Wall Street's most accurate stock-market forecaster says midterm elections can push the S&P 500 higher - but a surge in Treasury yields could stall a rally

• Morgan Stanley strategist Mike Wilson said the midterm elections could present more uncertainty for the stock market in the short term.
• But ultimately, the election will result in equities climbing higher and bond yields moving lower, he said in a Monday note.

The midterm elections will give investors cause to stay bullish on equities, but a surge in the 10-year Treasury yield could cap some gains in the S&P 500, according to Morgan Stanley equity strategist Mike Wilson.

In a Monday note, analysts led by Wilson — who was recently named Institutional Investor's top portfolio strategist — said the midterm elections could present more uncertainty for the stock market in the short term as the bond market will sustain rate volatility throughout the week.

But eventually, the midterms should be a catalyst for lower bond yields and higher stock prices, Wilson added.

"[W]e remain tactically bullish on US equities as recent risk events for bonds (November Fed meeting, Oct labor and inflation data) pass and leave scope for rate vol to come down further from historically high levels," he wrote.

The firm's upside targets for the S&P 500 fall in the range of 4,000 to 4,150, and Wilson said those numbers could be met this week if Republicans win decisive control of both the House and the Senate.

In that event, which some polls are forecasting, Democrats would have a harder time passing aggressive fiscal spending plans.

"[T]he Republicans have talked about freezing spending via the debt ceiling much like they did in 2011 (the Budget Control Act)," Wilson said. "This would be a sharp reversal from the past few years when budget deficits reached levels not seen since WWII. In our view, a clean sweep by the Republicans on Tuesday could greatly raise the odds of such an outcome."

But election results may not be clear by Tuesday night due to delays in counting mail-in ballots, meaning stock market volatility will remain elevated in the near term, he added.

And the S&P 500 could still see a potential ceiling to its climb if rates on 10-year notes climb further, while Thursday's forthcoming CPI report adds another reason for caution.

"[I]f 10-year Treasury yields make a new high (4.35%), the odds of the equity rally trading to higher highs (>3950) goes down considerably, and we would advise clients to consider exiting bullish trades at that point," according to the note. By midday Monday, the 10-year yield was at 4.2%.

Analysts maintained that for a stock market rally to carry on into the holiday season, yields on 10-year Treasury notes will have to drop.

In a separate Monday note, Fundstrat's Tom Lee similarly said the midterm elections and the Thursday CPI data could serve as "game changers" for investor sentiment this week and spark a rally. Depending on how the events shake out, Lee wrote, stocks could climb because much of the bad news is already priced in.