Forget The Myth About The Stock Run-Up Into Midterms; Goldman Explains Why
Goldman's economic team continues its string of market negative output, this time focusing on debunking the myth of an expected market run up into the mid-term election in 3 months. Contrary to the attempts of numerous pundits who consistently try to create a self-fulfilling prophecy and allow themselves better exit points on legacy underwater positions, Goldman performs a statistical analysis and reports that while in the past the stock run up has in fact occurred after the mid-terms, this was traditionally accompanied by loosening fiscal and/or monetary policy, resulting in a boost to the economy. As Goldman's Alec Phillips says: "For various reasons, market participants tend to take a more optimistic view of growth following the midterm election." And for all those who think this time is different, fiscal loosening post the elections will be hard to come by, and will be further impacted by the natural contraction of the economy following 2+ years of fiscal gluttony. Goldman says: "By contrast, our own estimates imply a tightening of fiscal policy in 2011, including decreased transfer payments as a result of expired unemployment benefits and increased tax liabilities as a result of tax expirations, and while we don’t have quarterly estimates for 2012, our budget projections assume additional further restraint on an annual basis then as well." In other words next time someone says that the market traditionally runs up into midterms, be aware they are uninformed. And not only that, but it is far more than likely that the stock market will drop after November, as the unprecedented disconnect between the contracting economy and the irrational stock market, finally collapses.
From Goldman's Alec Phillips:
The Midterm Election and Fiscal Policy: This Time Is Different?
- With the midterm election three months away, some market participants appear to be expecting additional policy stimulus in order to provide one last boost to the economy. There are several items on the table, including aid to state governments, tax measures such as bonus depreciation, credit programs for small business and commercial real estate, and the ever-present possibility of additional policy activity in the mortgage market.
- But despite what would seem to be an obvious motivation to provide additional support to the economy, previous electoral cycles do not indicate a pattern of stimulus ahead of midterm elections, at least not through fiscal policy. To the contrary, cyclically adjusted federal net saving is at its most stable, on average, leading up to the midterm compared with at any other point in the four year political cycle.
- Moreover, the current expansive fiscal policy is set to reverse, putting it on the opposite path of policy seen in most election cycles, when fiscal policy normally provides additional support for the economy between the midterm and presidential elections. So while the midterm is often seen as a turning point for markets and may well have other implications outside of fiscal policy, from the fiscal perspective this time may be different.
With the midterm election three months away, some market participants appear to be expecting additional policy stimulus in order to provide one last boost to the economy. However, public support for stimulus has declined, and a majority of the public now appears to support fiscal restraint over tax cuts or additional spending. This shift is also evident in what so far has been a failed attempt to provide additional support for the economy outside of emergency unemployment benefits. While it’s difficult to rule out any further actions, the prospects for additional measures outside of monetary policy are limited. Outside of any potential shift from the Fed, which is outside the scope of this note, there are only a few additional proposals on the table, most of which face challenges:
Spending: Extended unemployment benefits have been renewed through November 30 (i.e., until just after the election). Fiscal assistance to state governments has been stalled in the Senate over the last few months, but will come up again on August 3 for what is likely to be the final vote on the matter this year (whatever the outcome). The latest iteration would provide Medicaid and education grants of $16bn and $10bn respectively. Some states already assume this funding, so enactment would reduce the currently reported budget gap by $14bn, while failure would add $12bn. The outcome is unpredictable as it is likely to be decided by a one-vote margin and the bill has been changed in a bid to attract additional support, but for now the probability of enactment still appears below 50%.
Tax: These days tax policy is mostly about which tax cuts will expire, not whether additional tax breaks will be offered. That said, there are a few items still on the table. After expiring last year, bonus depreciation for business investment has, somewhat surprisingly, made it back onto the agenda as part of the Senate’s small business package. That package includes another $7bn in other tax breaks as well. Pending energy legislation would also provide some modest capital investment incentives. Of course, the bigger issue is the expiration of existing policies; assuming that the middle-income tax cuts are extended, this still leaves taxes on the upper brackets and capital gains/dividends to increase. Slightly more important from a growth perspective, there is an increasing risk that the Making Work Pay credit expires as well.
