Democrats sweep Congress! Morgan Stanley urgently redraws its trading map: equity overweight unchanged, AI data centers become the biggest losers

Morgan Stanley noted in its latest research report that Democrats have won control of the House and Senate, although some election results are still being counted. This decisive election outcome indicates that the situation is developing toward the "cohesive Democratic majority" scenario envisioned by the bank. Under this scenario, the uncertainty brought by the change in governing power could become a headwind for overall stock market performance, with effects similar to the market volatility triggered after the 2022 midterm elections when Republicans newly took control of the House. However, cuts to SNAP (Supplemental Nutrition Assistance Program) and Medicaid may be delayed, which would benefit consumer sectors and create some upside risk to economic growth forecasts. Morgan Stanley stated that the path for either party to advance a budget reconciliation bill along party lines has been closed, removing the main upside risk to U.S. Treasury financing needs. Although delaying cuts to SNAP and Medicaid spending would have the opposite effect, its impact may be smaller relative to the US$2 trillion fiscal deficit. The key policy battle is more likely to focus on the short term, because the Democratic majority can coalesce around policy demands and use the December government funding deadline and the 2027 debt ceiling issue as negotiating leverage. On the main market impact, AI market sentiment could be further negatively affected as expectations for data center restrictions rise. However, Morgan Stanley believes the incremental adverse effects will be localized and will not change the overall AI capex narrative. Its base case assumes AI-related capex will remain stable. At the same time, Morgan Stanley's overall outlook for resilient economic growth and continued gradual disinflation remains intact. In FX markets, Morgan Stanley expects short-term trading to remain consistent with its defensive market scenario, namely stronger JPY, CHF and EUR against the USD. AI-related headwinds could cause AUD to lag in cross rates, while targeted tariff risks could weigh on CAD relative to low-yielding currencies. Increased congressional resistance to another escalation of GEO Group Inc political conflict could also put downward pressure on NOK/SEK. Possible policy paths Four areas warrant close attention: 1. Fiscal policy. Morgan Stanley expects that the SNAP and Medicaid spending cuts in the One Big Beautiful Bill Act (OBBBA) may be repealed, delayed or softened during negotiations over fiscal policy deadlines. Democrats are likely to have a large enough majority both to reconcile differences within their caucus and to coalesce around a few policy goals. But overall, even if these cuts are delayed, the bank still believes the U.S. fiscal deficit will remain around 6% of GDP. 2. Administration-driven policy. Morgan Stanley believes that since the start of President Trump's second term, policy uncertainty has mainly been related to executive branch actions rather than legislative actions. Policies on tariffs, GEO Group Inc politics, trade (especially the USMCA review), deregulation and export controls are all expected to continue, so policy uncertainty should be expected to remain at a certain level. 3. Data center restrictions. Morgan Stanley believes the real risk is that state-level rules pushed by newly elected officials could further fragment the United States, leaving some areas open to new data centers while others do not allow such projects. The key levers that can truly constrain projectsgrid interconnection, large-load electricity pricing design, siting and tax abatementsare almost entirely in the hands of state regulatory commissions, state legislatures and county commissions. Therefore, power transitions in some governors' offices deserve close attention, though the related impact may be limited to specific jurisdictions. From a data center development perspective, the most important result in this election is undoubtedly the Texas gubernatorial election. In Texas, Democrat Gina Hinojosa's election as governor increases policy risk around data center approvals and construction timelines. Gina Hinojosa's campaign platform includes a moratorium on approving new data center projects. Given that the Texas governor can participate in approvals of new data center projects through multiple regulatory bodies, Morgan Stanley believes many projects could face significant delay risk. 4. Signals for the 2028 election. Morgan Stanley has consistently argued that midterm election results should not be directly extrapolated to the 2028 presidential election. However, the next two years will be a window for lawmakers to lay the groundwork for federal-level policy action in 2029 and beyond, provided control of the presidency ultimately changes by then. Morgan Stanley believes lawmakers may propose legislation targeting AI infrastructure, such as repealing the immediate expensing policy in OBBBA or taxing computing power. But given the president's opposition to such measures, these bills are unlikely to actually be enacted. Main market and economic implications U.S. equities. As Morgan Stanley discussed in last week's report, the midterm elections were the most obvious risk event and it has now passed, and historical performance also offers encouraging signals. Since 1982, in the six months after midterm elections, large-cap stocks have risen by about 15% on average on a market-cap-weighted basis and about 16% on an equal-weighted