Markets Rotate as Midterm Elections Reshape Washington

Executive Summary

Financial markets experienced a sharp decline last week as weakness in mega-cap technology and AI-related companies intensified following the midterm elections. However, continued outperformance by the equal-weighted S&P 500 suggests investors are rotating within equities rather than broadly abandoning risk assets. Importantly, strong corporate earnings, improving employment conditions, and resilient economic activity continue to provide a constructive foundation, even as elevated valuations, persistent inflation pressures, and growing policy uncertainty create a more demanding investment environment.

Key Takeaways:

• Market rotation intensified following the midterm elections. The S&P 500 suffered its worst weekly decline since April 2025, while the NASDAQ entered correction territory. However, relatively healthy market breadth and continued outperformance by the equal-weighted S&P 500 suggest selling pressure remains concentrated in mega-cap technology and AI-related stocks.
• Corporate earnings remain exceptionally strong, but investor expectations are rising. Third-quarter S&P 500 earnings growth is tracking near 31%, although investors are increasingly scrutinizing AI-related valuations, financing requirements, and the ability of substantial capital investment to generate sustainable profitability.
• Economic fundamentals continue to demonstrate resilience. October payroll growth substantially exceeded expectations, unemployment declined to 4.1%, and layoffs remained historically low.
• Consumer confidence remains weak despite robust economic growth. Although inflation expectations improved, elevated prices continue to strain household budgets. Consumer spending is growing faster than real disposable income, contributing to a declining saving rate and raising questions about the sustainability of recent spending trends.
• Political uncertainty and inflation remain key risks. Democratic control of both chambers of Congress could increase regulatory scrutiny of technology and AI while constraining major fiscal initiatives. Meanwhile, stronger employment reduces the urgency for Federal Reserve easing, making Tuesday’s inflation report an important test of the monetary policy outlook.

Financial Markets

U.S. equity markets finished decisively lower last week following a volatile stretch of trading shaped by the midterm elections, renewed concerns surrounding artificial intelligence, and shifting expectations for monetary policy. The capitalization-weighted S&P 500 suffered its worst weekly performance since the tariff-driven selloff in April 2025. Notably, the equal-weighted S&P 500 once again outperformed its capitalization-weighted counterpart, reinforcing the significant rotation occurring beneath the surface of the broader market.

The week’s most pronounced volatility came immediately following Tuesday’s midterm elections. Equities initially rallied on Wednesday as investors assessed the implications of Democrats gaining control of both chambers of Congress. However, those gains reversed sharply on Thursday as attention shifted toward the potential for increased oversight of AI development, data-center construction, and the technology sector more broadly. During Thursday’s selloff, the NASDAQ Composite entered correction territory, closing nearly 12% below its October 6^th record high. Friday’s partial rebound provided some relief but was insufficient to reverse the week’s losses.

Despite the severity of the headline declines, underlying market participation remained more constructive than the major indices suggested. On Thursday, the equal-weighted S&P 500 outperformed the capitalization-weighted index by approximately 1.5 percentage points, illustrating how concentrated the selling pressure had become among the market’s largest companies. Although declining stocks accounted for more than 80% of New York Stock Exchange trading volume that day, the S&P 500 recorded only nine more declining constituents than advancing ones (FactSet). These measures suggest that, while volatility has increased substantially, investors continue to reallocate capital across sectors rather than broadly abandoning equities.

Corporate earnings remain an important counterweight to the market’s recent weakness. With nearly 70% of S&P 500 companies having reported third-quarter results, blended earnings growth is tracking at about 31%, another exceptionally strong quarter for corporate profitability (FactSet). However, investor reactions have become increasingly demanding. Although earnings surprises remain widespread, their magnitude has moderated from the previous quarter, and companies are receiving less favorable share-price reactions to positive results. Similar questions surround the AI investment cycle, where spending and earnings growth remain robust but may be approaching peak rates of expansion. Investors are focused on valuations, financing requirements, free cash flow, and the ability to translate substantial investment into sustainable profits. For now, macroeconomic concerns and uncertainty surrounding AI regulation and financing appear to be overshadowing earnings as the primary drivers of market direction.

Fixed-income markets offered a somewhat more constructive signal. Despite a brief increase in yields following Friday’s stronger-than-expected employment report, Treasury yields finished modestly lower for the week. The 10-year yield declined from 4.94% to 4.86%, while the policy-sensitive 2-year yield eased from 4.61% to 4.52%. The decline suggests investors continue to balance concerns about persistent inflation against the possibility that elevated borrowing costs and heightened market volatility could eventually moderate economic growth.

