By Libby Cantrill, Managing Director, Public Policy at PIMCO
With Republicans having taken the U.S. House of Representatives and Democrats retaining the Senate, it looks likely the next two years will feature legislative gridlock.
Each party is on track for a razor thin majority in each chamber of Congress. This leads to another takeaway: The “red wave” that many pundits seemed sure of (although we had our doubts) never materialized and was instead replaced by a – choose your metaphor – “red rain drop,” “red ripple,” or “red whisper.” Indeed, Democrats may expand their majority in the Senate, depending on the outcome of the Georgia runoff race in early December.
Either way, wave or whisper, we believe the practical implications for the markets and the economy are largely the same whether Republicans had won only a House majority or won both the House and the Senate. After all, a majority is still a majority, and the primary levers for a party not in the White House – namely obstruction and oversight – will be available to House Republicans despite their skinny majority and control of only one chamber.
What to expect from a split Congress in 2023
So, what does a split Congress mean for economic policy? We see four main implications:
- A total freeze of President Biden’s legislative agenda. Perhaps most importantly for markets, this means that all tax increases have been taken off the table – whether on the personal side (e.g., capital gains increases) or corporate side (e.g., a windfall tax). This also suggests that the next inflection point for taxes will be 2025 when the Trump tax cuts are set to expire.
- More oversight. House Republicans will flex their oversight powers on issues from the Biden administration’s energy policy to its approach on China (which, in some circles, is thought of as not sufficiently hawkish) to the Securities and Exchange Commission’s panoply of proposed regulations. Oversight is likely to be more symbolic than substantive – after all, without veto-proof control of both chambers of Congress, there is little Republicans can do to alter policy. However, increased oversight can slow down the regulatory gears and make it more cumbersome to advance policy for any White House. While the Federal Reserve is also likely to be an object of oversight – from both sides – we doubt the Fed will be sensitive to any political pressure to change its seemingly singular focus on combatting inflation.
- More fiscal fights. This is where the slim majority for House Republicans may come into play and potentially be a source of market volatility next year. With little-to-no cushion to lose congressional votes, it may be more difficult for the future speaker of the House (who won’t be decided until January) to navigate upcoming fiscal inflection points, particularly the need to raise the debt ceiling given that some in the Republican caucus (e.g., the House Freedom caucus) have indicated they will not support any debt limit increase without commensurate spending cuts, a non-starter for the Democratic Senate and White House. Our base case is the statutory debt ceiling will be hit by the end of this year, but the Treasury Department’s extraordinary measures will extend that deadline until fall of 2023. However, despite expected brinkmanship and potential associated volatility, especially at the front of the yield curve, we believe that House Republicans will ultimately blink and the debt ceiling will be raised. Keep in mind that the 2024 presidential campaign will be in full swing by then, and it is unlikely Republicans will sacrifice a chance at the White House.
- Less fiscal support. Although we still believe there will be bipartisan support for ongoing aid to Ukraine and for the defense budget, we also believe there generally will be a higher threshold to providing broader countercyclical fiscal support, even if the economy slows. The U.S. economy has already seen significant fiscal contraction in 2022 by virtue of many of the COVID-related programs rolling off, and next year we can expect more contraction, which a split Congress is unlikely to do anything about. In other words, similar to the “Fed put” having been taken off the table, the “fiscal put” has also been effectively eliminated – at least until a new Congress comes into power in 2025.
While our expectation is largely for gridlock in the next Congress, we do foresee some areas of potential compromise. These include legislation that could bring better clarity to the regulatory remit on cryptocurrencies – a need that is even more urgent given recent crypto exchange issues – and energy-permitting language that could expedite both traditional and renewable energy projects.
Will markets like the election results?
While past is certainly not prologue, the equity markets historically have tended to do well in years of split government. Indeed, in previous years of a similar composition of power in Washington – namely, a Republican House, Democratic Senate, and Democratic White House, the equity market has returned on average 13.6% (per S&P 500 data), a higher average return than almost any other composition of power. Of course, 2023 may look quite different from history given sticky inflation, recession risk, and war in Ukraine. (Read our latest Asset Allocation Outlook for our detailed views on equities and other asset classes in the coming year.)
A quick pivot to 2024?
Of course, once the final ballot is counted, the midterm elections will quickly be in the rearview mirror. While speculation is rampant about who else is running (Donald Trump announced his candidacy as we penned this) – and who is not – for the White House in 2024, we would caution against extrapolating any conclusive outcomes this early in the cycle. Indeed, we are likely in for a number of twists and turns, which once again may surprise the pundits and defy history.