What a Pivotal Midterm Election Could Mean for Investors
At Barron’s, we try to look beyond any momentary chaos in the markets to anticipate what might move them in the future. So, too, with our coverage of Washington. There was plenty of chaos at Thursday’s Supreme Court nomination hearing, and we don’t expect the turmoil to end before the Nov. 6 midterm elections, or after. Our concern is with the longer-term impact of these historic races—specifically, what the outcomes will mean for the capital markets and investors. The stakes are particularly high in this election season, given America’s tariff battle with China, a growing federal budget deficit, and an aging bull market, not to mention the partisan slugfest consuming the country.
In that spirit, we present our first-ever policy-themed roundtable, featuring four panelists who specialize in the intersection of Washington and Wall Street. The group, which met recently in New York, includes Libby Cantrill, head of public policy at Pimco; Dan Clifton, head of policy research at Strategas Research Partners; Abby Joseph Cohen, an advisory director at Goldman Sachsand a member of the Barron’s Roundtable; and Ben Phillips, chief investment officer of EventShares, sponsor of EventShares US Policy Alpha ETF(ticker: PLCY), an actively managed exchange-traded fund focused on long-term policy catalysts.
Like many prognosticators, our roundtable members expect Democrats to win back control of the House of Representatives, and Republicans to keep their grip on the Senate. Divided government need not spell paralysis, however; it can lead to potentially fruitful horse trading that allows both parties to claim victory and the citizenry to win. In particular, the midterms could be a boon for infrastructure and health-care spending and stocks, they contend.
A lot can change in a month in the Capitol and the markets, and political polls can be spectacularly wrong. In the meantime, here’s what our experts have to say.
Barron’s: Will the midterms cause a tremor or an earthquake in Washington, or leave the landscape unchanged?
Dan Clifton: The betting markets are giving a 70% probability to the Democrats winning control of the House. They are giving 73% odds to Republicans keeping control of the Senate. In this year’s election, Senate Democrats are defending 26 seats and need to win just two additional seats to assume control. But the terrain is tough: 10 Democratic senators are running for re-election in states that President Donald Trump won in 2016. We expect the probability of Republicans keeping the Senate to decrease to 60% or 55%, but the highest-probability outcome is still a split government.
The second-highest odds are on a Democratic sweep, or Democrats winning control of both chambers of Congress. The third-most-likely scenario is that Republicans retain leadership of both chambers, but that’s a significant stretch.
Does anyone want to challenge Dan’s assessment?
Libby Cantrill: We also expect the House to flip Democratic. But the big question is the magnitude of the win. It will determine whether Nancy Pelosi [D., Calif.] becomes House Speaker again, which might influence the outlook for a presidential impeachment. If the Democrats take both houses, the markets will be caught off guard.
How might investors react?
Cantrill: An infrastructure bill would be more likely to gain traction if Democrats control both chambers of Congress. But the market would perceive a higher chance of impeachment and potential conviction of the president.
Abby Joseph Cohen: The “I” word most Democrats are talking about is investigation. One of the great frustrations among Democrats in Congress has been the lack of a thorough vetting of several issues, such as foreign interference in our elections, the president’s use of emoluments, and improper activities by some Cabinet officials. If the House switches to Democratic leadership, they will get subpoena power, and we can expect a more thorough airing of some of these concerns.
Clifton: There is a greater probability of impeachment than the [Democratic] leadership is letting on. Some people don’t want to talk about impeachment for fear it will mobilize Republican voters. I am more concerned, from an investor’s perspective, with the fate of the tax cuts that went into effect this year. If Democrats control the House, there could be a lot of pressure to repeal some of the corporate tax cuts, in return for raising the debt ceiling. If they win 50 or 60 more seats in the House, they can effectively tell Republicans, “Your tax cuts aren’t working.”
Let’s say the corporate tax rate is raised to 25% from 21%. Companies and analysts will start marking down their estimates for corporate earnings. Some infrastructure spending will probably be included in any negotiation. But a tax increase is immediate; infrastructure spending takes time to ramp up. We’d be big buyers of infrastructure stocks if the Democrats win.
A final point: The S&P 500 hasn’t declined in the 12 months following a midterm election since 1946. Historically, midterm elections haven’t been macro events; they have been sector events.
Ben Phillips: A blue wave is probably the worst-case scenario for the markets. What has been driving the markets higher in the past two years? Tax reform, deregulation, increased defense spending. With Democrats leading both chambers, investors would question the likelihood of further deregulatory efforts and executive moves that have been market drivers.