Economics

Last week’s economic data reinforced the resilience of the U.S. expansion, with labor-market indicators showing their greatest collective improvement in several months. October nonfarm payrolls increased by 165,000, well above expectations for a 65,000 gain, while upward revisions added 84,000 jobs to August and September. The unemployment rate declined to 4.1% even as labor-force participation improved, while annual wage growth accelerated modestly to 3.1%. Other indicators supported the stronger employment picture. September job openings rose to 7.5 million, hiring and voluntary quits increased, and ADP reported 86,000 additional private-sector jobs in October. Meanwhile, initial jobless claims declined to 189,000, their lowest level since 1969, and announced layoffs fell sharply from a year earlier. Taken together, these developments suggest the labor market may be moving beyond the “low-hiring, low-firing” environment that characterized much of the year, with hiring momentum improving and little evidence of widespread layoffs. Broader economic activity remains similarly strong. October manufacturing activity strengthened, with the ISM Manufacturing Index rising to 55.5, although input costs remained elevated. Encouragingly, third-quarter productivity increased at a 3.6% annualized rate, while unit labor costs declined by 0.7%, suggesting that improving efficiency could help offset wage and inflation pressures even as economic activity remains strong.

Despite these encouraging developments, the disconnect between strong economic performance and weak consumer sentiment remains striking. Preliminary November sentiment improved to 51.0 from 48.0 in October but remains approximately 10% below February’s level before the Iran conflict began. Year-ahead inflation expectations declined to 4.3% from 4.7%, an encouraging improvement, though still well above February’s 3.4% reading. High prices continue to weigh heavily on households, with 57% of respondents reporting that inflation has eroded their living standards. This disconnect is also evident in household finances. Over the past year, inflation-adjusted consumer spending increased 2.5%, compared with just 1.0% growth in real after-tax personal income, contributing to a decline in the personal saving rate from 5.1% to 3.8%. Rising household wealth, particularly among higher-income consumers benefiting from financial-market gains, has helped sustain spending, but that support may become less reliable if asset prices weaken or income growth remains subdued. The distinction helps explain why strong GDP growth and improving employment conditions have not translated into a comparable recovery in consumer confidence (WSJ: https://www.wsj.com/economy/us-economic-data-growth-9a4f7690). Overall, the economy remains on solid footing, supported by resilient employment, substantial business investment, and improving productivity, but persistent inflation pressures and the growing gap between consumer spending and income warrant continued attention.

Policy

The midterm elections produced a significant change in Washington’s political balance, with Democrats winning control of both the House of Representatives and the Senate. The investment implications of this outcome are not inherently positive or negative but will depend on which policies can be enacted, modified, or blocked. Divided government may constrain the administration’s ability to pursue additional deficit-financed fiscal initiatives, potentially limiting further expansionary spending. At the same time, greater congressional oversight could introduce uncertainty for industries facing increased political scrutiny. President Trump has signaled a willingness to work with the incoming Democratic Congress, although significant legislative changes will still require agreement between lawmakers and the White House. For investors, the immediate implication is greater uncertainty about the direction of fiscal and regulatory policy than about a predetermined economic outcome.

Technology and artificial intelligence are likely to feature prominently in this evolving legislative environment. The incoming Congress could pursue more extensive oversight of frontier AI development, data-center construction, electricity consumption, consumer protection, and competition policy. These issues have become increasingly relevant as the scale of AI investment expands and its economic implications extend beyond the technology sector. Potential changes to safety standards, permitting requirements, reporting obligations, or access to advanced computing technologies could influence development timelines, capital requirements, and the profitability of individual companies. Importantly, increased congressional scrutiny does not necessarily translate into new legislation, and the structural demand for AI computing remains substantial. The central question is whether additional regulation merely changes the timing and cost of investment or materially alters the long-term economics of AI deployment. The distinction is particularly important for companies whose valuations already reflect expectations for exceptional future growth.

Conclusion

Last week’s sharp market decline highlights the increasingly demanding environment for equities, particularly among mega-cap technology and AI-related companies. The NASDAQ’s correction, significant losses in semiconductors, and a muted investor response to strong earnings suggest that confidence in the AI investment cycle has become more fragile. However, continued outperformance by the equal-weighted S&P 500 and relatively healthy market breadth indicate that investors are shifting within equities rather than broadly abandoning risk assets. Importantly, the underlying economic foundation remains strong. October employment improved materially, layoffs remain historically low, and robust consumer spending, business investment, and manufacturing activity continue to support growth. Improving productivity offers an additional source of strength, potentially allowing the economy to expand without generating proportionate inflationary pressure. Nevertheless, elevated consumer prices, slower real income growth, and persistent input costs remain important vulnerabilities. Stronger employment also reduces the urgency for Federal Reserve easing, making Tuesday’s inflation report a critical test of whether resilient growth can coexist with moderating inflation.

Policy and geopolitical uncertainty add further complexity. The incoming Democratic Congress could increase regulatory scrutiny of technology and AI, while ongoing tensions in the Middle East and Russia-Ukraine conflict continue to pose risks to energy markets and inflation. These uncertainties, combined with elevated valuations and changing market leadership, suggest volatility may persist. For client portfolios, the appropriate stance remains constructive, diversified, and selective, emphasizing quality businesses, durable profitability, strong balance sheets, and disciplined attention to valuation as markets navigate an increasingly complex environment.

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