Policy, Politics & Portfolios

Transcription

1 Policy, Politics & Portfolios ALL ABOUT THE MIDTERMS October 30, 2018 Craig Holke Investment Strategy Analyst Midterm elections The midterm elections feature many close races that will determine the balance of power in Congress. In recent weeks, the Democratic lead has been reduced. Enthusiasm is much higher than in prior midterms, and enhanced turnout is expected to be the deciding factor in key races. We believe that the most likely outcome remains a divided government, with the Democrats taking the House, while Republicans maintain the Senate Wells Fargo Investment Institute. All rights reserved. Page 1 of 11

2 Midterm elections How do races stand? Races that may decide control: House 30 toss-ups Democrat: 1 Republican: 29 Senate 6 toss-ups Democrat: 4 Republican: 2 Source: RealClearPolitics, Wells Fargo Investment Institute Election night should be full of excitement, with some very tight races determining eventual control of Congress. The high degree of partisanship is making successive campaigns and elections ever more important to each base. Television networks currently are ramping up their coverage to levels normally reserved for presidential elections. Early voting, whether by mail or in person, is at much higher levels than has been seen in previous midterm elections. The advantage reflected in the Generic Congressional Vote has narrowed in recent polls, which project close to a 50/50 chance of Democrats gaining enough seats to claim the House of Representatives. There remain approximately 30 toss-up seats, of which 1 is currently held by a Democrat and 29 by Republicans. 1 Combine this with the currently projected 205 Democratic seats compared to the 200 projected Republican seats in the House and you get a very tight race. While the House appears close, we maintain our view that the numbers and history of the president s party losing midterm seats in the House are just too much for Republicans to overcome. Thus, we continue to believe that the House will flip to the Democrats. The Senate appears to be going in a different direction. While at first, it appeared that Republicans may even have difficulty maintaining their razor-slim majority, it now appears that Republicans may even pick up a handful of additional seats. The path to the Senate continues to look more difficult for Democrats (D), as several races (North Dakota, Tennessee, and Texas) have shifted toward the Republicans (R). There remain six races generally viewed as toss-ups: Arizona (R), Florida (D), Indiana (D), Missouri (D), Montana (D), and Nevada (R). If these races continue with the current trends, Republicans may even pick up a couple of these seats. Yet, even if Republicans lost all six toss-ups, they would still hold 50 seats in the Senate. With Vice President Pence as the tiebreaker, that would still allow Republicans to maintain control of the Senate. 1 Forecasts are courtesy of RealClearPolitics as of October 22, Wells Fargo Investment Institute. All rights reserved. Page 2 of 11

3 What is each party looking to accomplish if it governs? Tax revenue projections for 2018: Individual taxes: Payroll taxes: Corporate taxes: Other: $1.6 trillion $1.2 trillion $243 billion $278 billion It s time to take a look at the proposed agenda of each party. Without having a defined platform, as in a presidential election, we will base this on statements by members of party leadership. While there is no guarantee that any of these policies will be implemented following the election, we believe that a brief summary of contrasting positions will help to highlight the differences. Below, we highlight differences on some key issues affecting voters, the economy, and markets. Taxes Source: Congressional Budget Office Republicans successfully passed tax reform through the budget reconciliation process, after not being able to gain Democratic support. Following the midterms, Democrats have stated the desire to (at least) partially reverse portions of the tax cuts. Some Democratic leaders have stated a desire to repeal at least portions of the recent tax cuts. Likely changes to tax policy include a tax increase on top earners, potential increases in corporate rates, and a reinstatement of the Alternative Minimum Tax (AMT). Some have stated a desire to expand tax credits to transfer the recovered revenue to lower-income households. Depending on how much of the tax reform would be reversed, there may be a negative effect on individual and business sentiment. This could translate into lower spending and investment, resulting in slower economic growth. The Consumer Discretionary and Industrials sectors likely would be negatively affected by less spending and investment. Pleased with the passage of tax reform, Republicans had floated the idea of Tax Reform 2.0. This includes making the tax cuts for individuals and pass-through businesses permanent, in addition to other small changes that would benefit investment and retirement accounts. Deficits increased as a result of tax reform. These increased deficit forecasts recently have been reduced by the Congressional Budget Office as a result of higher economic growth. Yet, any further tax cuts (or making the individual cuts permanent) likely would result in even higher deficits. Making existing tax cuts permanent likely would have little impact on equity sectors. Fixed-income markets may underperform as rising deficits and debt levels drive interest rates higher. Wells Fargo and its affiliates are not legal or tax advisors Wells Fargo Investment Institute. All rights reserved. Page 3 of 11

