November 7, 2018—Tuesday’s election delivered the result largely expected by us and the markets: a split Congress, with the Democrats wresting control of the House but Republicans retaining the majority in the Senate. Voter engagement was extremely high, with a record turnout for a midterm election. While it is unusual for the House to go one way in a midterm election and the Senate to go another, the results fit the historical trend for midterm elections to see the president’s party lose ground in the House. Here we attempt to answer the five most pressing questions as they relate to the election and your portfolio.
1) What does the election outcome mean for markets?
Polls and other market indicators placed a very high probability on Tuesday’s election outcome. As a result, the immediate market response early Wednesday was fairly muted. Going forward, it is quite possible that the removal of election risk allows equity markets to move higher over the next 9-12 months (this has been the historical pattern, regardless of the midterm election outcome). Specifically, gridlock makes major legislation more difficult, which reduces uncertainty for investors and companies. Economic data and the Fed will instead drive markets, and in this regard, we expect equities and interest rates to move higher over the next twelve months, with the 10-year U.S. Treasury yield around 3.25-3.5%. Importantly, October’s correction leaves U.S. equity multiples at the lowest in two years and just above the long-term average. Coupled with the solid (though slowing) economic growth we are expecting in the U.S., this bodes well for our one-year equity outlook.
2) Should we expect changes to taxes?
A divided government makes changes to taxes unlikely. The Democratic House could propose legislative changes to the individual or corporate tax code, but these would not make it through the Republican Senate and would certainly be vetoed by the president. Similarly, the Republicans’ “Tax Reform 2.0” is unlikely to gain traction in the House. There is always a chance of a “lame duck” Congress enacting legislation, which could include making the personal tax cuts permanent or indexing capital gains to inflation, but the short timeline, legislative calendar, and narrow Republican majority in the Senate make this a low probability event, in our view.
While it is our base case that the tax code will remain unchanged, we are monitoring the risk that taxes may be used as bargaining chips for other “must-pass” legislation such as the debt ceiling. In 2011 we had the opposite makeup in DC: a Democratic president, a Republican House, and a Democratic Senate. One of the strategies used by the Republicans was to hold the debt ceiling “hostage” to extract spending cuts from President Obama. Standard & Poor’s downgraded the U.S. credit rating in August 2011, the S&P 500 fell almost 20%, and President Obama agreed to almost $1 trillion in spending cuts and deficit reductions. Importantly, prominent Democratic representatives do not seem eager to use the debt ceiling as a bargaining tool, but this is one possible though unlikely avenue for raising the corporate tax rate or shifting the composition of the tax cuts.
3) What policy initiatives are most important for investors?
There are a few areas where we think Democrats could potentially come together with President Trump and the Republicans, particularly if both parties are looking to claim legislative wins ahead of the 2020 presidential election. Healthcare was noted as a key concern for voters, but significant changes to the Affordable Care Act are unlikely. Instead, we think it is possible that a bipartisan deal could be struck on drug pricing, which has been a focus of both Democrats and President Trump.This would suggest downward pressure on pharmaceuticals.
Infrastructure is another area to watch, as both parties have talked about the importance of rebuilding aging roads, bridges, and public transportation systems. However, compromise here could be challenging given stark differences in how each party would go about crafting an infrastructure bill. Democrats would be likely to look to pay for infrastructure at least in part through clawing back some of the corporate tax cuts, which would benefit infrastructure stocks and industrials but hurt after-tax profits for the broader equity market. Republicans, on the other hand, have discussed partnership with the private sector. At the end of the day, the end goal may be similar but the means to that end vary drastically, making a deal difficult.
We are also watching closely for changes in the regulatory environment related to technology companies. Data breaches and privacy issues surrounding Facebook, Google, and others increase the risk that tech is targeted by Washington. Even if actual regulations are not enacted or end up being minor, public scrutiny could sour investors further on a sector that is already vulnerable following a difficult couple of months in the equity market. Long term we remain excited about the role technology will play in corporate investment plans across sectors, and valuations seem quite reasonable for tech overall.
4) How does the election impact our expectations for U.S. trade relations?
We expect President Trump to proceed with his trade agenda, and we do not see Democrats or Republicans providing much of a check on trade. Tariffs are really not supported by either party, but there is agreement that China overall needs to reform trade practices and the way they do business more generally. (Democrats have also focused on China-related humanitarian issues.) A deal with China will not be easy, but it would be supportive for economic growth in 2019 and 2020 if President Trump is able to come to an agreement that would remove tariffs. At the same time, we recognize that the president may continue to cater to his base with a tough-on-China stance. Trade remains one of the biggest determinants for our growth outlook in 2019 and 2020.
We would also point out that the “new NAFTA” struck in September (labeled the U.S. Mexico Canada Agreement) is slated to be signed by President Trump and Mexican President Pena Nieto on November 30 and December 1, respectively. However, Congressional ratification would fall to the new Congress. It is possible that Democrats revisit the terms of the agreement to try to extract more concessions, which would delay but probably not derail the deal.
5) Is Wilmington Trust making any changes to tactical asset allocation?
We are not making any imminent changes to our asset allocation as a result of the election, though we remain nimble and stand to adjust portfolios should economic or policy-related information change our overall view. More broadly, we continue to see the global growth environment as supportive of equities. At this time, we are maintaining a neutral allocation to U.S. equities given a solid but decelerating economic outlook. We see slightly more attractive relative value in non-U.S. equities, which we believe continue to warrant a slight overweight versus our long-term strategic benchmark. We expect interest rates to gradually move higher over the next 9-12 months, therefore we are maintaining an underweight allocation to fixed income. Within our sector strategy, we continue to favor cyclical sectors such as technology and consumer discretionary, and the policy outlook does not meaningfully change our sector views. Please reach out to your advisor to discuss these or related items further.
Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly owned subsidiary of M&T Bank Corporation. Wilmington Trust Company, operating in Delaware only, Wilmington Trust, N.A., M&T Bank and certain other affiliates, provide various fiduciary and non-fiduciary services, including trustee, custodial, agency, investment management and other services. International corporate and institutional services are offered through Wilmington Trust Corporation’s international affiliates. Loans, credit cards, retail and business deposits, and other business and personal banking services and products are offered by M&T Bank, member FDIC. Wilmington Trust Investment Advisors, Inc. is an SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T Bank affiliates and clients.
These materials are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.
The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.
Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. Some investment products may be available only to certain “qualified investors”—that is, investors who meet certain income and/or investable assets thresholds. Past performance cannot guarantee future results. Investing involves risk and you may incur a profit or a loss.
Any positioning information provided does not include all positions that were taken in client accounts and may not be representative of current positioning. It should not be assumed that the positions described are or will be profitable or that positions taken in the future will be profitable or will equal the performance of those described. Positions described are illustrative and not intended as a recommendation outside of a managed account. Indices are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses, such as management fees and transaction costs that would reduce returns.
Third-party trademarks and brands are the property of their respective owners.