Why Midterm Gridlock Favors Sector ETFs

Why Midterm Gridlock Favors Sector ETFs

Prediction markets point to a divided Congress after November’s midterm elections: Democrats retaking the House, Republicans holding the Senate.

Key Takeaways: A divided Congress after the midterms may limit big legislation but not targeted policy moves. Financials, tech, and energy funds pair sector exposure with premium income strategies. Defense, clean power, and multi-asset funds round out ways to navigate a fractured Washington.

Slim majorities in both chambers create gridlock that makes sweeping legislation unlikely, wrote Matthew Bartolini, global head of research at State Street Investment Management. That could push investor focus toward targeted sector opportunities instead of political bets. Investors shouldn’t rush to cash, according to the report. Bartolini pointed to sector and income-focused ETFs as ways to navigate a divided government.

The State Street Financial Select Sector SPDR ETF (XLF) offers broad exposure to that policy-driven demand. Financials could benefit most from inaction, the report noted. Much of the sector's regulation sits with the Federal Reserve, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission rather than Congress. As a result, new capital rules taking effect by year-end are expected to free up bank balance sheets.

Energy has outperformed the S&P 500 by roughly 20 percentage points over the past year. Yet State Street expects that growth to slow sharply, from 77% in 2026 to negative 11% in 2027. Meanwhile, AI-driven electricity demand is pushing grid capacity further into the policy debate. The State Street Energy Select Sector SPDR Premium Income ETF (XLEI) tracks the energy sector, turning volatility into income.

More Ways to Play the Midterm Divide

Beyond core sector funds, the report flagged additional targeted plays. Semiconductor demand tied to national security and AI self-sufficiency supports the State Street SPDR S&P Semiconductor ETF (XSD). Defense spending has risen 40% over five years, to $950 billion. That backs the State Street SPDR S&P Aerospace & Defense ETF (XAR). Rising AI-driven electricity demand is also pushing renewables toward the center of energy policy, according to the report. That trend backs the State Street SPDR S&P Kensho Clean Power ETF (CNRG).

Still, gridlock does not erase risks like sticky inflation and elevated Treasury supply, Bartolini wrote. The State Street Bridgewater All Weather ETF (ALLW) combines stocks, bonds, commodities and gold in one portfolio. The State Street Multi-Asset Real Return ETF (RLY) targets inflation-sensitive assets for added diversification. Both large-cap and small-cap U.S. stocks have historically risen more after midterm elections, once the political overhang clears. Resilient earnings and improving economic data could help extend that pattern, Bartolini wrote.