4 Spending Total federal debt as a percent of gross domestic product (GDP): 2001: 55% 2009: 81% 2017: 103% Democrats have stated a desire to increase spending on social services, while Republicans are more favorable to spending increases for defense and homeland security. Neither party mentions cutting spending or even reducing the rate at which spending increases. Even after tax cuts, the federal government received a record-setting $2 trillion in fiscal 2018 tax revenue. Spending increased $127 billion over the same period. This drove the annual deficit to $779 billion, up 17% in one year. 2 What we do know is that budget deficits are likely to continue increasing under either party. Below are some of the potentially favored spending priorities for each party. Source: Federal Reserve Bank of St. Louis Many high-ranking members support free college tuition. When first presented by Senator Sanders during the 2016 presidential campaign, free college tuition was estimated to cost around $800 billion over a decade. 3 Republicans increased defense spending in the latest budget, and it now totals $717 billion per year. Defense hawks in the party often are eager to spend more. Democrats also have been campaigning on a $1 trillion infrastructure plan. President Trump desired an infrastructure plan, but it was derailed by fiscally conservative members of his own party. Democrats may find an ally for infrastructure spending in President Trump. President Trump has just asked cabinet members to reduce their agency s budgets by 5%. The administration attempted a similar reduction in the 2018 budget, but the efforts were rejected by members of both parties in Congress. Funds for additional spending may come from the repeal of tax cuts, cuts in defense spending, and more debt. This could result in less discretionary income, higher debt servicing costs, and slower economic growth. The Consumer Discretionary and Industrials sectors likely would be negatively affected by less spending and investment. If Democrats worked with President Trump to pass an infrastructure package, we would anticipate that the Industrials and Materials sectors would benefit. Additional borrowing for either education or infrastructure at these levels likely would focus attention on rising deficits, negatively affecting fixed-income markets. Republicans are not likely to raise taxes to pay for additional spending. Without cutting spending in other areas, Republicans are likely to rely on debt financing to pay for any increases. Increased defense spending would be positive for aerospace and defense companies in the Industrials sector. Rising budget deficits and levels of debt likely would be negative for fixed-income markets. Yet, cuts in government spending may see fixedincome markets responding in a positive manner. 3 2 CNBC, U.S. budget deficit expands to $779 billion in fiscal 2018 as spending surges, Jacob Pramuk, October15, How the liberal wish list could bite Democrats, Timothy Noah, Politico, October 14, Wells Fargo Investment Institute. All rights reserved. Page 4 of 11

5 Regulations Federal regulatory cost in: 2017: $1.9 trillion Pages in Federal Register: 2016: 95, : 61,308 Source: Competitive Enterprise Institute The regulatory environment has changed significantly since President Trump took office. A number of regulations have been eliminated within the executive branch, requiring no involvement from Congress. Congress also has acted, including bipartisan work that was completed on reforms to the 2010 Dodd-Frank Act. In general, Republicans favor less regulation on businesses and individuals. Democrats generally find government regulations protective in nature and of great benefit. There is momentum within the Democratic party and the public for a national $15 minimum wage. If the Democrats win control of the House, they are likely to pass such an increase. If the Democrats take the House, they likely will increase scrutiny of the administration s attempt to reduce regulations. Republican efforts have been focused on removing regulations (deregulation) in an effort to stimulate the economy and removing burdensome government controls. Wages are the largest expense for a variety of businesses. Even a gradual minimum-wage increase to $15 may have a negative effect on equity markets. The effect on economic growth is unclear. Studies have shown either an increase in growth from more disposable income or a reduction in growth from workers losing jobs (stemming from the increase in wages). Continued easing of the regulatory burden on businesses would support the currently high levels of business sentiment. Rising wages equate to higher costs. These tend to be negative for profit margins and equity markets as a whole. A reversal in sentiment may reduce business leaders willingness to invest having a negative effect on the Industrials and Materials sectors. If Republicans maintain control of both chambers of Congress, deregulation may continue. This likely would benefit the Financials and Health Care sectors the most Wells Fargo Investment Institute. All rights reserved. Page 5 of 11

