Year in Review: The pollsters got the midterms right

For once, the pollsters got it right: in this year's US congressional elections, the Republicans kept the Senate, and the Democrats took the House. The upshot of this is political gridlock. Lawmakers won’t be able to enact major policy changes or undo market measures already in place.

The corporate tax cuts introduced by President Donald Trump in 2017 were viewed as supporting economic growth and company profits. In the lead up to the elections, many investors were concerned that a big swing to the left (a Democratic win) could lead to a reversal of these cuts. As it turns out, equity markets have taken comfort from the Republican Senate majority, which means a policy reversal is unlikely.

The second round of tax cuts proposed by Trump is viewed less favourably by the market. That’s largely because it includes tax cuts for individuals. The concern is that individuals who have to pay less tax may spend a lot more on goods and services, and this spike in demand could push up prices. That’s often not a bad thing, especially in an economy that is weak, but in an economy that is already growing strongly, as the US is, this procyclical policy could push up prices too fast for the liking of policymakers who have a mandate to keep prices growing at a more stable and predictable pace.

Prices that fluctuate too fast can threaten the stability of the economy because they make it harder for people and businesses to predict future prices, and without knowing what prices will be in the future, it’s very hard to make financial decisions, whether that be saving to buy a new car or in the case of a company, investing in a new factory to produce goods. A sudden spike in prices could prompt the country’s central bank, the US Federal Reserve, to raise official interests in order to rein in consumer spending and curb price rises. As a side effect, this would also hurt a lot of companies by making it costlier for them to borrow the capital they need to invest in their businesses – bad news for stocks.

Thanks to the Democrats taking the House, the second round of tax cuts are virtually dead in the water now, and the markets are breathing a sigh of relief. The pause on tax cuts is also good news for the government’s ever-ballooning budget deficit, which is a constantly recurring concern for investors. More tax cuts, if not offset by spending cuts, would have pushed the government’s deficit higher as they spend more than they tax. Increased government deficits need to be financed through government debt, and high levels of government debt pose long term risks to financial stability. High levels of debt serve to further increase deficits as interest must be paid on the debt, creating a viscous cycle.

Besides tax cuts, the other notable policy change proposal in the pipeline was a package of infrastructure spending, which would be positive for industrial stocks. An infrastructure bill appears to have support from both the Democrats and the Republicans, so it could still happen, but the problem is how to fund it. At any rate, the US$1 trillion bill that was promised in Trump’s election campaign is now highly unlikely, meaning less pressure on the deficit.

One potential downside of the split Congress is that the Democrats are likely to be emboldened and to use their House majority to investigate Trump, thus increasing political uncertainty.

The imminent finale of Special Counsel Robert Mueller’s investigation will coincide with the Democrats formally taking the House of Representatives in January. Democratic House committee chairs will now have subpoena power, which means they can require a person to appear in court as a witness or require the production of documents. This is a power they are highly likely to exercise.  It potentially gives them access to tax returns, campaign finance payments, business dealings, information regarding the firing of former FBI Director James Comey, possible collusion with Russia and anything else that could be used to tarnish Trump’s image. 

The legal risks are rising for Trump and these issues heighten political risk and unpredictability during the second half of his term in office. This political risk could be an ugly distraction for equity markets to contend with throughout 2019.

For US equities in particular, the political disruptions add to the headwinds facing corporate earnings coming off a cyclical peak as the effects of the tax cuts fizzle out. Expectations for earnings growth next year are significantly weaker than in 2018 (9% in 2019 vs 20% in 2018). Corporate profit margins have peaked this year and the outlook for 2019 looks patchy, factoring in political instability, slowing economic growth, higher interest expenses, and cost inflation. These factors, combined with a decline in dollar liquidity and tighter financial conditions, mean market conditions in 2019 will remain volatile and challenging.