In a lengthy in-house interview between Goldman’s Allison Nathan, editor of the popular Top of Mind newsletter, and Goldman’s chief political economist, Alec Phillips, the latter runs through the policy and market implications of various midterm election outcomes, arguing that the base case of a divided Congress – one which is already largely priced in – implies little change to the current direction of policy and economic growth.
In the context of Trump’s repeated allegation that “stocks will fall if Democrats win in the midterms, and rise if Republicans win”, Phillips counters that midterm elections have historically been less of a market event than presidential elections, with only modest market moves on the day regardless of the outcome, and points out that over the last 60 years or so, the S&P 500 has risen by 0.7% on average from the day before to the day after midterms.
On the other hand, Fund Strat’s Tom Lee argues that Trump “has history” on his side, and observes that of the 30 midterms since 1896, chows that markets have generally outperformed when there is no change in House majority control.
The Goldman strategist, in turn, responds that even when the president’s party suffered big losses or control of Congress shifted, the market reaction has been relatively muted, a fact which he attributes to midterm election outcomes usually being in line with prediction markets, and the market has tended to discount the results in advance.
That said, Phillips points out that the equity market rallies pretty consistently after the midterms, usually beginning not long before Election Day and continuing into the middle of the next year; in the last several decades there haven’t been many instances of negative returns during that period. That isn’t the case with presidential elections.
Overall, the impact on the macro markets is likely to be small, especially relative to other drivers. But to the extent that the base case of divided Congress suggests slightly weaker fiscal stimulus and growth, and little reason to expect friendlier trade policy, I see slight downside risk to Treasury yields and the dollar, all else equal. Since a divided Congress is the consensus view, some of this may be priced in, but probably not all of it. In contrast, Republican control of both chambers would imply slightly higher growth expectations on more fiscal stimulus and reduced regulatory risk, which could see yields and the dollar—as well as equity indices—rise.
While there is more in the full interview (see below), perhaps the most notable question was what, if any, scenario would present the biggest shock to the macro markets? Here is Phillips’ answer:
I’m not sure any outcome would provoke a strong reaction from the macro markets, but the one with the biggest chance is probably Republicans gaining a bunch of seats in the Senate. Six Democratic seats are up for reelection in states that Trump won by a substantial margin in 2016. So far the focus has been on how many of those seats Democrats can hold, but they are all competitive races, and it is certainly possible that the Republicans increase their majority instead. That matters because a larger majority would provide Republicans extra room to pursue priorities such as further tax cuts more aggressively, which would imply even more upside to Treasury yields.
As for Trump’s claim that a Republican victory would be good for stocks, while a Democrat win bad, it is unlikely that any party would stop the runaway fiscal spending debt train which is now the dominant source of equity upside in the US, and therefore beyond all the posturing, it is unlikely that anything will change for the trajectory of market based on who ends up winning the House or the Senate.
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Alec Phillips is Chief US Political Economist at Goldman Sachs. His full Goldman in-house interview is below:
Allison Nathan: How do you expect the midterm elections to play out?
Alec Phillips: It’s hard to argue with the consensus view that Republicans will hold the Senate and Democrats will win the House majority. Polling suggests the chances of the Democrats gaining the Senate majority have declined in recent weeks, but they appear to be ahead in about 30 Republican-held House seats, more than the 23 they need to win the House majority. Generic ballot polling also still points clearly to a Democratic-led House. And Democrats still seem to have a turnout advantage judging by their larger share of the vote among people “likely” to vote, as opposed to those who are simply registered. That said, polling for the House is particularly unreliable and many of the races that are leaning Democratic are only doing so by a slim margin; so the marginal races that will actually determine control are tighter than what some headlines suggest. That raises the risks around the base case of a divided Congress, though I still agree it’s the most likely outcome.
Allison Nathan: How have markets typically responded to midterm elections?