6 Health Care Cost of federal health care programs for 2018: Medicare: $583 billion Medicaid: $383 billion Insurance subsidies: $54 billion Children s program: $16 billion Source: Congressional Budget Office Health care affects everyone and is typically a top issue for voters. Republicans unsuccessfully attempted to repeal the Affordable Care Act last year. Even the suggestion of needing to make changes to Medicare and Medicaid has led to Senate Majority Leader McConnell being heckled in public. This is one of the stronger issues that Democrats campaign on, and Democrats are using it successfully in this election cycle. Many Democrats have stated a desire for some form of a single-payer, government-run health care system for all Americans. Democrats also have stated a desire to reduce prescription drug plan costs through increased competition and price controls. Republicans have focused on removing government mandates on private health markets. President Trump also authorized changes to Medicare that would focus on increasing competition among prescription drug companies. The hope has been that this will lower prices. Cost estimates for a single-payer health care system have come in between $2.4 and $2.8 trillion per year. 4 Democrats have proposed paying for it with a combination of tax increases and cost savings associated with having the government as the single payer. Health care companies may see profits reduced. Lower health care costs are positive for both individual and government finances. Pharmaceutical companies may see reduced profit margins as the price for branded drugs is reduced. The implementation of a single-payer system would be negative for the Health Care sector. Government-mandated pricing structures likely would adversely affect profits and advancements in products and services. With the cost absorbing essentially all of the current federal tax revenue, borrowing likely would increase. We would anticipate that the levels of additional borrowing required would be viewed very negatively by fixed-income market participants. Increased competition may place downward pressure on profits in the Health Care sector. This may offset the benefits to the sector from Republican deregulation. 4 4 How expensive would a single-payer system be?, Louis Jacobson, Politifact, July 21, Wells Fargo Investment Institute. All rights reserved. Page 6 of 11

7 Immigration Immigrants as percent of U.S. population: 1890: 14.8% 1970: 4.7% 2018: 13.5% States with largest share of immigrants: California: 24% Texas: 11% New York: 10% Immigration is typically a hot topic and generally one of the more divisive ones. Democratic members of Congress tend to be more supportive of increased immigration and a path to citizenship for those already here. Republicans counter that the border must be secured before any discussion may be had about a path to citizenship. The thousands of individuals who have been marching through Central America and Mexico on their way to the southern border of the U.S. may be moving this issue up the list for certain voters. The more progressive members of the party have called for the elimination of Immigration and Customs Enforcement (ICE). They also desire a pathway to citizenship for those already here. President Trump has yet to fulfill his campaign promise for a wall on the southern border. Source: Pew Research Center Illegal immigrants would be brought into the economy, paying more in taxes and having the ability to vote. If Republicans maintain control of Congress, President Trump may see some progress on building the wall. Yet, members of his own party have been hesitant to foot the bill. Independent cost estimates have centered between $15 and $25 billion. 5 Citizenship for illegal aliens living in the U.S. may lead to higher wages and more discretionary income for those not currently working in the taxable economy. The Consumer Staples sector may benefit from the addition of these workers to the economy. Tax revenue would be expected to increase, benefiting government revenue and decreasing deficits. This would be viewed positively by fixed-income market participants. Construction would likely benefit the Industrials and Materials sectors. Without increased revenues from a new source, the cost of the wall would likely result in additional borrowing. Although this cost is less than that of other significant policy plans, fixed-income markets may respond negatively to rising deficits. 5 5 Here s What We Know about Trump s Mexico Wall, Bloomberg, December 11, Wells Fargo Investment Institute. All rights reserved. Page 7 of 11

