However, investors are growing nervous about market resilience.

The surge in AI investment and the high government debt levels have pushed borrowing costs to multi-decade highs, exposing market vulnerabilities. Seema Shah, chief global strategist at Principal Asset Management, expects to monitor fiscal policy closely, as it could become even more constrained after the election. Treasury yields fell on Wednesday as investors welcomed the fact that Trump's promise of $5,000 checks to US adults in case of a Republican victory did not materialize.

The looming debate over fiscal 2027 spending, scheduled for a deadline on December 11, adds to the market volatility. Analysts anticipate a "white-knuckled ride" for the next year.