Alec Phillips: Midterm elections have historically been less of a market event than presidential elections, with only modest market moves on the day regardless of the outcome. Over the last 60 years or so, the S&P 500 has risen by 0.7% on average from the day before to the day after midterms. Even when the president’s party suffered big losses or control of Congress shifted, the market reaction has been relatively muted. I attribute this to the fact that midterm election outcomes have usually been in line with prediction markets, and the market has tended to discount the results in advance. However, the equity market rallies pretty consistently after the midterms, usually beginning not long before Election Day and continuing into the middle of the next year; in the last several decades there haven’t been many instances of negative returns during that period. That isn’t the case with presidential elections.
Allison Nathan: Is the historical pattern of positive equity returns following the midterms likely to hold this time?
Alec Phillips: I’m doubtful that midterms will provide the same boost. Setting aside the fact that many other factors impact equity performance, one thing that’s different today is the timing of fiscal stimulus. Typically, fiscal policy contracts early in the four-year election cycle, and then eases after midterm elections as the focus shifts to the presidential race. This time around, we have the opposite; a big fiscal boost took hold in the first half of the cycle and is now set to fade. All else equal, to me, that calls into question the historical trend.
Allison Nathan: Would any of the possible election outcomes materially impact your base case of fading fiscal stimulus?
Alec Phillips: Probably not. Regardless of the outcome, the midterms are unlikely to substantially change the medium-term path of fiscal policy; we would still expect the fiscal boost of 0.75-1.00pp of GDP in 2H 2018 to fade to about neutral over the next couple of years. In the base-case scenario of a divided Congress, we don’t expect any changes to taxes, but see slightly more spending coming out of the budget deal Congress will have to negotiate next year for fiscal years 2020-21. Under a Republican-controlled Congress we might see slightly more fiscal stimulus, but only on the order of a couple of tenths of a percentage point of GDP. That’s because heightened political sensitivity around the rising deficit will constrain lawmakers from much further action. So under Republican control of both chambers, we might see a small additional tax cut partly offset by more restraint on spending, for example.
Allison Nathan: Could next year’s fiscal deadlines be more disruptive under certain midterm outcomes?
Alec Phillips: A divided Congress is probably the most disruptive scenario in terms of fiscal deadlines, and in particular for raising the debt limit, which will have to happen in July or August 2019. The last time that we really got into trouble around those deadlines was in 2011 and 2013, when we had a divided Congress and a divided government. So far congressional Democrats have not pushed against the Trump administration on these fiscal deadlines in the same way that congressional Republicans pushed against the Obama administration, but every year that goes by, the odds increase that they try to use it for leverage. And next year, under a Democratic-led House, might be the moment when Democrats demand something in return. But at this point it’s difficult to predict—and having President Trump on the other side of the negotiating table makes it even less predictable.
Allison Nathan: Does trade policy become more or less market-friendly under a divided Congress?
Alec Phillips: The administration generally has more discretion over trade policy than many other policy areas, so the midterms are unlikely to have a large impact. But they will still be relevant for a few reasons. First, the next Congress will need to approve the new US-Mexico-Canada trade deal that is set to replace NAFTA. I think Democrats will ultimately support the deal, but under a Congress that is divided or under Democratic control, the process could be bumpy; Democrats would probably seek some changes or side agreements in areas like labor and the environment. And in the face of this opposition, President Trump might once again raise the possibility of withdrawing from the existing NAFTA in order to pressure Congress into approving the new deal. So Congress might end up facing a take-it-or-leave-it situation, which leaves some uncertainty. Beyond that, a more constrained legislative agenda under a divided Congress might very well push the president to take more action in areas like trade where he has more executive authority. If he moves forward with additional trade restrictions that face bipartisan opposition, such as auto tariffs, Congress could attempt to restrict the administration’s trade authority. But given the president’s veto power, this is unlikely to result in any real change. So, while we don’t expect big changes to the trajectory of trade policy as a result of the midterms, none of the potential paths look particularly market-friendly.
Allison Nathan: Given these views, how might the macro markets respond to your base case or other midterm scenarios?
Alec Phillips: Overall, the impact on the macro markets is likely to be small, especially relative to other drivers. But to the extent that the base case of divided Congress suggests slightly weaker fiscal stimulus and growth, and little reason to expect friendlier trade policy, I see slight downside risk to Treasury yields and the dollar, all else equal. Since a divided Congress is the consensus view, some of this may be priced in, but probably not all of it. In contrast, Republican control of both chambers would imply slightly higher growth expectations on more fiscal stimulus and reduced regulatory risk, which could see yields and the dollar—as well as equity indices—rise.
