By Mickey D. Levy
The Democrats gained control of the House of Representatives and Republicans maintained control of the Senate in the 2018 U.S. midterm elections, as predicted by political analysts. At the time of writing this note, election results show Democrats with 220 seats in the House and Republicans with 198, with 17 seats undeclared. Republicans are projected to maintain a majority in the Senate.
We expect the highly partisan and polarized next session of Congress with split powers between the two political parties to lead to significant political rancor and theatrics but little meaningful legislation. We expect even more Congressional dysfunction - if that is possible - to lead to more convolutions in the already dysfunctional budget process and more threats of government shutdowns.
Nevertheless, President Trump is erratic but practical in certain ways and may approve of select Democratic initiatives. Senate Republicans will not agree to any Democratic legislation without Trump's approval and the Trump Administration would almost certainly be able to veto any legislation it opposes. However, even without legislation, changes may be implemented through changes in administrative laws and Executive Orders. This may include such populist issues like pharmaceutical costs. So even despite projected Congressional gridlock and Washington dysfunctionality, there may be changes that affect select industries.
Trump's stance on trade will be unchanged and unaffected by the split Congress, and the Trump Administration will continue its deregulatory agenda.
Our expectations for the economy (2.8% real GDP growth in 2019 and 2.4% in 2020, both above consensus) and for Fed policy (that the Fed funds rate increases in December and in 2019) remain the same.
Financial markets are expected to take comfort with the split power in Congress: it will be perceived as a check on President Trump. The decent election results for Republicans in the Senate should lessen perceptions of a shift to the hard-left in the 2020 elections and ease concerns about a roll-back of pro-business policies.
The Republican Congress may try to pass legislation during the lame duck session (through January 3, 2019). However, given the tight legislative calendar and other priorities through year-end, such as funding Federal government departments beyond December 7, this may be difficult. Ratifying the United States-Mexico-Canada Agreement (USMCA) likely will be a top priority. Even if the USMCA is not ratified by this lame duck session, we expect that it will be ratified by Congress by 2019, insofar as many Democrats approve of the thrust of Trump's trade initiatives that are aimed at protecting U.S. jobs.
Also, Congress may pursue legislation that makes permanent the individual income tax cuts enacted by the Tax Cuts and Jobs Act of 2018; the House has already passed such legislation. If Congress during the lame duck session does not consider making the tax cuts for middle-class household permanent, it is uncertain whether a Democratically-controlled House Ways and Means Committee would consider such legislation, which puts Democrats in the awkward position of denying a further tax cut for the middle class, even though everybody knows about the budget constraints and projections of persistently rising deficits and debt under current law.
We do not expect Trump's promise of a 10% tax cut for the middle class to be fulfilled. Democrats would insist that any middle-class tax cuts be accompanied by an increase in taxes for high-income earners and Senate Republicans would disagree. The new House Financial Services Committee is expected to push back on the recent easing of regulations on big banks, which will generate tension between Congress and the Administration and the Federal Reserve.
Democrats will gain control of the committees in the House and set the House's legislative agenda, hearings, and calendar. While any legislation enacted in the House is unlikely to become law - the Senate would block the legislation - these initiatives and issues will frame the debate for the 2020 Presidential election. House Democrats may initiate Presidential impeachment proceedings, but are less likely to do so than if they had also won the Senate majority. If the House proceeds with impeachment hearings, they would be long and drawn out. Financial market responses to such hearings would likely depend on the trajectory of economic conditions and Federal Reserve policy. Note that during the impeachment hearings of President Clinton, the stock market appreciated amid strong economic performance, while the stock market fell during President Nixon's impeachment hearings amid economic recession and soaring inflation generated by the first major negative oil price shock in 1973.
Actual impeachment of President Trump requires a simple majority vote in the House and a supermajority of two-thirds vote in the Senate. This is very unlikely. We expect Democratic-led investigations, subpoenas, and political drama to drive news headlines, but economic fundamentals should be unaffected.
U.S. government budget policy will continue to be constrained by high and rising deficits, regardless of the composition of Congress. The Congressional Budget Office (CBO) projects that deficits as a percent of GDP will rise under current law and average 5% over the next decade and that Federal government publicly-held debt held will balloon to 96% of GDP in 2028 from under 80% currently. Despite these worrisome projections, which are driven nearly exclusively by rising spending for entitlement programs, Congress is unlikely to take any steps to bring the deficit under control. Congress may actually be more likely to make short-run decisions for political expediency.
Both sides of the political aisle agree that U.S. infrastructure is in dire need of an upgrade, but two critical issues likely will combine to preclude enactment of any sizable infrastructure spending legislation. The first is severe budget constraints. Second, the political parties have very different approaches about how a new infrastructure program would be financed and administered. Democrats favor a centrally-administered and financed program (Presidential candidate Clinton proposed creating a new Washington bureaucracy) while Republicans favor cost-sharing by state and local governments as well as businesses and locally-chosen and administered programs. These issues are expected to erect legislative roadblocks, although the Trump Administration could force House Democrats and Senate Republicans to work on some compromise. The likelihood of successful enactment of any meaningful and comprehensive infrastructure legislation seems low.
Trump's approach to trade policies will remain unchanged, particularly his brass-knuckles negotiating tactics with China. Although the House Ways and Means and Senate Finance Committees have jurisdiction over trade, the Trump Administration's use of Section 232 of the Trade Expansion Act of 1962 to impose tariffs based on national security threats bypasses Congress. Moreover, many Democrats are aligned with Trump's protectionist policies because of their close ties with trade unions, and most Republicans and Democrats support the Administration's objectives of opening access to China's markets and reducing its unfair investment practices.
Democrats will look to restore some of the provisions of the Affordable Care Act that Republicans and the Trump Administration have changed or removed, but such attempts are likely to fail in the Republican Senate. Trump and Democrats have both expressed interest in limiting increases in pharmaceutical drug prices, and legalizing the importation of select pharmaceuticals from Canada to generate competition and reduce the costs of pharmaceuticals. The House Health Committee could hold hearings on pharmaceutical drug prices.
The Democratic-Chaired House Financial Services Committee may hold hearings to break up the big banks. Such legislation would not make it through the Republican-controlled Senate. It will be interesting to see how President Trump responds to this issue. If he tilts toward siding with Democrats against big banks, it may add to his conflict with the Fed.
Markets should be comfortable with a split Congress that allows for additional Congressional checks on Trump and a continuation of fiscal policy and ongoing deregulation that has lifted economic growth over the last couple of years. But eventually, the market reaction will be influenced by perceptions of the 2020 presidential elections. A lot can change in two years, but the midterm election results do not necessarily increase the perception of a shift to the hard-left in the 2020 elections and a roll-back of the Trump Administration's pro-business policies. As a result, a jarring of confidence in stock markets and drop in business investment and hiring seem unlikely.
Historically, stock markets have appreciated in the year following midterms. This is true of midterms in which the President's party lost one or both chambers of Congress. In 2010, when the Democrats lost control of the House and maintained the Senate majority, equity markets rallied for eight months, then fell because of the euro debt crisis and the S&P U.S. credit rating downgrade. The broad-trade weighted value of the dollar was unchanged after 12 months and the 10-year U.S. Treasury yield was lower. Past performance does not guarantee future responses, but sound fundamentals, not politics, are likely to continue to drive economic performance.
The next two years will be very interesting.