Working at cross-purposes. (Photo by eelnosiva/iStock.)
Disclaimer: As always, our political commentary is intended to be nonpartisan. We favor no party nor any politician, and neither do markets. We assess developments solely for their potential market impact.
In the dog days of summer, the last thing anyone wants is more hot air, but that’s exactly what politicians are giving us. Thankfully, it has a silver lining, and yes we know we’re mixing metaphors: All the squabbling and posturing amounts to gridlock, which lowers legislative risk and makes stocks happy—even as people mostly hate it. The less gets done, the less markets have to worry about sweeping change creating winners and losers.
After last year’s elections gave Republicans the White House and Congress, many expected an avalanche of new legislation and policies. Investors’ opinions were fairly polarized. Some cheered the prospect of tax cuts, infrastructure spending and changes to the Affordable Care Act and Dodd-Frank, while others feared the same, anticipating ballooning deficits and regulatory chaos. Yet six months into the new administration, very little has happened. The Trump administration hasn’t done anywhere near as much as folks hoped or feared. While some are disappointed (and some cheered), for markets, we think it’s an underappreciated positive—and not because any of the GOP’s proposals were inherently bad. Rather, all major change, regardless of the party drafting it, risks creating winners and losers, which raises legislative risk for markets when things happen inside the Beltway. Stocks don’t enjoy it when property rights change, and regulations and taxes are key ways of changing them. Investors now have a good sense of President Trump’s relative political muscle, and gridlock is blocking radical change. For stocks, this should bring relief.
Two of the administration’s flagship pledges—health care and tax reform—are withering on the vine. After numerous incarnations, the latest Affordable Care Act replacement bill has all but died, rejected by Senate Republicans. A House attempt to repeal and replace similarly failed in March. Leadership revived it in May and passed it, but by June the new bill wasn’t gaining much traction in the Senate and was deemed “too harsh” by the president. So the Senate launched its own effort, which has also fallen short—despite Senate Majority Leader Mitch McConnell’s best shot, with four GOP Senators signaling opposition. It takes only three breaking ranks to kill a bill. McConnell said they would try simply repealing Obamacare with a two-year delay—time to draft a suitable replacement—but a similar House approach earlier this year already failed. And an early tally suggests Senate Republicans lack the votes needed to pass it.
An Obamacare replacement may still eventually pass but, if so, likely in much reduced form. Bipartisan support for a compromise bill is also possible—though a low likelihood—and they probably wouldn’t agree on anything radical. Some see this as negative, believing the ACA is poison and has to go. Others see it as positive, fearing the disruption that could accompany repeal if it leads to a big increase in uninsured patients and upheaval for insurers. This is obviously a matter of debate, but the thing is, stocks price in all these opinions, and they’ve decided to rally. Health Care has outperformed bigly this year. Why is always harder to know than what, but we suspect it’s because the uncertainty associated with potential change is fading. For better or worse, markets know what they’re dealing with. Love or loathe the ACA, stocks have done fine since it passed in March 2010.
With ACA reform flailing at best, people’s attentions are turning to tax reform. Presumably, it’s a more popular policy with widespread appeal among the Republican base, which should make passage easier. Perhaps! However, we see a few confounding monkey wrenches. Although folks love a good tax cut, lawmakers often insist on making them “revenue neutral,” lest anyone accuse them of “Voodoo Economics” if they try to argue growth will eventually pay for them. Hence, “tax cuts” become a matter of closing loopholes and axing deductions to offset rate cuts, which is no easy task. After all, politicians’ primary goal is to get re-elected, and a good way to lose someone’s vote is to take away their favorite handout.
Some lawmakers want to pay for corporate tax cuts with a border-adjustment tax. But big importers—such as major retailers—who might suddenly face high tax bills are opposed. Their home-state Senators aren’t on board. There are also proposals to offset rate cuts by closing loopholes like corporate interest tax deductions. Armies of tax lawyers (and political donors) aren’t terribly amused. A tax amnesty on repatriated corporate earnings sounds nice at first blush, potentially bringing mountains of money back here to fuel investment. But there has been talk that this would come at the expense of deferred taxation of future foreign profits—they’d be taxed immediately upon recognition, whether home or abroad. Not exactly win-win.
There are similar tradeoffs on the individual tax side. The Trump administration proposed cutting the number of tax brackets and cutting rates to some unspecified levels, but they’d also do away with most deductions (mortgage interest and retirement contributions would still get favorable treatment). On the chopping block: Deduction of state income taxes from federal returns. Good luck getting lawmakers from high-tax states to vote for that.
Investors might be disappointed with a lack of tax reform, but it has always been a myth that tax cuts are über-bullish. Returns following tax cuts vary—US fiscal policy is just one driver. Plus, the proposals as outlined would create winners and losers. Prospect theory tells us reordering winners and losers can be a headwind. Because losers feel more than twice as much pain as winners enjoy their gains, net negativity can weigh on markets as consequences unfold. If tax reform happened and made investors really happy, and they eventually had to face a reality that wasn’t so good as they thought, it could set up some disappointment for markets.
Gridlock eases this risk, and investors now have a pretty good sense of it—even more than they did when Trump took office. One argument back then was that despite the Republicans’ divisions and slim edge, Art of the Deal author Trump could strike bargains galore. Six months later it’s clear this hasn’t happened and his political capital has fallen, giving lawmakers less incentive to fall in line. The less businesses and investors have to fear property rights changing, the more willing they usually are to take risk—and risk-taking is what ultimately powers investment, economies and markets.