The 2016 United States election was a landmark event, and its impact has rippled through nearly all asset classes and the domestic and global economies. On November 6, 2018, Americans will go back to the polls for the midterm elections. Might this round of elections have similarly significant financial market and economic consequences? In this special report, we lay out the key assumptions that underpin our economic forecast and highlight how that thinking might change under different conditional midterm election outcomes.
In short, we are skeptical the 2018 midterms will match the 2016 election in terms of sweeping macroeconomic implications. The 2016 election was a watershed election, and it resulted in the first “unified government” (i.e., one party controlling the White House and both chambers of Congress) since 2009-2010 and the first Republican unified government since 2005-2006. Generally speaking, the move from divided government to unified government opens up more possible policy outcomes as one party unites to pass landmark legislation. As we look to the other side of the 2018 election, the two possible outcomes are a move from unified government to divided government or a continuation of the status quo. Regardless of which occurs, we believe these two outcomes are less likely to produce a clear inflection point in the nation’s fiscal policy, as happened in 2016.
More specifically, the tax cuts enacted at the end of last year are unlikely to be repealed or significantly expanded, in our view. In addition, unless the economy begins to decelerate markedly, we are also skeptical the stars will align for another discretionary spending increase as large as the one that Congress passed in Q1-2018. The United States-Mexico-Canada Agreement (USMCA) to replace the North American Free Trade Agreement (NAFTA) will likely see a vote in 2019, although a divided government could make this a bit more of a rocky process. Finally, other policy areas, such as health care, could also enter the spotlight in the next Congress. But, while the political battles in these areas will surely grab major headlines as the Affordable Care Act debate did in 2017, more often than not these debates are not enough for us to make material changes to our macroeconomic forecast for U.S. economic growth, interest rates, etc. That said, politics, like the economy, is often full of surprises, and we will be monitoring any developments in the month ahead that might change our view. Should that occur, we will update our forecast and readers accordingly.
The Landscape: Where Do Things Stand?
Before we dive into possible policy outcomes, what would it take for Democrats to take back one or both chambers of Congress? In the House of Representatives, Democrats need to gain a net 23 seats to secure the 218 seats needed for a majority. Historically speaking, the president’s party tends to lose seats in midterm elections. In the 18 midterm elections since World War II, the president’s party has lost seats 16 times, with an average of about 25 lost seats for the president’s party. Thus, even an “average” midterm election for the party out of power (the Democrats in this case) could be enough for them to flip control of the House.
At first blush, the math in the Senate also seems favorable for Democrats. Republicans hold a slim 51-49 seat advantage, so Democrats would need to gain a net two seats to gain control of the Senate (in the event of a 50-50 tie, the vice president breaks the tie). Unlike the House, however, only one-third of Senators are up for election every two years, and this particular class of 35 Senators contains 26 Democrats to just nine Republicans. Of those 26 Democrats, several of the Democratic Senators up for reelection are campaigning in states won decisively by President Trump, such as West Virginia, Indiana, Missouri, North Dakota and Montana. Thus, while it is certainly possible Democrats could gain control of the Senate, it is an uphill battle. Furthermore, even if Democrats somehow swept the floor and won every Senate seat, they still would fall short of a “supermajority” (traditionally deemed 60 votes to overcome a filibuster).
As we approach the climax of the campaign season, the U.S. economy continues to expand at a healthy clip despite perceived uncertainty about the political outcome post November 6. While difficult to measure, some of the leading measures of economic policy uncertainty or partisan conflict have shown few signs of breaking out (Figures 1 and 2).1 Given this backdrop, in the sections below we highlight some of the key areas we will be watching post-midterms and lay out what assumptions underlie our macroeconomic forecast at this time.
Tax Policy: Could the Tax Cuts and Jobs Act Be Repealed or Expanded?
The tax reform bill passed at the end of 2017 (denoted here as the Tax Cuts and Jobs Act, or TCJA) was arguably the most significant policy change to occur since the 2016 election as it relates to our macroeconomic outlook. Perhaps the two questions we hear most often on this front are 1) might a Democrat-controlled Congress repeal the tax cuts or 2) might Republicans maintaining control of Congress lead to even more sweeping tax cuts?
At this time, neither of these two scenarios are our base case, and as such as we have no major tax policy changes baked into our forecast for the foreseeable future. While Democrats in Congress may wish to repeal some or all of the TCJA, it seems unlikely the president would sign a bill to repeal one of the landmark achievements of his presidency were Congress to pass a bill along these lines. Even in the most successful of election outcomes, Democrats would need bipartisan support for the two-thirds majority necessary in the House and Senate to override a president’s veto.
What about the possibility of more tax cuts from a Republican-dominated Congress? This is possible, although any “Tax Reform 2.0” is likely to be limited in scope, as we laid out in a report written in August.2 In short, when Republican policymakers outlined their main goals of a second tax bill, the key plank appeared to be an effort to make permanent the individual tax cuts that are currently set to expire in 2025. Unless Republicans are able to secure a 60 seat majority in the Senate, however, this would require bipartisan support or some way to offset the cost of making the tax cuts permanent. This is because the reconciliation process, which was used to pass the TCJA with less than 60 votes, is likely not an option for making the individual tax cuts permanent (had it been an option, they probably would never have been temporary in the first place). Thus, from our point of view, the likelihood of a significant fiscal contraction or expansion from a change in tax policy next year is relatively small, absent a major change in economic conditions.
Federal Spending: Tighter Times Ahead?
