Morgan Stanley's Hartnett Warns of Market Shock from Democratic Sweep in Midterms

Original author: Zhao Ying

Source: Wall Street Journal

Bank of America Securities Chief Investment Strategist Michael Hartnett warned that the global surge in bond yields to a twenty-year high is becoming the biggest threat to the AI capital spending boom, and the upcoming U.S. midterm elections could be the catalyst that triggers market turmoil.

Hartnett noted in the latest edition of The Flow Show weekly report that if the Democrats sweep both chambers in the midterm elections, the U.S. stock market could face a decline of more than 10%, a weaker dollar, falling bond yields, and a heightened risk of an AI bubble bursting. He characterized a "Democratic sweep" as one of the market’s most significant tail risks, which investors are currently pricing in almost nowhere.

Polymarket data shows the probability of a Democratic sweep of both chambers has risen to 50%, far exceeding the 10% probability of a Republican sweep. President Trump’s approval rating currently hovers between 35% and 40%, significantly below the historical average of 53% two months prior to midterm elections, reinforcing Hartnett’s warning logic.

Hartnett believes that last week's most significant market event was not the stronger-than-expected jobs data, but the broad collapse of the global bond market.

The 10-year U.S. Treasury yield rose to 4.81%, nearing levels seen during the 2008 financial crisis; the 30-year U.S. Treasury yield climbed to 5.31%, the highest since 2007. Meanwhile, Japan’s 10-year government bond yield surpassed 3.0% for the first time since 1996; the 30-year Japanese bond yield reached 4.2%, roughly four times the Bank of Japan’s policy rate. In Europe, Germany’s 10-year government bond yield rose to 3.38%, the highest since 2011; the spread between French and German yields widened to 88 basis points, while the spread between Italian and German yields reached 84 basis points—both at levels last seen during the 2012 European debt crisis. The Bloomberg Global Bond Yield Index has climbed to its highest level since 2007, just one percentage point below the century’s peak.

Hartnett distilled this phenomenon into a core thesis: “Bond-dominated bubble.” He argues that long-term yields—not stock narratives—are the true anchor for today’s AI trades, and notes that AI infrastructure builders and investors will continue to underperform AI application providers until global 30-year yields fall below 5%.

Hartnett acknowledged that the midterm elections are not "regime change" events akin to Thatcher/Reagan in 1980 or Brexit/Trump in 2016, and will not fundamentally alter the upward trajectory of U.S. government spending. However, he emphasized that the structural differences in the election outcomes cannot be ignored in terms of their impact on asset prices.

The Bank of America August fund manager survey found that 47% of respondents expect a Republican-controlled Senate and a Democratic-controlled House, 23% expect a Democratic sweep, and only 9% expect Republicans to maintain control of both chambers. Currently, Republicans lead 53-47 in the Senate and 218-212 in the House.

In terms of Senate race outcomes, for the Democratic Party to achieve a sweep, it must win at least four of the six Republican-held seats considered vulnerable: North Carolina (flip probability 92%), Maine (69%), Alaska (64%), Ohio (55%), Texas (51%), and Iowa (37%), while also holding onto its own vulnerable seats in Georgia (94%), New Hampshire (84%), and Michigan (65%). Hartnett has identified Ohio, Texas, Iowa, and Michigan as key battleground states that investors should closely monitor.

Notably, Wall Street has turned its attention to the Texas gubernatorial race—where incumbent Republican Governor Abbott (49% approval) faces Democratic challenger Hinojosa (45%)—seen as a key indicator of the future direction of AI data center expansion policies. Abbott recently had to announce a pause on data center construction to stem declining poll numbers.

Hartnett provided a clear transmission logic for the market impact under a Democratic sweep scenario.

He believes that a shift in the electoral landscape from "populist capitalism" to "populist socialism" would mean a reversal in tax and regulatory policies—from reduction to increase—negatively impacting corporate profits, while accompanying policy directions such as lowering inflation, improving healthcare accessibility, and alleviating K-shaped wealth inequality would directly dampen the AI capital expenditure boom and the "too big to fail" Wall Street ecosystem. Additionally, the erosion of Trump’s political capital will weaken his ability to execute priorities such as AI, resource monopolies, and diplomatic pressure.

Based on the above analysis, Hartnett’s asset allocation recommendation for a Democratic sweep scenario is to short financial stocks and the U.S. dollar as the optimal hedges; equities are expected to decline by more than 10%, the dollar to weaken, and bond yields to fall; international equities are projected to outperform, with Europe leading over Asia.

Conversely, if the Republican Party unexpectedly retains control of both chambers, it would signal a broad resurgence in risk appetite, greenlighting the AI bubble and reigniting the narrative of U.S. dollar exceptionalism. The most probable scenario—a Republican-controlled Senate and a Democratic-controlled House—corresponds to moderate risk appetite: "gridlock as goldilocks."

Within the above macro framework, Hartnett maintains his cross-cycle core allocation recommendation: long commodities and gold as hedges against inflation and geopolitical risk. He notes that government fiscal interventions, "at all costs," are suppressing long-term yields and supporting nominal GDP growth, under which the strategic logic that "any asset is better than bonds" remains valid.

At the AI trading level, Hartnett’s warning is more direct. He notes that the free cash flow of hyperscale cloud providers has turned negative under pressure from capital expenditure commitments, and the AI bubble "could burst at any moment." He proposes a post-bubble trading framework of "longing humiliation, shorting arrogance," recommending a shift toward long-duration bonds and defensive sectors, including consumer staples, mining/raw materials, and healthcare, while avoiding crowded AI infrastructure-related assets.

From a long-term perspective, Hartnett also notes an inverse signal: over the past 10 years, the rolling return for U.S. equities has been 15%, commodities 11%, and U.S. Treasuries -2%, marking the worst performance in nearly a century. Historical data shows that when bond returns turn negative over the long term, it has often been a strong buying opportunity for stocks (1939, 1974, 2009) and commodities (1933, 2018), providing historical support for his tactical bullish view on bonds in Q4.