Is Political Gridlock Good for the Market?

Earlier this week, Americans headed to the polls for what was widely considered one of – if not the most important midterm election in history, seen as potentially shaping the future of American politics. As the results are still being finalized with some races too close to call or spilling over into runoffs, the baseline forecast appears to have materialized with Democrats winning control of the House and Republicans expanding their majority in the Senate.

Many argue split power across Republicans and Democrats in Congress is positive for the markets as it is widely expected to result in gridlock. Of course, gridlock, while it implies a certain level of certainty for the markets given massive legislation is unlikely to pass, could also prove detrimental for the very same reason. After all, the market has fared relatively well in the past few years thanks in part to the administration’s fiscal stimulus amid still-solid economic fundamentals.

Victories on Both Sides

The stakes were extremely high in this year’s midterm elections. All of the 435 seats in the House of Representatives were up for grabs, along with 35 of the 100 Senate seats. Of course, of the 435 in the House, more than 300 were seen as “safe” by all accounts, with the remaining 135 deemed at risk seen as either toss-ups or leaning slightly. As the votes tally, Democrats appear to have secured 225 seats for a net gain of 30. In the Senate, Republicans began with 51 seats and are likely to walk away with 52 (with 32 races in, 2 undecided races in Florida and Arizona and with the Mississippi race going to a runoff). 

While many of the usual suspects won in historically red and blue territory, respectively, there were some more notable victories: Republican Ron DeSantis, a vocal supporter of President Trump, appears to have won the race for governor in Florida over Tallahassee Democratic Mayor Andrew Gillum. Additionally, Ted Cruz re-secured his Senate seat against Beto O'Rourke in Texas and Alexandria Ocasio-Cortez in New York's 14th District, became the youngest woman ever elected to Congress.

Gridlock Good or Bad?

Ahead of Tuesday’s election, analysts from either side inferred the possibility of a sizable “wave” coming through the political system colored either blue or red, respectively. But as the political lines of victory were drawn, neither side seems to have outperformed very much relative to expectations. Of course, regardless of the lean of this week’s results, gridlock was seemingly inevitable. If Republicans kept the majority, gridlock would likely result from “infighting” as one news outlet described it. On the other hand, more traditional gridlock would be the product of Democrats gaining control in Congress with either one or both chambers, leaving the legislative branch at odds with the executive branch.

But is gridlock good for the markets? It can be, particularly if certainty is deemed more favorable than change even if said change holds the potential of being positive. After all, gridlock negates the possibility that meaningful legislation or “big legislation” could pass. And, the sheer absence of political uncertainty generally provides positive support for equities. In fact, in many instances, after midterms, stock performance is more favorable in years three and four then in a president’s first two years of office. (Of course, historical comparisons are hardly apples to apples with economies of the time in very different shape or varying positions in the economic cycle.)

This time around, however, gridlock could prove detrimental for the markets, and for the very same reason some argue gridlock is potentially favorable – limiting the likelihood that meaningful legislation has a chance of being passed. After all, much of the support for the market and the broader economy over the past two years has been the result of action taken by the White House including tax reform and the expectation of additional reforms coming down the pipeline via President Trump’s pro-business agenda. Thus, no further legislative action could mean no further fiscal support. 

Tax Reform

In fairness, the outcome this week – the House going to the Democrats and Republicans maintaining the majority in the Senate – was widely anticipated, meaning the realized results were already priced into the market. And furthermore, with the expected results, the likelihood of earlier policies of the Trump administration, including regulatory reform and tax cuts, are not expected to be undone with the Senate still in the hands of Republicans. So no surprises there. The shift in the House, however, makes it less likely that tax cuts will be made permanent and reduces the probability of pushing through additional reforms on anything from immigration to regulation to health care. In other words, some of the support for the market and more generally economic conditions has been realized legislation as well as optimism for future policy initiatives which will now expectedly face fierce opposition, or at least additional barriers for success. 

Tax reform, for example, while hardly a silver bullet for the economy, helped perpetuate the recovery through 2018. According to a survey published by the National Association of Business Economists (NABE), economists estimate the nominal impact on real GDP from the resulting tax legislation was roughly two to four-tenths of a percentage point in 2018. While seemingly modest on the surface, the benefit of a more favorable tax environment had compounding benefits, including more robust spending for both consumers and businesses amid rising confidence. The result was above-trend growth April-September. As domestic activity is expected to wane into 2019 and beyond, rolling back tax cuts will presumably compound the loss of momentum in baseline GDP. 

Infrastructure Spending

Additionally, with a further divide in the Congress, aside from tax reform, the likelihood of any additional stimulus measures including infrastructure investment has a muted chance of materializing. Disappointingly, while members from both sides of the aisle have championed the need for further investment in the country’s antiquated infrastructure, paying for such investment remains a point of contention. And without the prospect of an agreement on funding for such projects, the airports bridges, tunnels and roads in this country will become a victim of gridlock.

Some expect President Trump, as well as some on the left, to reach across the aisle in the interest of the county to reach a deal on desperately needed domestic investment. However, much of the political environment in the recent election cycle has been driven by a “stop them” mentality, whatever the cost, which leaves little room for civil negotiations. 

Infrastructure spending, like tax reform, could prove to be a very large support to growth, and by extension, a positive prospect for the markets. Political gridlock, however, is likely to block such legislation with politicians from both sides drawing lines in the sand. In fact, according to the Federal Reserve, while a number of favorable factors, including stimulative federal tax and spending policies, as well as accommodative financial conditions, have supported above-trend growth, additional stimulus including infrastructure spending could act as a sizable tailwind for the economy, further propelling domestic activity. Speaking last week at a Chicago Fed conference, Chicago Fed President Charles Evans specifically noted infrastructure spending could offer a buffer in growth as the economy will expectedly lose traction at the end of the expansion.