8 Trade U.S. manufacturing jobs lost since China joined World Trade Organization in 2001: 3.8 million Percent of manufacturing jobs lost over that time: 24% Source: U.S. Bureau of Labor Statistics President Trump raised concerns with his attempts to redefine U.S. trade relations. What started as a dispute with China soon evolved into threats against rivals and allies alike. The successful negotiation of the U.S-Mexico- Canada Agreement (USMCA) has alleviated concerns. With China likely being a longer-term issue, members of Congress will need to decide what actions to take in support of (or against) the president s agenda. Yet, the president has wide-ranging authority on trade, and there might be limited actions either party can take. Democrats have historically taken a more protective stance on trade, seeking to safeguard union supporters. This has prevented them from opposing the president s actions as much as they may have liked to do so (with regard to trade policy). Republicans had threatened legislation to limit the president s authority. While the Republican party historically has been the party of free trade, Republicans have not been eager to draw the ire (or Twitter wrath) of President Trump or his supporters. If the Democrats assume control in Congress, they likely would increase scrutiny on the president and his agenda. Impact on trade would be limited, due to the president having significant discretion in trade negotiations. Markets generally have had a muted reaction to the constant barrage of trade concerns. The successful negotiation of the USMCA has quieted some of these concerns and granted the administration the leeway to pursue further negotiations. Regardless of which party wins, we believe that the market impact will be independent of the elections outcome. The effect of tariffs is now being felt across much of the economy. While equity markets generally have shrugged off the tariff effects (up to this point in time), we recently have seen increased volatility and greater concern contributing to declining equity prices. Outside of the effect on agricultural markets, the sectors with the greatest exposure to China remain Information Technology and Industrials Wells Fargo Investment Institute. All rights reserved. Page 8 of 11

9 We still believe that divided government is the most likely midterm-election outcome, with the Republicans holding the Senate and Democrats taking the House. In this scenario, neither party would be expected to achieve most of its goals. Significant legislative action likely would be minimal until the next presidential election in Democrats may attempt to advance their spending plans while slowing the president s agenda with committee hearings and subpoenas. The Republicans remain satisfied with having passed tax reform and likely will focus on further cabinet and judicial appointments. Markets may find continuation of the Republican agenda, with potentially less federal regulation and spending, a more appealing outcome. Either way, we believe that the headwind from uncertainty hanging over markets should be removed once the midterms have passed. We caution investors to wait and see the direction in which policy looks to head before making rash portfolio moves. Without further economy-wide changes such as tax reform, markets should have time to focus on fundamentals. As the current cycle continues to mature, we believe that greater attention will be needed to identify investment opportunities. U.S. economic growth has been solid and, in our opinion, should remain so into next year. This economic growth should continue to support further market gains. As a result, we remain favorable on U.S. large-cap and mid-cap equities. We also remain favorable on U.S. short-term taxable fixed income as the Federal Reserve continues to raise rates. Continually rising deficits eventually will place upward pressure on rates. This leads us to be most unfavorable on U.S. long-term taxable bonds. In our view, longer-term security yields are just not high enough to compensate for the additional interest-rate risk to which these bonds are subject. We have an unfavorable outlook on the taxable high-yield debt market. Yields are too low, given the downside risk these bonds may face from changes in credit-risk appetite. Even as debt levels rise, we expect municipal bonds to be supported by a decline in issuance from tax-code changes and by ongoing, healthy demand. As such, we remain favorable on municipal bonds Wells Fargo Investment Institute. All rights reserved. Page 9 of 11

10 What to watch on election night We continue to believe that turnout will be a key factor in how the midterm elections play out. Democrats may have had an early lead on increasing turnout; their voters appear eager to send a message to President Trump by eliminating Republican control of Congress. Republicans seemed somewhat complacent after the successful passage of tax reform. This may have changed during the confirmation process for Supreme Court Justice Brett Kavanaugh. Which group is able to maintain the enthusiasm or momentum through the election likely will have an outsized impact on specific races. It also will be interesting to see if polling has been more accurate for individual races than it was in There always is a chance for surprises on election night. Barring any upsets, several races will be key to determining which party controls the House and Senate. In the House, early reporting of suburban districts in areas such as New York and Virginia may foreshadow how the night will end. If Democrats are successful in these current Republican districts, it may be the initial signal that the night will not go well for Republicans. In the Senate, with North Dakota looking as though it may turn red and Tennessee likely being held by Republicans, the Arizona and Nevada races are expected to be key tests for whether Democrats are able to pick up Republican seats. While we maintain our base case of a divided government following the election, each chamber always could end in a major surprise upset in either direction. And that s why we stay up and watch Wells Fargo Investment Institute. All rights reserved. Page 10 of 11

11 RISK CONSIDERATIONS Each asset class has its own risk and return characteristics which should be evaluated carefully before making any investment decision. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is taxfree, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT). General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 11 of 11