SUMMARY
This note explores potential differences for policies affecting investor sentiment based on a unified Republican 118th Congress, with a few noted nuances in the increasingly unlikely event Democrats hold the Senate. Macroeconomic policy decisions, the timing of those decisions and implementation effects, will understandably dictate Washington’s risk profile for the coming four-to-six quarters at a minimum. But regulatory and judicial policy outcomes potentially portend crisper sector and company impacts.
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OUTLOOK
As we have noted it is historically consistent for a first-term president to lose House and Senate seats in the midterms (on average 29.3 and 2.53, respectively, since Truman). But an energized Republican-controlled Congress and an approval ratings-challenged Democratic president present plenty of policy risks to market participants. Unlike the last time we had a similar confrontation in 2011, this time there is an unprecedented confluence of macroeconomic, geopolitical, social, and worsening climate challenges.
Macroeconomic Policy Risk
Macroeconomic policy risk is grounded by three related ‘knowns’: (1) inflation continues to damage household budgets; (2) fighting that inflation will create even more dire burdens on households reliant on wage/salary income; and (3) economic contraction slight or significant will pressure fiscal policymakers to respond or explain why relief beyond automatic stabilizers is not needed. This context, framed within divided government will:
- Test the willingness and ability of the Fed and Treasury to respond in cooperation with Congress, should economic and financial stress lead to Treasury and broader market liquidity concerns
- Encourage the extremes of both parties to seek maximum leverage before negotiations begin accommodating a debt ceiling adjustment (unless resolved by a difficult maneuver during the lame-duck Congress). Dollar confidence suffers in this scenario.
- Make tax policy changes difficult to achieve, both because of debt/deficit concerns and the difficulty of overriding a presidential veto (which requires a two-thirds majority in both houses of Congress).
- Render FY23 funding less certain in the lame duck as ascendant Republicans press their leaders to pass short-term continuing resolutions to increase leverage in fiscal talks with Biden in 2023. A lack of new appropriations threatens infrastructure funding, which is a big part of Biden’s 2021/22 accomplishments.
Geopolitical Risks
Geopolitical risks will intensify in a divided government as foreign state and non-state competitors test common purposes of the US government and popular opinion on key issues. This will be exacerbated by the perceptions and realities of a possible lame duck president. We highlight three challenges in this context:
- Support for Ukraine will be less certain, implying a stabilization of recent defense spending upticks, possibly limited to replenishment of the US arsenal with concentrated risks to that task.
- Biden’s Russia and Saudi Arabia agenda grows more complicated, and an opposition Congress likely pushes the president to sharpen his already tough positions against China, Iran and possibly North Korea.
- If these international frictions materialize, foreign direct investment into the US could chill as global allocators focus on the 2024 presidential as the next best signal of FDIUS policy environment.
Sector-specific Risks
Sector risks will come to the fore in a combination of increasing and decreasing pressures. We highlight five sectors to watch under divided government:
- Banking: Regulatory risk comes mainly from regulators and won’t change much, except funding for the Consumer Financial Protection Bureau which is at risk after the recent Fifth Circuit finding that its Fed funding is unconstitutional (a boost to WFC).
- Digital Assets: Legislation and regulation take a back seat to pending lawsuits. Any legislative initiative falls to veto risks.
- Energy: Conventional energy, particularly midstream and utilities, probably get a boost as the pace of energy transition slows and favors older sources of power generation. Senator Manchin’s permitting bill likely will be enacted by Democrats this year or Republicans in 2023. Upstream benefits won’t easily come to fruition as the Administration controls those opportunities. Refiners (downstream) are unlikely to see policy benefits until delivery systems of sweeter, lighter crude can reach the gulf. They have enjoyed a good run of late purely on market fundamentals.
- Big Tech: Likely benefits from lower risks of platform or content regulatory changes, but competition policy risk remains a threat from the Administration.
- Healthcare: It is a mixed bag as pharma names might benefit from Republican attempts to slow or block CMS prescription drug price negotiations, but the nascent effort to boost bioeconomy expenditures still needs to be funded by FY23 appropriations.
As the biennial scrum of US elections captures investors’ attention, policy uncertainties flowing from nearly three years of successive, largely unresolved global shocks naturally take a backseat, at least for now. Moreover, the outcome of the 2022 midterms is not necessarily dependent upon those shocks or uncertainties. Under a Republican-controlled 118th Congress and a Democratic president, we expect divided government will likely contribute to a growing risk-off sentiment rather than quell it.