“In addition to providing much needed public services at relatively low costs, infrastructure projects may be able to play a role in buffering the economy during an economic downturn…A period of low interest rates and widely available unemployed and underemployed labor is an advantageous time to build or improve infrastructure because the costs to do so are lower.”

-       Chicago Fed President Charles Evans, Chicago Federal Reserve Conference, November 3, 2018

“…no doubt, the effect of the fiscal policy changes, the tax cuts, and the spending increases – that’s got to be part of the [growth] story.”

-       Federal Reserve Chairman Jerome Powell, September 26, 2018 Press Conference

Regulation

With the political environment tensing in Washington, some in Congress have warned of a fierce “battle” brewing with President Trump. In fact, a “return of the gavel” to the Democrats in the House post midterms opens the door, according to some, for a host of subpoenas aimed at President Trump and those close to him. California Democrat Maxine Waters, for example, slated to become the chair of the powerful House Financial Services Committee, has suggested a need to collect all documents concerning any ties that Trump might have to Russia. Previously, with a Democratic minority, Republicans held the power to issue subpoenas. 

Additionally, and arguably more important, at the helm of the House Financial Services Committee, while it does not have jurisdiction over budgeting, affords control over financial regulation and housing finance reform. A self-proclaimed fierce foe of Wall Street, Waters has repeatedly called for increased regulation of the nation’s major banks, an agenda seemingly at odds with the Trump administration which continues to seek to reduce financial-sector regulation. In other words, most anticipate House Democrats to not only block any further deregulatory actions, but intensify oversight of both big banks and federal agencies. 

“I have not forgotten you foreclosed on our houses. I have not forgotten that you undermined our communities. I have not forgotten that you sold us those exotic products, had us sign on the line for junk and for mess that we could not afford...And for doing that, I have people who are homeless who have never gotten back into a home. What am I going to do to you? What I’m going to do to you is fair. I’m going to do to you what you did to us.”

-       Maxine Waters, Black Women Network Breakfast, November 3, 2018

Political Cover for Rising Rates

With the balance of power shifting to the Democrats – at least in the House – more economic stimulus, i.e. support for the market, may be hard to come by. Coupled with a lack of future fiscal stimulus, trade tensions and rising interest rates are also likely to continue compounding the potentially negative impact on the market and broader economy. From a political standpoint, however, such a proverbial blockade may provide Republicans cover should the economy lose significant momentum over the coming months/years pointing the finger at both Democrats and officials at the Federal Reserve as the likely cause.

Politics aside, weakness already appears to be bubbling under the surface of the U.S. economy, particularly in the U.S. housing market. Federal Reserve officials, however, have failed to notice such a deterioration of conditions, as they continue to project additional rate hikes in the coming weeks and months. Nevertheless, with a potential fourth-round rate increase coming as soon as forty days from now at the December FOMC meeting, the White House has amped up its criticism of the Federal Reserve, arguing the country’s central bank should be seeking to help support or further perpetuate the recovery with low interest rate policy.

Speaking at a September press conference in New York, President Trump clearly voiced his displeasure with further Fed action. “I am not happy about that,” he said. "I'd rather pay down debt or do other things, create more jobs, so I'm worried about the fact that they seem to like raising interest rates. We can do other things with the money."

Earlier this week, the Fed opted to keep rates unchanged at the November 8th FOMC meeting. While holding steady, more recently, however, the Committee has been gradually raising rates for three years and appears poised to again raise rates in December, marking the fourth-round increase for the year. And, according to the Federal Reserve Chairman, political factors such as pressure from the White House or comments from officials on Capitol Hill are not being factored into the Fed’s policy decisions. The Fed, independent from the Federal government, focuses and will continue to focus on the evolution of the data and “best thinking” in determining interest rate policy.

According to Bloomberg, the market has assigned a 77% probability to a December rate hike with the potential for three more interest rate increases next year. 

"We've been given a really important job to do on behalf of the American people by Congress, and we've been given the tools to do it, and my colleagues and I are focused exclusively on carrying out that mission."

-       Federal Reserve Chairman Jerome Powell, September 26, 2018 Press Conference

Balance of Power

Whether Democrat, Republican, or Independent, Americans headed to the polls this week to help shape the direction of American politics. And, as expected, the direction appears to be somewhat muddled with both sides victorious and gaining ground respectively in the House and the Senate: the majority in the House shifted to the Democrats with Republicans extending their control of the Senate. With gridlock anticipated regardless of the outcome, however, the market is left reeling. Historically, gridlock is positive for the markets, but in this case, gridlock could stunt legislation market participants were anticipating as part of the administration’s pro-business agenda, which has arguably helped support solid equity growth over the past few years. 

Ahead of the polls, some analysts argued a Republican sweep would send Treasury yields higher and weigh on stocks, though others argued a Republican victory could propel equities given further expected support for the administration’s pro-business agenda. Of course, as the WSJ pointed out Tuesday ahead of the poll results, the very same split prediction was being offered should Democrats take control of the House. With the realization of power divided, all we can expect with certainty is uncertainty; brace for further volatility in the financial markets as politics appear increasingly decisive as of late.

-Lindsey Piegza, Ph.D., Chief Economist