The spending side of the ledger is a more obvious catalyst for change on the other side of the midterm elections. At present, the United States is operating under a two-year budget deal that expires on September 30, 2019. This most recent budget deal increased discretionary spending well above the caps imposed by the Budget Control Act of 2011 (BCA) and was nearly quadruple the increase passed for the FY 2014/FY 2015 period (Figure 3). Under current law, however, inflationadjusted discretionary spending would likely fall in FY 2020 as the BCA caps snap back into place. Were this to occur, the spending side of the ledger would likely swing from a net positive to a netnegative for the direct impulse to economic growth.
In our forecast, we have essentially split the difference between the fiscal expansion of the past few years and the looming fiscal contraction that would occur under current law (Figure 4). Inflationadjusted federal consumption and investment growth converges toward zero in 2020, leading federal spending to have a more neutral direct impulse to growth. With the 2020 election starting to loom by fall 2019, it seems unlikely policymakers on either side of the aisle will want a material fiscal contraction. That said, with budget deficit pressures having mounted significantly, there will also likely be some counter pressure to limit (to some extent) any additional spending growth. Put more plainly, our base case is for policymakers to once again increase discretionary spending above the BCA caps, but more in-line with what was seen from FY 2014-2015.
That said, we see more uncertainty in this forecast than on the tax front. President Trump has appeared sympathetic to policy stimulus of all kinds, and our current forecast is for U.S. economic growth to start slowing in the second half of 2019 into 2020. Were that to occur, it is possible fiscal policymakers might see another large boost to spending as just what the doctor ordered. Alternatively, it is easy to imagine a scenario where a Democratically-controlled Congress and the president engage in a prolonged budget standoff next year that results in a sharper deceleration in federal government spending than we currently envision.
When turning to history as a guide, the trend in federal consumption and investment shows no obvious trend when the federal government is under divided or unified party control, regardless of which party holds the reins (Figure 5). Thus, we see the balance of risks here as roughly balanced, though regardless of the outcome the impact will not likely be felt until 2020.
The Budget Deficit: Will the Pace of Growth Continue?
Against this backdrop, our forecast for the federal budget deficit in FY 2019, which just began on October 1, is $1.05 trillion. If realized, this would mark a significant widening from the FY 2018 budget deficit of $779 billion, as the tax cuts and increased spending will be in effect for the full fiscal year. After FY 2019, however, we expect the deficit to continue widening, but at a much slower pace than seen over the FY 2018-2019 period. An aging population and rising health care costs/interest rates will be structural pressures, but the one-time level shift in the deficit as a result of the tax cuts/2018 budget deal will have largely faded. Skyrocketing net interest spending is one reason we are skeptical of a major infrastructure bill passing the next Congress if the economy remains in fairly healthy shape (Figure 6). In a sense, the time to “borrow and build” has passed as interest rates have continued to normalize.
Might the next Congress, regardless of its composition, surprise us with more fiscal stimulus than we have baked into our forecast? It is certainly possible, particularly if the economy were to sharply decelerate. But when viewed through an international lens, fiscal policy in the United States is already remarkably expansionary. Despite economic growth that is among the fastest in the developed world at present, the United States is currently running the largest budget deficit across all levels of government relative to its major developed economy peers (Figure 7).
What about other Policy Areas?
One final policy area we will be keeping an eye on post-midterms is the debate over the USMCA, the deal negotiated to update and replace portions of NAFTA. Though the president will likely sign the agreement before year’s end, a vote in the House and Senate is unlikely until 2019. Divided government, should it come to pass, could make this a bit more of rocky process. One aspect of the trade agreement process that should help regardless of the election outcome is that, unlike many other forms of legislation, the process by which trade agreements are voted on in Congress makes it much harder for a determined group of Senators to use procedural measures to indefinitely delay a vote in the upper chamber.3 Thus, while the road ahead may prove to be rocky at times, our forecast assumes that the NAFTA renegotiation of the past couple years ends with the eventual adaptation of the USMCA.
Other policy areas, such as health care, could also enter the spotlight in the next Congress. But, while the political battles in these areas will surely grab major headlines as the Affordable Care Act debate did in 2017, more often than not these debates are not enough for us to make material changes to our macroeconomic forecast for key variables such as U.S. economic growth, interest rates, etc. We will be monitoring them closely and will update our readers should any developments in these other policy areas change our thinking about the economic outlook.
In this report, we have laid out the key assumptions that underpin our economic forecast and done our best to highlight how that thinking might change under different conditional midterm election outcomes. Broadly speaking, however, we are skeptical that the 2018 midterms will have macroeconomic consequences of the same magnitude as the 2016 election. That said, politics, like the economy, is often full of surprises, and we will be monitoring any developments in the month ahead that might change our view. Should anything occur on the policy front that changes our thinking, we will update our forecast and readers accordingly.
1 For those interested in reading more about these indices, please see http://www.policyuncertainty.com/media/EPU_BBD_Mar2016.pdf https://www.philadelphiafed.org/research-and-data/real-time-center/partisan-conflict-index
2 Bryson, J.H., Kinnaman, A. & Pugliese, M. (August 2018). “Tax Reform 2.0: The Sequel.” Wells Fargo Securities Economics Group. Also available upon request.
3 For further reading on the procedural timeline for USMCA’s future in Congress, see Fergusson, F. I, & Davis, M.C. (September 2018). “Trade Promotion Authority (TPA): Frequently Asked Questions.” Congressional Research Service.