Economic and financial implications of the 2018 midterm election
INSIGHT ARTICLE |
Gridlock—that’s the primary economic and financial implication of the Democrats’ takeover of the U.S. House of Representatives and the Republicans’ retention of power in the Senate. While financial markets tend to favor gridlock, the lack of major policy changes and a White House that continues to press on a deregulation agenda likely portend fierce policy battles that will revolve around the fiscal path of the federal government, trade, environmental policy and health care.
Through the end of September, the economy was on course to grow nearly 3 percent this year, with the impact of the 2017 Tax Cuts and Jobs Act and 2018 fiscal budget agreement responsible for roughly 0.7 percent of the lift to GDP. Despite this growth, we expect momentum from both the tax cut and the budget agreement falling off beginning in September 2019 due to temporary items incorporated into each. We expect U.S. growth to slow to 2.4 percent in 2019 and to revert to its long-term trend of 1.8 percent growth in 2020, a trend that would prove counterproductive for all heading into the 2020 election. Given the significant political polarization in Washington, D.C., and the anticipated acrimony between the new majority in the House and the president, it is difficult to see how the 116th Congress and the Trump administration can engage in initiatives that result in anything but a continuing resolution based on current law. This gridlock will carry real economic implications going forward.
While it is certain that the House will pass, mostly for political window dressing, a budget that reverses the 2017 tax reform and a budget that will curtail defense spending, those moves have little chance of becoming law due to the president’s veto pen and Republican control of the Senate.
Major areas of friction in early 2019
Budget caps set to expire in 2019, the expiration of temporary provisions in the 2017 TCJA, and the noticeable decline in overall government spending set to begin late in 2019 are expected to be the major areas of contention between the House, the Senate and the White House.
Lifting the federal government’s debt ceiling is likely to be first, coming in March 2019. At this point, almost no constituency for fiscal probity exists in either party, a problem in past years marked by divided government. It is important to note that financial markets demand certainty over the issuing of government debt. During an extended 2011 government impasse, the Standard & Poor’s 500 declined 20 percent, largely due to the risks around government default. Given the president’s comments as a candidate regarding debt and debt renegotiation, a lack of discipline on this issue will likely roil markets and cause a significant increase in financial market volatility.
Second, under current law, the discretionary budget for national defense is scheduled to decline by 11 percent to $576 billion in fiscal year 2020 from fiscal year 2019, while non-defense spending deteriorates by 9.2 percent to $542 billion. Current law dictates $126 billion in scheduled spending between fiscal years 2019 and 2020. To put this in context, during the third quarter of 2018, U.S. GDP increased by $159.9 billion, or 3.5 percent, driven significantly by government spending. The expected $126 billion scheduled decline in spending carries the risk of causing a much more pronounced economic slowdown than our forecast of 2.4 percent growth in 2019 and 1.8 percent growth in 2020.
To date, the Republican-controlled Congress has not scheduled a vote to pass the NAFTA update known as the United States-Canada-Mexico Agreement, likely putting it up for review under the new Congress. While the administration did reach out to organized labor during the negotiation process, the Democrats are expected to put their imprint on the trade treaty, with an eye toward protecting domestic workers. Neither party is certain how the president will respond.
A bipartisan consensus in Washington, D.C. contends that the alleged theft of U.S. intellectual property by China must be curtailed. Given the Democrats’ move away from free trade over the past two years, it is difficult to foresee a large pushback on trade in the House. In fact, we would not be surprised to see an increase in tariff mitigation, currently at $12.7 billion, directed at farmers, ranchers and others in agribusiness. If the White House moves to lift import taxes on Chinese goods to 25 percent from 10 percent on New Year’s Day 2019—and then imposes a 25 percent tax on a total $517 billion of Chinese imports by midyear—it is hard to conceive there will not be other rounds of corporate welfare for the entire retail complex. Middle market business should prepare for the worst when it comes to exposure to supply chains and import taxes linked to China in 2019.
Investigations that would carry the most financial weight would be those directed at the financial sector in general, and large banks in particular. We expect investors to begin to price in these concerns, which will likely act as a drag on financial stocks.
Areas of possible cooperation
Areas of possible cooperation between the parties are quite limited and largely revolve around non-market solutions in health care and prison reform. Possible, but less likely, is a bi-partisan deal on infrastructure.
Both Democrats and Republicans, including the White House, are interested in prison and sentencing reform. The economy could get some relief from a new pool of workers if reform allows individuals with non-violent felonies to be brought out of the shadows and into the workforce. Given that there is currently only .87 worker for every job opening, this could provide a modest lift to the economy in the second half of 2019, if reforms occur early in the year.
The White House and the new majority in the House have remarkably similar outlooks on the use of government power in the setting drug prices. The major opposition on this substantive topic is the Republican control in the Senate, where the majority will likely not agree on reducing drug prices via government mandate. Any cooperation here would not auger well for large pharmaceutical companies.
Perhaps the most interesting outcome from the 2018 election will come at the state level where Medicaid expansion is a major issue. According to the Kaiser Family Foundation, more than 3.8 million uninsured adults could gain Medicaid coverage if the eligibility expansion under the Affordable Care Act were adopted in the 17 states that have refused it. Every Democratic candidate for governor running in this year’s midterm election supports expansion, and four states had ballot referendums calling for Medicaid expansion.
Infrastructure improvement, the area with the highest potential for an economic payoff, likely has the lowest probability of action. Once thought to be a major White House priority, infrastructure has faded from view. Supporters in both major parties quickly lost patience with the changing views out of the White House during the first year of the administration. But even a modest agreement that results in action could boost the fortunes of construction and transportation companies.
However, with the April departure of the administration’s point man on infrastructure, no one inside the White House is currently dedicating time and resources toward a major infrastructure bill.