Unlike the surprise result in the presidential election two years ago, that fooled pollsters and statisticians both, last week’s mid-term election results were in line with predictions—although a few surprises still unfolded. The Republicans held their majority position in the Senate, while the Democrats won a majority in the House of Representatives. However, both were by a slightly wider margin than initially expected.
Historically, a divided government has generally provided a mixed to somewhat favorable environment for equity market returns, but results were very much regime and economic-cycle dependent. This is a bit contrary to what some would first expect, based on the assumption that a pro-business, anti-tax Republican-led regime would always lead to stronger market sentiment; while Democratic leadership that’s pictured as anti-business and pro-spending/pro-tax would weigh on returns. The key, however, it seems in these results has been starting expectations, the need for certainty versus uncertainty, and how extreme policy ideas happen to be. Many times, high hopes for a regime aren’t always realized nor is extreme pessimism often warranted.
A divided government, with the inherent checks and balances on the various branches, can provide a ‘status quo’ outcome or a level of gridlock where little of significance (or fewer partisan policy ideas) are implemented. While that can be frustrating for voters, it can provide a level of certainty to markets (if nothing else, by removing uncertainty). For corporations, knowing what to expect is important when it comes to decision-making, growth initiatives and capital spending. In bond markets, more certain estimates on government fiscal spending can help in projecting the supply of treasury issuance, which leads to better understanding of technical market dynamics and possible paths for long-term interest rates.
With more balanced power, it obviously becomes much more difficult to pass single party-sponsored initiatives than it was during the last two years. Additionally, it’s probably fair to expect contention on a variety of issues that get to the core of each party’s base. Issues that remain at the forefront of congressional debate, including investment impacts, could include several of the following:
While a divided Congress would pre-empt any reversal of last year’s tax cuts by the House, the chances for making individual and small business cuts permanent and/or proceeding with deeper cuts as first hoped a few weeks ago have also fallen. Concerns for Democrats are focused on the benefits for higher-income taxpayers relative to lower-income, while many on both sides are hesitant to further increase the deficit, which would be exacerbated by lower tax receipts in coming years.
After passage of the Affordable Care Act, attempts at full repeal or watering-down of various provisions has resulted in a gridlocked situation between the parties. Therefore, status quo could be the base case. However, there does seem to be consensus among both parties for a solution to the growing cost of prescription drugs and high profits earned by pharma and biotech companies. This could add potential uncertainty to elements of the health care sector, as we’ve seen tinges of in recent years.
While supported by both parties, a widespread bill to shore up and expand America’s crumbling infrastructure is at risk for a variety of reasons. One is the cost. With the fiscal deficit already wide, partially due to recent tax cuts, adding an expensive plan could be a deal-breaker. Politically, whether Democrats are willing to partner with the President, who may claim victory on such a high-profile deal, also remains in doubt. If so, hoped-for gains in affected groups in industrials, energy and other segments may remain on pause.
Traditional Republican policy favors higher levels of defense spending, which has benefitted the aerospace group, while a Democratic-controlled house could certainly rein this in as a budget item.
There has been growing support on both sides of the aisle (for unique reasons) for some type of privacy regulation, considering the long list of data breaches and questions about information sharing for commercial purposes. The European General Data Protection Regulation (GDPR) implemented this year could serve as a model for what such legislation could look like in the U.S., but this is only speculation. This could negatively affect info tech firms, for whom this massive trove of data is a key asset, and earn substantial revenue from it.
With broad, and often unilateral, discretion remaining with the executive branch, the change of party leadership in the House may not have a direct effect on the President’s recent imposition of tariff policies. Formal trade agreements, however, such as the updated version of NAFTA, require legislative approval. Market sentiment sensitivity to trade news continues to run at a high level, with an apparent consensus base case that some type of deal with China will be put into place. Sentiment has been more challenged in Europe and Asia, which could be more negatively affected than the U.S. by a broader trade war.
In the financial sector, certain provisions could again be brought to the surface for discussion—notably those intended to reduce systematic financial risk or affecting consumer finance oversight to some degree. However, due to the split Congress, agreement on substantial changes is not expected. On a broader level, as with trade, the executive branch has a degree of discretion on lowering regulatory burden for companies, which is likely to continue.
Talk has already begun about the numerous ‘impeachable moments’ that could be pursued by the House against the President. Requests for information through subpoenas and additional news focus could prove embarrassing at the very least, or worse, such as resulting in impeachment proceedings, if evidence of wrongdoing is found. Based on financial market responses during the Nixon and Clinton scandals, any big news here could raise volatility significantly. While fundamentals wouldn’t be necessarily affected, such an event would qualify as internal ‘geopolitical’ risk that shakes confidence in risk-taking generally.
With a divided Congress, the risk of petty squabbles increases—this could manifest in the form of fights over short-term budget extensions (potentially leading to government shutdowns) and the government debt limit expiration next year (last time this negatively impacted the U.S. credit rating and raised market volatility significantly).