Cohen: Using a different time horizon leads to different conclusions. Current fiscal policy is a poor policy for intermediate and long-term economic growth. Structural deficits will increase, and there is no benefit in terms of government investment in future growth. The Obama administration’s tax-reform package, which had some bipartisan support, included significant corporate tax cuts. But there was a quid pro quo: There would be an emphasis on long-term research and development, job training, and so on.
The short-term implications of the tax cuts are obvious. Shares of the S&P 500 companies with the highest tax rates are up 16% this year. Companies with the lowest rates and, therefore, those that didn’t benefit much from tax cuts, are up only 5%, versus the index’s gain of 10%. But there has been a significant increase in the budget deficit. What is the deficit being used for? The administration’s infrastructure program resulted in an 80-page report, but no specific proposals or meaningful discussion in Congress. Most of the increase in corporate free cash flow has gone into share repurchases, not capital spending.
Given the increase in the deficit, what are the implications for interest rates? How might the government deal with a recession if it is already running large deficits? The U.S. might end up, again, relying dramatically on monetary policy, putting pressure on the Federal Reserve. The long-term implications of rising deficits are daunting.
Cantrill: At a recent forum, we talked about how, in some ways, the tax cuts have given us a sugar high. We estimate that the tax and spending bills passed earlier this year will add 0.6% to real growth in gross domestic product in 2018, and 0.4% to real GDP growth in 2019. The impact will fade quickly thereafter, especially if Congress doesn’t address the return of sequestration [automatic budget cuts] in 2020, although it probably will. Fiscal policy is giving a short-term boost to real GDP, not necessarily a longer-term lift.
Also, I have to push back against Dan’s argument that the Democrats might tie tax-cut repeal to a debt-ceiling increase. The Republicans tried to delay or defund the Affordable Care Act during the budget negotiations in 2013, but realized that wouldn’t work. Presidents are reluctant to overturn their signature legislation, as President Obama was with Obamacare, and President Trump likely will be with tax cuts. The Democrats will be smarter in emphasizing an infrastructure bill. They care about repealing the tax cuts, but they care about infrastructure much more.
Clifton: Threatening not to lift the debt ceiling might give the Democrats leverage, but that gets back to whether Pelosi becomes Speaker again. Pelosi has been through this before; she doesn’t want to play with the full faith and credit of the U.S. If she is removed by the more left-leaning wing of her party, this will be someone else’s decision. That is a low-probability, high-risk scenario.
To Ben’s point, the market reads the tax cuts positively. The economy was growing by 2% a year before the tax cuts. Now real GDP growth will probably average between 3% and 3.5%. We wouldn’t expect to see massive capital investment in the first six months after passage. But we look to be in the early stages of a capex [capital spending] and productivity rebound. Also, using fiscal policy is allowing monetary policy to normalize.
Let’s get back to the midterms. A split Congress usually means legislative gridlock. Is that a reasonable assumption if the Democrats win the House?
Cohen: Yes. There are limitations to the policy changes that can be made with Republicans leading the Senate and the president in the White House. Moreover, many changes implemented in the past couple of years were the result of executive actions. Trade policy, typically the purview of Congress, has been shaped mostly by executive action. The same can be said for regulations affecting consumer protection and the environment. A leadership change in one house of Congress won’t affect these policies much.
Betting markets aren’t infallible. It is still possible that Republicans keep both chambers. If so, what are the policy implications?
Cantrill: Reconciliation, a procedural tool allowing expedited passage of legislation with a simple majority vote, would come back into vogue in the Senate. There is likely to be a big push to pass Tax Reform 2.0, which would make some individual tax cuts permanent, or at least longer-lasting. But it isn’t a slam-dunk, given that the U.S. is running large deficits.
Phillips: A red wave, or the status quo, is the Goldilocks scenario for investors. It is more of the same. Under this scenario, we would prefer to own what is currently working. Nontraditional lenders such as CURO Group Holdings[CURO], OneMain Holdings[OMF], and FirstCash[FCFS], which own and operate pawn shops, could do well under a status-quo outcome. These finance companies serve a segment of the population that doesn’t have access to capital. Likewise, there has been a bipartisan focus on nuclear defense and building out our naval fleet. BWX Technologies [BWXT] has a 75% market share in supplying nuclear-reactor components used by the Navy is another policy pick.
We also own Adtalem Global Education [ATGE], one of the better companies in the for-profit-education space.
Clifton: Health care has been missing from investors’ discussion ever since Republicans failed to repeal and replace Obamacare. If there is a red sweep, Republicans could use the reconciliation window to modify Obamacare. They lost by one vote in 2017, cast by the late Sen. John McCain, to shrink the ACA. They might tackle health care before Tax Reform 2.0 because the budget numbers are going to be significantly better in next year’s tax season.
