Split government may push economic policy to the middle

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by Gary Schlossberg, Global Strategist

Key takeaways

  • Fiscal stimulus remains on the table. Should Georgia Republicans prevail in at least one of two January 5 runoff elections for U.S. Senate, a split-government compromise likely will reduce the size of any stimulus to about half the $2 trillion package previously being negotiated.
  • In post-election trading, prospects for Washington gridlock over potential Biden tax hikes, spending increases, and regulatory changes outweighed disappointment over prospects for aggressive fiscal stimulus, propelling stock and bond prices higher. Executive mandates would likely be the main policy instrument in any new administration — with the greatest potential for policy change in COVID-19 management, energy, financial services, and trade.

What it may mean for investors

  • Split-government economic policy ultimately should be a net plus for investors, in our view, restraining interest-rate increases, softening the threat to after-tax profits, and advancing a policy environment more supportive of world-trade growth.

Shifting gears

Investors have adjusted well to the possibility of a split government from the “blue-wave” sweep that many expected before the election. Possibility will become reality if Georgia Republicans prevail in a January 5 runoff election for the two remaining seats in the U.S. Senate. The rally in asset markets has been hitched to a “do-no-harm” economic policy under fiscal gridlock, even as hopes for aggressive stimulus have faded.

Fiscal support remains on the table, but it’s likely to be a good deal smaller than the stimulus a Democratic “sweep” scenario may have produced. The economy could determine just how soon Congress can pass a package and how big it may be.

The good news is that economic activity has a head of steam as it nears the fourth quarter’s midpoint. The bad news is that it could lessen the sense of urgency in getting a bill passed ahead of multiple threats to the growth recovery.

  • The first threat is the potential for COVID-19 spread serious enough to disrupt activity in much the same way as it has in Europe.
  • The second threat is the onset of cold weather disrupting outdoor dining and other retail businesses.
  • And the third threat is the delayed impact on economic growth of reduced government support on business bankruptcies, loan foreclosures and rent deferments.

So, what can we expect from a fiscal stimulus bill? We believe both sides are willing to compromise. In a split government, Democratic leverage for a multi-trillion-dollar program is out the window. The Democrats also have been hurt by their reduced majority in the House and, perhaps, by Speaker Pelosi’s reduced influence in getting a consensus on a compromise package. On the Republican side, Senate Majority Leader McConnell recognizes the need for early stimulus. However, we expect Republican spending hawks to dig in their heels and push for a package of no more than $500 billion, centered on health care, schools, and small-business loans.

Look for a compromise amount closer to $1 trillion, including smaller direct stimulus checks and less aid to state and local governments than Democrats have favored. With little to gain by waiting, both sides might be willing to negotiate a deal late in the lame-duck session, awaiting the next president’s signature soon after the inauguration on January 20, 2021. Getting a bill that size over the finish line might require further compromise on the part of the Democrats, a forte of former Vice President Biden. One outside possibility — a willingness by the Democratic leadership to make the Trump personal income tax cuts permanent.

A do-no-harm presidency?

Beyond fiscal stimulus, the market is counting on gridlock to prevent unwanted tax hikes, as well as equally unwanted spending increases, changes to prescription drug pricing, enhancements to the Affordable Care Act (ACA), and other legislated regulatory changes included in the Biden economic program. With infrastructure, environmental, and other regulatory bills on hold, executive mandates are likely to be the main policy tool of the incoming administration. However, even these can be instruments of change, much as they were during the final years of the Obama and Trump administrations. The sleeper issue is the president’s ability to get nominations for cabinet and regulatory posts through a Republican-controlled Senate. That could encourage nominations of moderates to speed approval, another potential plus for the market.

Where are executive mandates likely to make their mark? Start with COVID-19 management, including greater coordination at the federal level for improved testing, tracing, and treatment programs. Regulations also could foster a tilt away from fossil fuels toward renewables, perhaps more effectively than President Trump was able to counter the worsening economics against coal consumption. There also is some presidential leeway to toughen regulations governing financial services and health care.

And then there’s trade policy, with plenty of operating room for the president. Differences between Trump and Biden on foreign economic policy often have had more to do with how to achieve goals, rather than the goals themselves. Both favor reshoring multinationals’ overseas operations to the U.S. However, President Trump proposed tax breaks to incentivize the move, while former Vice President Biden has favored facilitating the move through penalties, tax increases, and a tilt in government procurement toward domestically operated businesses.

Both also favor a tough stance toward China. However, Biden would use more of a “velvet glove” approach, favoring more deliberate and predictable multilateral coordination with our trading partners to negotiate core grievances with China. That same multilateral approach lessens the chances of a confrontational approach toward Europe and other trading partners.

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Risks Considerations

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