A post-election recipe: Gridlock with a dash of stimulus
Equity markets' usual year-end Santa Claus rally might get an additional boost
As widely expected, Democrats captured control of the House of Representatives in the midterm elections on 06/11/18, emerging with a majority in the 116th Congress that opens on 3 January 2019.
Still, the “Blue Wave” of Democratic voter enthusiasm crashed against a breakwater of challenging electoral math in the Senate: Democrats had to defend 10 seats in states that then-candidate Trump won in the 2016 presidential election, while only one Republican incumbent was up for re-election in a state that Hilary Clinton won.
In addition, Republicans have been no less enthused about the midterms than Democrats, and turnout for both parties is reported to have been high. As a result, Republicans actually picked up seats in the Senate, increasing their majority there.
A divided Congress has traditionally lead to a fair degree of gridlock – neither party can move forward on their legislative priorities unless there is some commonality of purpose with the other. In addition, it is reasonable to expect that Democrats would not want to pursue bipartisan legislative efforts that President Trump could portray as significant accomplishments during a re-election campaign. Democrats might also decide to use their majority power over new legislation mainly to “advertise” their agenda ahead of the next Presidential election, that is, pass bills that are likely to be popular with their base and independents even if those bills have no prospect of passing through the Senate and avoiding a Presidential veto.
Finally, the legislative work of Congress could grind to a halt if Democrats in the House decide to focus their energy on oversight investigations of administration policies and personnel, including possibly building a case for an eventual impeachment.
All of these arguments contribute to the market consensus that there will be little in the way of successful legislative efforts over the next two years. Still, one advantage of divided Congress is that it can make passage of controversial legislation more likely, since neither party can be blamed exclusively if the legislation proves unpopular with certain constituents.
One controversial area where a compromise could emerge is comprehensive immigration reform (recall that the last serious attempt at immigration reform occurred with a divided Congress). Still, compromise will not be easy – the core of the Republican base may reject any path to citizenship for undocumented immigrants, while Democrats will likely oppose any meaningful funding for a wall on the southern border – a possible precondition for avoiding a presidential veto.
There are also areas where both parties may share common goals. For example, both parties will want to at least maintain spending levels on discretionary programs that align with their policy priorities. As such, the two parties are likely to extend the budget deal reached earlier this year into fiscal years 2020 and 2021.
Infrastructure is another area where agreement is possible, though reaching a compromise will be challenging. Republicans have voiced some tentative support for President Trump’s call for infrastructure spending, though the administration has not clarified specific priorities that could guide legislative efforts. For their part, the current Democratic leadership has already proposed a significant infrastructure spending program, hoping to present voters in 2020 with a tangible accomplishment that demonstrates their capacity to lead. But the hurdles to an agreement are significant.
Republicans will balk at the USD 1 trillion price tag on the Democrats’ proposal. Some Democrats have also proposed a carbon tax to fund the infrastructure program, an idea that will not resonate with Republicans. Finally, the administration, as well as many Congressional Republicans, favour infrastructure projects that leverage private sector funding.
Our expectations for trade policy are independent of the election’s outcome as trade is largely in control of the president. Nonetheless, if President Trump becomes frustrated with a divided Congress, he could turn to trade policy as one area where he can move forward, perhaps increasing the odds of escalation. He could even find a Democratic House more receptive to protectionist measures, as it is the Republicans who were traditionally pro-free trade and the Democrats who supported measures to defend domestic industry.
Given that the election results were largely as expected, the immediate reaction of the markets should be muted. Over the medium term, however, the path may well be different than it would have been had the Republicans retained control. Historically, the combination of a Republican president and a split Congress has resulted in the lowest average real annualised returns since 1952, -4.3% (see exhibit 1). By contrast, a Republican president and a Republican-controlled Congress have delivered average returns of 12.9%, the third best of the possible permutations.
Exhibit 1: S&P 500 returns under different governmental configurations
(configuration is for presidency and congress. Please note: D = Democrat, R = Republican, S = Split).
Source: FactSet, BNP Paribas Asset Management, data as at 5/11/2018 showing real annualised returns since 1952 for two calendar years following election
All gridlock is not equal, however. Of the four scenarios shown in the table that can be classified as gridlock — that is, control split between the parties (presidency + congress = D+R, D+S, R+D or R+S) — the two with a Democrat as president delivered above average returns, while the two with a Republican leader were below average.
We nonetheless do not put much weight on these figures as forecasts because there are simply too few occurrences for them to have much meaning. The Republican president plus a split Congress combination has occurred just five times since the 1950s and the range of returns has been wide: -20.5% from 2006-2008 (coinciding with the Global Financial Crisis) and -19.2% from 2000-2002 (the Internet bust), with 17.9% returns in the mid-1980s. Neither the negative nor the positive returns were obviously the result of legislation that was never passed because of a gridlocked Congress. They were instead the result of much broader, macro forces.
Similarly, the outlook for US equities today will depend far more on the path of interest rates set by the US Federal Reserve than it will on government discretionary spending or infrastructure initiatives.
Many market analysts have nonetheless noted that US equities typically rally following a mid-term election. While this is true, it ignores the fact that there is almost always a “Santa Claus” rally at the end of the year. The elections would only be notable if the rise were greater after mid-term elections than they were in other years. It turns out that is the case.
The “Santa Claus” rally over the last 65 years has produced a 2.7% average return from early November through the end of December. There is a discernible difference in the pattern of the returns depending on whether it was a year when a presidential election was held, a year when there was a mid-term election, or a year with no election. The average return for presidential years was just 1.9%, while in non-election years it was 2.7%.
In mid-term years, however, the market advanced 3.6% and the distribution of returns is higher than for the other periods (see exhibit 2). So investors may have an extra percentage point in gains to look forward to as we move into the holiday season.
Exhibit 2: S&P 500 returns from election through the end of the year
Source: FactSet, BNP Paribas Asset Management, data as at 5/11/2018
US Treasury bonds have also tended to rally at the end of the year, resulting in an average drop in yields about 6 bp. The range of the moves is similar between presidential and non-presidential election years, with the notable exception of 2008 when yields declined dramatically. Excluding that episode, the average change in yields in presidential years was 3 bp, compared to -12 bp in non-presidential years (see exhibit 3).
Exhibit 3: US 10-year Treasury yield change from election through the end of the year
Source: FactSet, BNP Paribas Asset Management, data as at 5/11/2018
In contrast to equities, however, a Treasury rally is less probable. There was a positive return for equities 73% of the time from the election through the end of the year, whereas government bond yields fell only 52% of the time. They were still more likely to fall if it was a mid-term election year (69%), so even here, there is a chance Treasuries could yet contribute to positive portfolio returns over the next couple of months.
In the absence of any significant legislation, equity market returns will largely be determined by earnings growth and valuations, and government bond yields by inflation and policy rates.
Despite talk of “peak profits”, expectations for earnings growth for US corporations over the next year are in line with historic averages. Valuations following the recent market sell-off are certainly lower than they were a month ago, though equities are not cheap in absolute terms . Inflation expectations remain subdued, though the Fed is likely to increase interest rates over the next year by more than the market currently forecasts.
We will soon all be refocusing our attention on these issues as we leave the ballot box behind.
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The Federal Reserve’s evolving policy strategy framework
Struggling for some time now to hit its inflation mark sustainably, the Federal Open Market Committee may move to adopt average inflation targeting, or even temporary price level targeting, in its upcoming strategy review. Such a shift should steepen the Treasury curve, lower real interest rates, and support a widening of long-forward TIPS breakevens.