Via Goldman Sachs,
As the global election cycle begins to slow down we turn our attention back home to give investors a working roadmap for the Midterm Elections in the US. Indeed, with the President at the midpoint of his last term and policy uncertainty having abated (to a degree), we believe the market has not focused on what by all accounts looks like a toss-up in terms of election outcomes with no volatility being priced into the options market. To that end we focus on how a single-party Congress might impact the policy agenda and what needs to happen for that to occur.
What’s needed for Republicans to take the Senate? Democrats currently have a 55/45 majority in the Senate which implies Republicans need a net gain of 6 seats to secure a 51/49 majority. The particular subset of seats up for election this year has driven some in the press to expect that Republicans have the easier road to victory (note we do not take a view on the outcome of the election). Specifically, there are a total of 36 Senate seats up for election, 21 held by a Democratic incumbent and only 15 by a Republican. Further, just 1 of the Republican-held seats is in a state that voted for President Obama in the 2012 elections, while 7 of the Democrat-held seats are in a Romney-voting state. If all states voted as they did in the Presidential elections, Republicans would secure the net-gain of 6 seats needed for a majority.
What is the market pricing in, if anything? While the November 4 elections are still several months away and the political climate remains fluid (most recently evidenced by House Majority Leader Eric Cantor (R-VA) losing in the Virginia Primary to Republican challenger Dave Brat), we look to two market-based measures to gauge expectations around the election outcome.
- Prediction Markets suggest election outcome is a toss-up. Today, online prediction markets show a roughly equal probability of a Republican controlled House and Senate (implied probability: 45%) as a maintaining of the status quo (implied probability: 40%), although these measures have shown significant volatility YTD. At the start of the year the implied probability of status quo was approximately 55% (Rep. House & Senate 37%), while less than two months ago the markets saw a higher likelihood of Republicans taking the Senate and maintaining control of the House (~55%). Our US Economics team notes that online prediction markets are often unreliable this early in the campaign cycle. For example, up until two months before the 2012 elections, prediction markets were implying that Republicans would gain the four seats necessary to win a majority in the Senate, while they ultimately lost two seats.
- Option markets are not pricing in high volatility around the election. Expectations for elevated volatility around the midterm elections would leave ripples in the options market, in our view. Below we measure average implied volatility for S&P 500 stocks across contract maturities, finding no evidence of increased hedging demand near the time period of the election (i.e. December contract expiry). We note that at this point ahead of prior recent midterms (i.e., 2010 and 2006) there was a similar complacency in the options market, and the election was indeed followed by relatively small market moves (S&P 500 -0.2% in Nov-10; +1.6% in Nov-06). However, midterm elections are not always quiet times for the market. Over the 1962-2002 period, the median absolute move in the S&P 500 during the month of the midterms has been 4.7%. For context, the median absolute monthly move for all Novembers over the 1962-2002 time period is 3.7%, and 3.1% in nonelection years.
How might a single-party Congress impact the policy agenda? While a Republican controlled House and Senate could potentially serve as a catalyst for the high priority agenda items of Republicans (e.g. corporate tax reform), it is less clear that this would increase the likelihood of any proposed legislation becoming law as the need for bi-partisan support remains. Most policy items require 60 votes from the Senate and the President maintains the power to veto a bill. To the extent that Republicans in the House and Senate spend more time working with each other than across the aisle with Democrats, the likelihood of any major reform being passed could potentially fall, rather than rise. Therefore, it is unclear that the political gridlock will improve after the midterms and the possibility remains that much of today’s policy agenda could be pushed out until after the 2016 presidential election.
Policy agenda items we are watching:
Repealing or Amending the Affordable Care Act: While discussions over a Republican-led repeal of the Affordable Care Act have been circulating since the law was passed in 2010, the likelihood of a full repeal has seemingly waned as ACA implementation has ramped. Still, many Congressional Republicans remain steadfast to amending the law. One such example is the American Health Care Reform Act of 2013 which was introduced by Rep. Phil Roe (R-TN) last September and has the support of 130 House Republicans. Additionally, in his role as House Majority Leader, Eric Cantor (R-VA) was a driving force in the ACA repeal effort, overseeing more than 40 votes in the House on the topic, and it is unclear how his defeat in the Virginia Primaries impacts the Republican strategy from here.
Managed care companies (e.g. UNH, WLP, AET, CI) are potentially the most exposed to any legislative changes to the ACA, and could stand to benefit if certain aspects of the law are changed (e.g. a reprieve to the Medicare Advantage reimbursement cuts). That said, with the political backdrop as fluid and uncertain as it is today, insights regarding what legislation (if any) will ultimately be proposed and how the healthcare sector may be impacted remain unclear, in our view.
GSE reform appears unlikely near-term: Housing finance reform remains a focus, with a number of proposals introduced this year, including Johnson-Crapo, a bi-partisan bill by Chairman Johnson (D-SD) and Ranking Member Crapo (R-ID) that passed the Senate Committee in late May and the PATH Act in the House, which was proposed by Rep. Jeb Hensarling (RTX) that was introduced in January, among others. However, there are large differences across the proposals, leading many to conclude legislation is unlikely to be passed near-term.
A key concern of legislators seems to be the impact any reform may have on the housing recovery, particularly affordability. Homebuilders, title insurers and brokers (e.g. RLGY) revenues are very sensitive to the volume of home sales. Private mortgage insurers (PMIs) would also likely be impacted by reform, but the direction is less clear. There could be a larger role for PMIs (such as MGIC, Radian and Essent) as the private sector takes more credit risk, but their business models are also dependent on the existence of a GSE-like institution that requires mortgage insurance for high LTV loans. In addition, competitiveness vs. alternatives (like the FHA) could also shift depending on the scope of reform.
Corporate Tax Reform remains a key agenda item but the potential election impact is unclear: Both Republicans and Democrats have discussed and set forth sweeping corporate tax reform proposals this year (i.e. President Obama’s FY 2015 Budget and the Tax Reform Act of 2014 set forth by Rep. Dave Camp, R-MI). Key debates on issues such as revenue neutrality have kept law makers at odds and recent focus has been narrower in scope. For example, in May Senator Carl Levin (D-MI) introduced the “Stop Corporate Inversions Act of 2014” which specifically aims to end the practice of corporations re-domiciling outside of the US by means of an M&A transaction. Recent press also indicates that Senators from both parties, including Rand Paul (R-KY) and Senate Majority Lead Harry Reid (D-NV), are in discussions over a potential repatriation tax holiday. As mentioned above, it is not clear that a Republican-controlled Congress would increase the likelihood of any becoming law, but it could revert the focus back to more broad-based reform.