Cohen: We are talking about a temporary improvement over a short period, not a change in direction. The deficit is forecast to hit 5% of GDP and higher in coming years.
Clifton: The stock-market rallies that follow midterm elections usually occur because the president begins to focus on his own re-election. Presidents get much more aggressive on pro-growth policies. President Obama said he wouldn’t extend the Bush tax cuts up until Election Day in 2010. Within a month, they not only were extended, but we got a payroll tax cut and the estate-tax exemption was lifted, helping him win re-election in 2012.
How will the bond market react to your midterms assumptions, and the policies that result?
Cantrill: For various reasons, including trade policy, nominal interest rates are likely to be range-bound, at least in the short term. Longer term, as Abby asserted, fiscal policy might have less room to run in the next downturn. That suggests the next recession likely would be deeper and last longer than might otherwise have been the case. As a result, there will probably be an upward bound on interest rates.
Phillips: Rate-sensitive sectors such as utilities, consumer staples, and real estate could perform relatively better if Democrats win more seats in Congress, which could mean lower interest rates. Perhaps the market is saying that if Republicans win, the economy will be stronger and rates will be higher. Also, if we pay for an infrastructure plan with tax increases, that’s bearish short term for overall growth.
Cohen: Policy makers are concerned that they have unreliable measures of GDP and productivity. There are even concerns about the way inflation is measured. I interpret from Federal Reserve comments that the risks of waiting too long to normalize interest rates are higher than the risks of the opposite. There is a good chance the Fed will continue to move up the short rates it can control. If monetary policy becomes the only game in town, the Fed better make sure it doesn’t drop the ball.
Our fixed-income team believes 10-year government notes in most developed economies are overpriced—that is, yields are too low. There is a desire to provide economic stimulus in countries still facing slow growth and financial-system disequilibria. The global environment keeps our yields lower than they otherwise would be; for now, international investors are comfortable owning U.S. dollar-denominated securities. Some 37% of the U.S. Treasury market is owned by non-Americans, as is 29% of the U.S. corporate bond market.
But what if something changes, reducing international demand for Treasuries? I don’t expect that to happen soon, and it is unlikely that 10-year yields go much above 3.5%. It is important to talk about this, however, because budget deficits are getting larger. The Treasury’s borrowing portfolio is pretty short-duration. As it begins to turn over at higher yields, rising interest expenses could have a deleterious impact on budget estimates.
How will foreign markets react if Democrats win control of one or both chambers of Congress?
Clifton: That is related to how they are thinking about trade. The Chinese are probably holding off on serious discussions with Trump until after the midterms because they think he’s going to be weakened by the outcome. The market, by the way, has begun to price in a resolution of trade tensions; the dollar peaked in value against other currencies in mid-August. Small-cap stocks have been rolling over since then, as well. Emerging markets would rally on a trade deal. I am watching emerging market stocks, relative to the S&P SmallCap 600 index. Their relationship will tell you if the trade environment is getting better or worse. If Republicans keep control of Congress, Trump will be emboldened on the trade front. On trade, this election matters.
Cantrill: I would argue that the trade risk is divorced from the midterm elections. First, people have underestimated the sincerity of President Trump’s feelings on trade. They date back to 1980s. He has been critical of China’s ascension to the World Trade Organization. He has been consistent on this issue, and has staff around him in the White House who support his view.
Most important, as Abby noted, he has a lot of executive authority around trade. Wisely or unwisely, Congress ceded significant authority to the executive branch through the 1962 Trade Expansion Act and the Trade Act of 1974. Also, being tough on trade polls well. Some Democrats are sympathetic with the president on trade. The trade conflict with China is going to get worse before it gets better. The U.S. has just finalized a second tranche of tariffs on imported Chinese goods. There could be a third tranche. Our demands of China get to the heart of their industrial policy, Made in China 2025 [China’s plan to upgrade companies to dominate high-tech industries.]
Nafta risk could also increase after the elections. If Democrats take back the House, they will make other demands to approve Nafta 2.0. That might scare off Republicans, and the risk of withdrawal from Nafta 1.0 could escalate. This has implications for the peso and emerging markets. That’s a long way of saying trade-policy risk continues to dominate.
What is the likelihood of a multilateral agreement, including Canada, as opposed to a bilateral deal with Mexico?
Cantrill: The idea that Congress is going to approve a bilateral deal with Mexico is misplaced. Members of Congress wouldn’t see that as a political victory. It would be hard to sell to their constituents.