basis; over the following year, both measures gained about 22% cumulatively. Morgan Stanley believes investors widely expected Democrats to sweep the elections and secure a narrow Senate majority. Therefore, given that Democrats also won the Texas gubernatorial election, the outcome could intensify short-term market volatility. However, the bank believes this could also mark the final stage of the rolling market correction discussed since this summer. After the election, another escalation of military conflict between the U.S. and Iran, or further U.S. tariff increases, could also pose short-term risks. Cross-asset allocation. Based on the midterm election results, Morgan Stanley continues to recommend overweight global equities and underweight core fixed income. Year to date, the bank has held a constructive view on global equities, mainly based on expectations that the AI capex cycle will continue. Because U.S. technology-related investment may not change much at the aggregate level, Morgan Stanley expects that corporate earnings support across regions, including Europe and emerging markets, will not disappear. The outlook for global fixed income markets is also broadly unchanged. Although sentiment toward AI-related capex is no longer as optimistic, financing demand for digital infrastructure will still keep corporate credit issuance elevated. Heavy issuance could push credit spreads wider, especially in lower-rated credit. Beyond AI, oil prices and fiscal risks outside the United States remain important factors affecting equities, yields and stock-bond correlation, and deserve attention alongside U.S. politics. The midterm election results have not materially changed these factors. Until these factors change, Morgan Stanley's asset allocation stance will not change either: continue to overweight equities and underweight core fixed income. AI market sentiment/capex. Given the defeat of incumbents in some key state and local elections, Morgan Stanley believes the election results could have the greatest impact on AI market sentiment, because more durable and broader restrictions may be introduced at the local level. The bank expects the incremental adverse effects to be localized and not to change the overall AI capex narrative, but they could lead to divergence across U.S. regions: some areas allow new data centers while other states or municipal jurisdictions do not. U.S. rates. Democratic control of both chambers of Congress means that a Republican-led budget reconciliation bill will not be able to advance after the new Congress convenes in January next year, thereby removing the main upside risk to U.S. Treasury financing needs. Pre-election market pricing had already reflected limited investor expectations for additional Treasury supply, because prediction markets saw only a single-digit probability of unified Republican control of Congress, meaning the potential positive impact on swap spreads from such an outcome may be relatively limited. The new majority party may seek to delay cuts to SNAP and Medicaid spending at each fiscal policy deadline, which could slightly increase issuance in the 2-year to 7-year sector. Overall, Morgan Stanley believes the belly of the U.S. Treasury yield curve may see only modest relative underperformance. If the lame-duck session fails to raise the debt ceiling, the U.S. Treasury will proceed with planned increases in coupon-bearing Treasury auction sizes in February 2027. By then, Democrats may seek to attach their own policy priorities to the next debt ceiling increase, thereby lengthening the time needed to resolve the issue. This could cause short-term Treasury bills maturing around the so-called X-datewhen the U.S. Treasury is expected to exhaust special financing measures and cash balancesto trade lower in price and higher in yield, while long positions in the SOFR/federal funds rate basis for the end of Q3 2027 may become increasingly attractive. Regarding AI, related corporate bond issuance has become a source of supply for long-duration assets, so the market perceives a link between data center construction and 10-year and 30-year U.S. Treasuries as well as credit spreads. If state and local restrictions slow construction, smaller AI-related bond issuance plans could reduce the supply of long-duration assets, potentially pushing 10-year and 30-year U.S. Treasury prices higher and yields lower. Morgan Stanley's base case assumes AI-related capex will remain stable, so we view this as a risk scenario rather than a base forecast. Nevertheless, changes in investors' views on the probability of different outcomes could still provide a path for further declines in U.S. Treasury yields. U.S. dollar. Morgan Stanley believes the market is pricing in more obstacles to AI-related investment, stronger congressional resistance to another escalation of GEO Group Inc political conflict, and rising risks of targeted trade actions. In the near term, Morgan Stanley expects FX trading to be consistent with our defensive market scenario, namely a stronger JPY, CHF and EUR against the USD; while AUD may lag in cross rates because of its sensitivity to AI-related equity sentiment, especially after Democrats won the Texas gubernatorial election. Morgan Stanley also expects CAD to lag relative to low-yielding currencies as the market prices in a higher risk of U.S. tariff increases. Combined with potential political and financing headwinds that could limit further escalation of GEO Group Inc political conflict, these factors may temporarily put downward pressure on NOK/SEK. U.S. economy. Morgan Stanley's overall outlook for resilient