Allison Nathan: What scenario—if any—would present the biggest shock to the macro markets?
Alec Phillips: I’m not sure any outcome would provoke a strong reaction from the macro markets, but the one with the biggest chance is probably Republicans gaining a bunch of seats in the Senate. Six Democratic seats are up for reelection in states that Trump won by a substantial margin in 2016. So far the focus has been on how many of those seats Democrats can hold, but they are all competitive races, and it is certainly possible that the Republicans increase their majority instead. That matters because a larger majority would provide Republicans extra room to pursue priorities such as further tax cuts more aggressively, which would imply even more upside to Treasury yields.
Allison Nathan: Shifting to the equity markets, what sectors should we be watching?
Alec Phillips: Healthcare is the sector most in focus when it comes to midterms largely because it’s such a priority for Democrats. Democratic voters typically rank healthcare first among their concerns and generally give Democrats better marks on healthcare than on most other issues, so Democratic candidates have seized on the issue. That said, in a divided Congress, Democrats probably won’t be able to enact any legislation, although they’ll surely try. In a Democratic-controlled Congress, things would get much more interesting because they could use the reconciliation process—the same process Republicans used last year to pass tax reform—to pass healthcare legislation without any Republican support, and send it to the president. Normally, a Republican president would veto anything a Democratic Congress sends to his desk. But in the case of an issue like reining in drug costs, which Trump has endorsed, it’s unclear what he would do.
Infrastructure is also in focus because both parties seem to support an infrastructure program. But I am skeptical that anything on infrastructure will actually happen. I liken bipartisan support for infrastructure to bipartisan support for lower deficits: the two parties may be in favor of it, but they disagree on almost everything else related to the issue. So under a divided Congress, I just don’t see sufficient common ground to make progress. If Republicans control both chambers, a small infrastructure program is possible, but a small spending boost seems more likely. On the other hand, should the Democrats control Congress, they could attempt to pass a larger program under reconciliation, but they would most likely try to pay for it by repealing some of the 2017 tax cuts, which would surely invite a presidential veto. They could figure out another way to pay for it, but I’m skeptical that Democrats would want to give Trump that legislative victory going into the 2020 presidential election. So when all is said and done, the market is likely too positive on the prospects for infrastructure legislation.
Allison Nathan: What about defense?
Alec Phillips: Defense spending will come up next year simply because the budget deal that Congress enacted in March of this year expires next September, and about half of that deal was defense spending. Typically, congressional Democrats have been less supportive of defense spending, while congressional Republicans have been less supportive of domestic spending. But the agreement they struck earlier this year had a lot more of both. So under Democratic control of the House or of both chambers, the next spending increase would likely be more heavily weighted towards domestic spending. But we’re not talking about substantial cuts to defense spending; it’s probably more a question of whether it is down slightly or up slightly.
Allison Nathan: How do you see the prospects for regulatory change?
Alec Phillips: Major changes on the regulatory front are unlikely, simply because most legislation requires 60 votes in the Senate, which would necessitate bipartisan support under any plausible midterm scenario. And in areas where bipartisan support exists—like aspects of financial regulatory reform— legislation was already enacted earlier this year. On most other aspects of financial regulation, or regulation in other sectors for that matter, there is not much agreement between the parties. So I think most regulatory change ahead will have to come from the administration. That said, I do think increased congressional scrutiny of the tech sector will continue regardless of the midterm outcome, although it could intensify under a Republican-controlled Congress and lessen slightly under a Democratic-controlled one. But either way, it is very unclear at this stage what that might entail.
Allison Nathan: What else should we be watching going into these elections?
Alec Phillips: If the Democrats do gain control of the House, I think we will see more action on some policy areas that haven’t been getting as much attention from lawmakers lately. One that might be especially important to investors, many of whom are already focused on labor costs, is raising the minimum wage.
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