Phillips: Disruptions in global trade are the biggest risk to the markets, regardless of the election. If there is a breakdown in trade negotiations or a disruption in trade, especially between the U.S. and China, look for lower asset prices, slower growth, and higher inflation.
Cohen: Consider S&P 500 earnings; they will grow about 19%-20% this year. Roughly seven percentage points are due to the lower corporate tax rate. Earnings-per-share growth is further boosted by share repurchases. We estimate 7% profit growth next year. If the U.S. imposes the tranche of tariffs now being threatened by the White House, and China reacts in the ways it has been discussing, that could eliminate next year’s profit gains.
Regulating the biggest technology companies also could rattle the markets. What is the post-midterms outlook for tech?
Phillips: Regulation of big tech is coming, regardless of the election outcome. It is a question of timing. The most policy-sensitive companies are Amazon.com [AMZN], Alphabet[GOOGL], Facebook[FB] and Twitter[TWTR].
Clifton: Google [owned by Alphabet] faces the most immediate risk, followed by Facebook, then Amazon. The risk to Google is antitrust investigations. The risk to Amazon is higher shipping costs and more scrutiny over cloud contracts. Some well-known investors shorted for-profit education companies going into President Obama’s election. The trade went against them for two years as more people went back to school during the financial crisis. It wasn’t until the end of Obama’s second year in office that regulators moved against the industry. The regulation of tech seems to be following a similar time frame. Strategas is overweight tech, but there are better risk-reward scenarios in non-Facebook, -Google, and -Amazon stocks.
Phillips: Antitrust regulation might not become an issue until 2020. It is a complicated area of law.
Clifton: Once IBM[IBM] and Microsoft[MSFT] came under antitrust investigation years ago, their resources were diverted. Facebook’s resources have already been diverted by investigations into fake accounts, data-privacy issues, and such.
How are you playing potential passage of an infrastructure bill?
Clifton: Even if the Democrats win the House alone, there is enough support for this in the Senate. Our infrastructure plays include Aecom[ACM], Jacobs Engineering Group[JEC], Granite Construction[GVA], Vulcan Materials[VMC], Martin Marietta Materials [MLM], United Rentals[URI], and Nucor[NUE]. I see a two- or three-year infrastructure bill that costs about $10 billion a year. It doesn’t affect the macro economy much, but it moves the stocks in a meaningful way.
Phillips: If the House flips blue, we’d look to start buying some infrastructure names. We have looked at Fluor[FLR], KBR[KBR], Granite, Martin Marietta, and Vulcan.
Cantrill: I still think that the Democrats’ price tag will be so high that it spooks some Senate Republicans concerned about profligate spending.
Let’s get your closing thoughts on the market and your favorite investment opportunity. Dan?
Clifton: We’re more bullish on U.S. economic growth than stocks, but stocks can go a little higher, putting the S&P 500 in the 3000-3050 range. The best opportunities are in companies that will prosper under any political scenario. We like small-cap defense names such as Huntington Ingalls Industries[HII] and FLIR Systems[FLIR], and makers of life-sciences tools.
Cantrill: We’re a bond shop. We are neutral to underweight duration. We are underweight credit, which is priced for perfection. We’re investing opportunistically in emerging market debt, and we like mortgages.
Phillips: The midterms outlook doesn’t matter for trucking and logistics stocks. Things are tight across the supply chain, due to regulations and a tight labor market. We have been buying shares of Daseke[DSKE], a flatbed and specialized trucker that is less sensitive to the global supply chain. It has a market cap of about $550 million and has been buying similar companies. Shares trade for around seven times enterprise value to Ebitda [earnings before interest, taxes, depreciation, and amortization] versus peer multiples of 10, 11, 12 times EV/Ebitda. We expect the gap to narrow as Daseke earns a higher multiple. The stock could double in the next 12 months.
Cohen: While we love to talk about Washington, earnings and cash-flow growth matter most to stocks. The S&P 500, based on corporate performance, interest rates, and so on, is now at fair value. As such, there is little cushion for disappointment. At the start of 2018, the Goldman Sachs year-end fair value estimate for the S&P 500 was 2850; the 2850-2900 level is what the fundamentals still support. Our 2019 forecast range is 2900 to 3000.
This year, the U.S. has outperformed other equity and credit markets. The dollar has done well. Will there be less emphasis in 2019 on momentum, and a reversion to value? The S&P 500 is up 10% this year in dollar terms. Emerging markets are down 10% to 20%, or more. A lot of money has come out of Asia, in particular, because of concerns about trade policy and slowing growth in China. If these trade worries abate, we might see a rebalancing that favors emerging markets.
Thank you, Abby, and everyone.