LARRY KUDLOW: For the midterms, it’s still early in the game

Recent data cited include combined ISM purchasing managers' indexes for manufacturing and services at their strongest in nearly two years, with productivity gains and wages reportedly outstripping inflation. A Harvard CAPS/Harris poll shows improving personal financial situations and strong public support for tougher border enforcement and a platform favoring reduced spending, lower taxes, tougher trade deals and lower drug costs. Politically relevant fundraising figures are substantial: $26M via Trump's joint fundraising committee in H2 last year, $8M to his leadership PAC, and a linked super PAC holding over $300M (approximately $375M total firepower). The combination of improving economic indicators and large campaign war chests heightens the political backdrop that could influence policy risk and investor positioning ahead of the midterms.

Analysis

Market structure: A growth-friendly midterm narrative (PMIs at ~2-year highs, wages > inflation) favors cyclicals — banks (higher NII from steeper curve), industrials, small caps and defense/border-security contractors — while compressing multiple expansion in long-duration growth and some pharma names if drug-price rhetoric resurfaces. Expect steeper Treasury curve (10s–2s widening by 10–30bps on positive macro) and stronger USD; industrial commodities (copper, oil) outperformance vs gold. Volatility should compress on sustained good data but spike around polls/legal headlines.

Risk assessment: Tail risks include a sudden policy shift (aggressive drug-pricing or tariff announcements), a reversal in wage momentum, or a surprise midterm political shock — any could flip capital flows in 48–72 hours. Near term (days) markets will react to ISM/CPI prints and fundraising headlines; short-term (weeks–months) hinges on message penetration and labor data; long-term (quarters) depends on enacted fiscal/tax changes. Hidden dependency: real consumer demand is contingent on credit health and savings drawdown; watch household credit delinquencies and payrolls.

Trade implications: Direct plays — overweight XLF (financials ETF) and XLI (industrials) and small-cap IWM for 3–6 month horizons; underweight QQQ/long-duration growth. Pair trade: long IWM (2%) / short QQQ (1.5%) to capture cyclicals vs growth rotation. Options: buy 3-month XLF 5–7% OTM call spreads (limit cost to 0.6–1.2% NAV) to play steeper curve; hedge with 3–6 month TLT calls if CPI >3.5% prints. Entry on 2–4% pullbacks or after ISM/CPI beats; trim into mid-October and reassess into Nov midterms.

Contrarian angles: Consensus overestimates the translation of fundraising/polls into lasting policy certainty — markets underprice policy/regulatory gamma (drug pricing, deportation-related security contracts) that can re-rate sectors fast. Historical parallels: 2010–2011 post-midterm rotations reversed when fiscal/tax actions disappointed; mispricing exists in stretch valuations of mega-cap growth. Unintended consequence: aggressive pro-growth messaging could re-ignite inflation expectations and force rates higher, crushing duration — maintain convexity hedges if positioning into November.

Key Decisions for Investors

• Establish a 2–3% long position in XLF (Financial Select Sector SPDR) for a 3–6 month trade; add single-name overweight in JPM (+1%) for NII upside if 10s–2s steepens >15bps; set stop-loss at -8% and target +12–18% on thesis.
• Implement a relative value pair: long IWM (Russell 2000 ETF) 2.5% vs short QQQ (Nasdaq-100 ETF) 1.5% for 3 months to capture cyclicals > growth; tighten if QQQ outperforms by >5% intraperiod or if ISM falls below 50.
• Buy a 3-month XLF 5–7% OTM call spread sized to cost no more than 0.6–1.2% of portfolio (limit exposure) to play steeper curve/risk-on into midterms; simultaneously buy 3–6 month TLT calls sized 0.5% if CPI prints >3.5% YoY to hedge inflation shock.
• Trim large-cap growth exposure: reduce QQQ weight by 2–4% now and reallocate to XLI (Industrials ETF) and defense names LHX/LMT (aggregate +2%) because border/security policy tailwinds could lift revenues; revisit allocations after October CPI and ISM prints.