Financial: Legislation to backstop loans to small businesses has been bogged down in the Senate over mostly unrelated issues. It could still become law this year, but probably not until late September. It would loosen lending requirements and increase loan amounts in existing small business lending programs. More important, it would establish a program to distribute $30bn in capital to small banks, theoretically sufficient to support $300bn in lending. A second effort involving guarantees for roughly $20bn in small-balance commercial real estate (CRE) loans is on the table as well, with bipartisan support but little movement to date. But the proposal that has received the most attention from market participants is the one that seems to be receiving the least amount of attention in Washington: using the GSEs to increase refinancing activity, as a form of indirect stimulus. We noted the possibility of incremental activity in this direction two weeks ago (see “GSE Policy: Looser Now, Tighter Later?”, US Daily, July 16), and there has been additional market commentary since. However, as we wrote then, while we wouldn’t rule out the possibility of changes in this direction, there is no sign that a policy change is imminent.
2. This year isn’t so different from the past. Despite what appears to be a widely held impression that policymakers will want to provide support to the economy ahead of the election, on average presidential administrations have started the four year term with a fairly quick loosening of policy, followed by a relatively unchanged position through the midterm election. The current trajectory, shown in blue (labeled 2009-2011) in the chart below, follows the same general path up to the midterm election, albeit after a much sharper than usual decline in the fiscal position (we use CBO estimates of cyclically adjusted federal net saving through 2009, after which we use our own cyclically adjusted estimates. This measure is similar to the federal budget balance, but includes interest payments and excludes financial stability programs and certain other capital transfers.) The upshot is that although many market participants seem to expect additional stimulus ahead of the election, on average this doesn’t appear to have been the experience historically (there is greater average easing of fiscal policy in the first year of the term when the president’s part controls at least one chamber of Congress than when it doesn’t, but in both cases there is little additional easing in the midterm election year).
3. The difference is what’s on tap next year. While the relatively unchanged path of fiscal policy in the midterm year isn’t all that different from prior electoral cycles, what is more unusual is the post-midterm trajectory. In the 12 electoral cycles from 1961 and 2008 shown in the chart above, fiscal policy has been loosened on average by nearly one percentage point of GDP leading up to the middle of the presidential election year. This is probably at least one of the factors behind the pattern of real disposable income growth, shown below, which slows on average leading up to midterm elections, and then reaccelerates thereafter. This trend is particularly noteworthy at the moment, in light of a decline in private sources of personal income that has been offset through lower tax liabilities and increased transfer payments.
By contrast, our own estimates imply a tightening of fiscal policy in 2011, including decreased transfer payments as a result of expired unemployment benefits and increased tax liabilities as a result of tax expirations, and while we don’t have quarterly estimates for 2012, our budget projections assume additional further restraint on an annual basis then as well. While it is natural for fiscal policy to begin to contract once the economy has begun to recover, the current trajectory appears to be at the edge of the range of fiscal policy in previous recessions, as shown in the chart below. This isn’t a surprise, given the extraordinarily large fiscal policy response seen in early 2009, but it does point to a greater than usual risk from fiscal policy during the recovery.
4. So throw the usual election-year pattern out the window? The chart below shows the level of the equity market over the four year political cycle, measured against its level at the end of October of the second year (i.e., a few days before the midterm election). What is notable is that not only do equity prices tend to increase around the time of the midterm election, but in previous midterm elections back to 1950, prices have been higher in every instance six months out. (While less reliable, the yield curve is also steeper about three quarters of the time six months following mid-term elections). For various reasons, market participants tend to take a more optimistic view of growth following the midterm election. The risk over the next several quarters is that the pattern noted above—i.e., that fiscal policy is set to be tighter than usual—will overshadow the factors that normally lead to post-midterm optimism. While there may be other factors involved—for instance, the typical loss of 15 to 20 House seats by the president’s party in a midterm election may lead to reduced policy uncertainty, as legislation is perceived to be more difficult to enact—fiscal policy is unlikely to operate as it normally does over the course of this electoral cycle.