economic growth and continued gradual disinflation remains intact. Under this scenario, the upside risks to growth are greater. Delays in SNAP and Medicaid cuts could add up to 0.4 percentage point to personal consumption growth in 2027 and support a faster broadening of consumer spending. AI-related financing. The focus of AI-related financing may gradually shift from power and data center shell financing to chip financing. By the time projects reach the chip installation stage, data center construction and energization activities are usually already complete, and these are precisely the areas most vulnerable to potential policy headwinds. This shift could drive continued flattening of the credit yield curve. U.S. healthcare. A Democratic sweep may be seen by the market as positive for Medicaid-focused managed care companies such as Centene Corporation (CNC.US) and Molina Healthcare (MOH.US); while diversified managed care companiesUnitedHealth Group Incorporated (UNH.US) and CVS Health Corporation (CVS.US)may see only relatively modest market reactions. The election outcome will give Congress more room to advance Democratic healthcare policy priorities, including restoring enhanced Affordable Care Act (ACA) subsidies or repealing some Republican Medicaid cuts such as work requirements. Although Morgan Stanley still believes major changes in healthcare policy are unlikely before the next presidential election cycle, the election outcome could change the direction of related policy discussions, especially after several key supporters of Trump's healthcare policy/"Make America Healthy Again" (MAHA) agenda departed. Shares of Medicare Advantage-focused companies such as Humana (HUM.US) could weaken on the market's first reaction, because Medicare Advantage remains more closely tied to the Republican policy agenda. However, in Morgan Stanley's view, the share price reaction could be significantly more positive for Medicaid-related companies. Lame-duck session: what happens next? Morgan Stanley focuses on the following policy catalysts to watch before year-end: Government funding. The U.S. government has already passed a continuing resolution (CR) that keeps government funding at current levels until December 11. At that point, Congress must pass another continuing resolution or full-year appropriations bills to avoid another government shutdown. Democratic leadership has signaled a desire to complete consideration of the appropriations bills during the lame-duck session. But in Morgan Stanley's view, the election results will determine whether party leaders extend the debate into 2027. Morgan Stanley's prior research noted that government shutdowns have limited market impact, mainly reflected in delayed economic data releases rather than material downside economic risks. In its earlier report on Washington policy developments, the bank also mentioned that experts believe a continuing resolution could extend into calendar year 2027 (CY27), and this risk should not be ignored. Defense. Morgan Stanley's base case is that the FY2027 National Defense Authorization Act (NDAA) will be passed before year-end. Items worth watching in the bill include: several export control legislative proposals that may be included, such as the MATCH Act (aimed at coordinating export controls among allies), the AI OVERWATCH Act (to codify the Commerce Department's chip export policy into law), the Chip Security Act (involving chip location verification) and the Remote Access Security Act (RASA). Overall, Morgan Stanley believes the policy direction will be further tightening of restrictions, and that the force driving this trend will increasingly come from Congress, while the U.S. government prioritizes stable relations with China. Regarding the Department of War (DoW) base budget and supplemental funding, Morgan Stanley believes the White House's roughly US$1.5 trillion budget request is quite aggressive, but in the coming months the bank will watch whether additional funding is provided through the budget reconciliation process. Office of Management and Budget (OMB) Director Russell Vought said in early October that he was optimistic Republican lawmakers would push a budget reconciliation bill through the legislative process during the lame-duck session, but the bank still believes related efforts will face considerable resistance. "Reconciliation 3.0." Beyond additional defense funding, the lame-duck session is the last suitable window for Republicans to advance a legislative package on their own. Morgan Stanley believes the legislative calendar is very tight, with multiple priorities still to be handled before year-end. However, according to its rates strategists, this would be the main upside risk to U.S. Treasury financing needs. The debt ceiling could also be addressed in advance through a reconciliation package before year-end, but Morgan Stanley believes it is more likely that the debt ceiling issue will become a catalyst in the second half of 2027. Based on projected financing needs, the bank's rates strategists estimate that U.S. public debt outstanding will reach the debt ceiling in March 2027, at which point the debt limit begins to bind. The so-called "X-date"when the U.S. Treasury exhausts all special financing measures and cash balances and can no longer meet all debt obligations in full and on timeis expected around the end of Q3 2027. Leadership elections. Leadership votes will take place shortly after the election, with committee member appointments occurring at the same time. Tonight's election results mean Democrats will gain committee chairmanships, which are