What US Midterm Elections Could Mean for FinReg

Scott Clemons

In the US, November 6 marks midterm elections where voters will decide all 435 seats in the House of Representatives and about a third of the 100 Senate seats. We thought we’d take this opportunity to sit down with BBH’s Chief Investment Strategist Scott Clemons for not only a look at what the election could mean for financial regulation, but also his area of expertise: what it could mean for financial markets.

What can we expect from the midterm elections?

Well, it’s rather common for the party in control of the White House to lose control of Congress two years into their four-year term. And recent polls suggest as much: Democrats are trending to a majority in the House of Representatives but not necessarily in the Senate. If the Democratic Party takes control of the House, some might interpret that as backlash against the Trump administration — and I’m sure that’s true to a certain degree — but historically, it’s actually a relatively normal development.

What do the midterm elections mean for President Trump’s deregulatory agenda? 

I don’t think midterms pose a threat to the tailwind of regulatory reform. What you may see is a democratic Congress trying to retake control of some aspects of regulatory oversight as a means of stymieing the Trump administration. But let’s not forget the White House could veto any effort of that nature.

A divided government does not stall the de-regulatory agenda because it’s largely not part of the legislative process. It could stall making this year’s tax reform permanent for individuals and families, because that’s a legislative action. But on a regulatory front, many aspects are out of the hands of Congress.

As BBH’s Chief Investment Strategist, you spend a lot of time interpreting the market and identifying areas that pose risks to investors.  Do you see the midterms as being a disruptive market event?   

Although we might see some initial volatility due to sentiment, I don’t think midterm elections pose a threat to the fundamental value of markets, no matter what the outcome is. Financial markets actually tend to like divided governments because markets don’t like change. When a different party controls Congress from the White House, markets tend to do better. It’s harder to pass legislation (i.e. make changes), when you have divided governments. So, if the Democrats retake control of the House of Representatives, which is the likely outcome, then that makes it harder for the White House to make progress with its legislative agenda.

Might midterm elections cause the market to shift? Absolutely, of course. On any given day, anything can be a catalyst. I spend a lot of time – and I encourage our clients in Private Banking to spend time –  making a distinction between developments that threaten to impair sentiment (causing price movement) and the developments that threaten to impair fundamentals (deteriorating value). The latter, of course, is a much more impactful kind of shift.

Does the market volatility we’ve witnessed over the past few weeks have anything to do with midterm election uncertainty?

The volatility we’ve seen over the last month is just a return to a normal market environment. We have become accustomed in the US, over the past couple of years, to an absence of volatility. But if you look back over multiple years, usually the market has a setback of 5% or more two or three times a year. But there were no major setbacks in 2016 or 2017. Even the uncertainty of the Brexit referendum in 2016 was short lived – the market rebounded in less than two days. The reality is, when you’re reintroduced to volatility, it seems new. Volatility is the hallmark of a normal, functioning market. The abnormal environment is the one we’ve been in without volatility.

Let’s turn now to another major geopolitical event: Talk to us about Brexit.

Let’s assume the worst-case scenario, one in which the UK leaves the EU without a trade agreement in place (a hard Brexit), they fall back on World Trade agreements, so there is a bit of a safety net there. The UK would not suddenly be outcasts in the world economy. However, WTO agreements are not nearly as beneficial as current arrangements and are to the detriment of both the UK and EU, so it’s in the best interest of both the UK and the EU to have a solid trade treaty in place. I think both parties have the same incentive there.

I also look at the way the UK competes on a global stage. Yes, the EU is a major trading partner, but they aren’t the only trading partner. Undoubtedly a hard Brexit will be disruptive to its economy, particularly in the short term, but I don’t think it fundamentally changes the shape of the UK economy. The UK was a major trading partner before they joined the EU and will continue to be after they leave. But at the end of the day, there’s no question that in some industries, and financial services is one of them, this is a big deal. In terms of US markets, Brexit in its broadest sense is unlikely to fundamentally impact the US stock market.

In the US, and perhaps abroad, there’s been a lot of focus on the Federal Reserve’s (the Fed) rate agenda. Can you give us your perspective? 

The Fed has two mandates. One is to pursue policies that foster full employment. There are many definitions of “full employment” in the US, but most would agree we’re there. The unemployment rate for people with a college degree or higher is 2%.

The Fed’s other mandate is price stability. Usually those two goals are in conflict, because if you really want a strong labor market you get it at the risk of inflation. For roughly the last ten years, those have not been in conflict. Now, the Fed is looking forward. They see inflation has run at or above 2% for 13 consecutive months – not dramatic, but above. So, the Fed has begun raising interest rates to a level that more appropriately reflects the strength of the labor market and the strength of the economy. That’s what central banks do.

What I think this Fed (and the two previous chairpersons) have done very well is to be transparent about what the market should expect. There is a truism in capital markets and I think it’s probably also true in life: the most expected risk is least dangerous, and the least expected risk is most dangerous. So, when the market places a high probability on the Fed raising interest rates at their December meeting – what happens on that day when the Fed raises interest rates? A collective shrug. the market says that is what we expected, and life goes on. So, I do not believe the Fed’s current policy poses a risk for markets or the economy.

Do you see any risks for the markets or economy in the near future? What should we watch for in 2019?

There is more inflationary pressure building than either the Fed or the markets anticipate. We’ve seen a long-awaited increase in average hourly earnings – they’re now up to 2.8%. When you add the potential impact of trade disputes and tariffs, that’s where the added or unanticipated inflation may come from.