typically held by the previous senior minority members. More broadly, the arrangement of committee members and chairs and the voting results can reflect the likely future direction of overall policy in related areas. For example, healthcare policy may be reflected through the arrangements of the Health, Education, Labor and Pensions Committee (HELP Committee). Permitting reform. The bipartisan American Affordability and Jobs Act would reform federal environmental review and provide greater certainty for projects that have already been approved. In addition, the bill would require data centers to bear the transmission costs associated with them (effectively turning the Ratepayer Protection Pledge from a voluntary commitment into a federal mandate). Morgan Stanley believes that given major partisan differences over policy and a limited legislative calendar, whether the bill can pass remains uncertain. Data center restrictions in focus Democrat Gina Hinojosa's victory in the Texas gubernatorial election could increase policy uncertainty and limit future data center supply, thereby raising the relative value and pricing power of existing data center facilities that already have secured power. In August this year, after Texas Governor Greg Abbott ordered a review of all data center projects waiting for interconnection in the Electric Reliability Council of Texas (ERCOT) queue, Texas paused some data center interconnection processes. At that time, related interconnection applications had reached about 474 GW, more than five times ERCOT's historical peak power demand, with data centers accounting for about 90% of new power demand applications. Abbott warned that development on such a scale could threaten grid reliability and stability, prompting ERCOT to delay the "Batch Zero" transmission planning study for the first projects entering Texas's new large-load interconnection process. Part of the purpose of the review was to distinguish genuinely credible projects from speculative applications that may inflate Texas's future power demand forecasts. As for actions the Texas governor can take, they include: issuing executive orderstemporarily pausing new projects until the state legislature establishes clear guidelines. However, if the Republican-dominated state legislature acts quickly, the pause may last only a few months. Appointing power regulatory membersnamely members of the Texas Public Utility Commission (PUCT). Commission members serve six-year terms, with the next round of terms expiring in 2027. Providing approval policy guidance to state agenciesfor example, halting permits not yet issued by relevant agencies. Governor-elect Hinojosa has advocated a moratorium before relevant legislation is enacted, applying to new project permits rather than projects already under construction. The following measures would require legislation to implement: pushing for more durable policy changes, including tax policy changes such as eliminating sales tax exemptions; granting local governments the power to veto projectsGovernor-elect Hinojosa plans to give local officials the power to negotiate with developers, but this requires changes in law; codifying ratepayer protections into law; and requiring projects to employ union workers. All of these measures would require state legislature approval. In Ohio, Democratic candidate Amy Acton's election as governor also brings significant delay risk to the state's data center projects. The largest project at risk in Ohio is a 10 GW project involving NVIDIA Corporation and a major U.S. AI lab. Another large project under construction is Amazon.com, Inc.'s 1.5 GW facility in Fayette County. In May this year, Ohio paused consideration of new data center tax exemption applications while the state legislature studies growth in the state's data center industry. Tax exemptions are a crucial consideration for data centers when choosing where to locate projects. Morgan Stanley expects private infrastructure investment platforms (PSPs) with significant Texas exposure could come under pressure. The bank's preliminary judgment is that previously assigned success probabilities for multiple potential data center projects in Texas may need to be lowered, especially those subject to the "Batch process." Morgan Stanley will closely watch statements from Governor-elect Hinojosa, especially whether she may freeze the final classification of proposed data center projects in the "Batch process." These projects include GLXY's Helios II, CIFR's Colchis campus and MARA's development project. Morgan Stanley also wants further clarity on whether projects under construction could be affected, including GLXY's Helios I phases II and III, HUT's Beacon Point and multiple CIFR projects. We believe these projects are less affected by policy uncertainty. By sector, Morgan Stanley expects the independent power producers (IPPs) sector overall to see a sentiment-driven short-term decline, but before considering the potential upside from data center business, existing asset cash flows, contracts and forward price curves will still support valuations. For power equipment and on-site power supply companies, the sector overall will underperform due to risks of slower data center industry growth, not merely Texas market exposure. Utilities with greater Texas exposure are most sensitive to potential downside risks. Potential impacts could come from two areas: first, slower data center activity; second, as regulatory commission terms expire, new regulators may be appointed (two commissioners' terms expire in 2027), and new regulatory policy could be less favorable to investors.