Yesterday we hinted at the one 'uncertainty' that was anything but at record-lows [5]; and it seems Goldman Sachs (who recently opined on what's at stake in the Midterms [6]) agrees that after a period of relative calm, the US political environment looks likely to become more uncertain again. Recent developments have raised the prospect of renewed political tensions this fall. While they suggest the chance of another government shutdown is not high, the political environment has changed enough that the deadlines are likely to create real uncertainty, and an agreement may be reached only at the last minute. Crucially, if Republicans succeed in capturing the majority in the Senate following the November midterm elections, the routine around fiscal deadlines that markets have become accustomed to over the last few years may become more unpredictable (and may spill over into another debt limit debacle).
Polarization is worst than ever... among polticians...
[7]
and the people...
[8]
Prediction Markets suggest election outcome is a toss-up.
[9]
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%).
Via Goldman Sachs,
Political Risks Are Likely to Rise Somewhat This Fall...
Following the government shutdown and debt limit debate in October 2013, the US domestic political environment has not been an important factor for markets so far this year. Policy uncertainty, as measured for example by the Economic Policy Uncertainty Index, is reasonably low, the debt limit was increased earlier this year with little fanfare, and the absence of any meaningful deadlines since then has diverted attention from Washington. However, domestic political tensions seem likely to come back into focus a bit over the next several months.
[10]
Some of this has to do with the recent defeat of House Majority Leader Eric Cantor in the Republican primary election held in Virginia on June 10. This was notable because primary losses among incumbents are rare; they are even more uncommon among members of congressional leadership. Following the change in leadership, there has already been a shift in the stance that House Republican leaders are taking on certain items on the policy agenda for the next few months. There are three areas where Congress faces near term deadlines:
Export-Import Bank: The Ex-Im Bank provides roughly $30 billion annually in credit and credit guarantees to facilitate US exports, particularly for aircraft and energy- and industrial-related equipment. The bank’s authority to provide new export financing expires September 30, 2014. Congress typically extends this once every few years, and although House Republican leaders had until recently been supportive of renewing the bank’s authority, the new leadership team has indicated they prefer to let the Ex-Im Bank’s authorization expire. Democrats in both chambers of Congress are broadly supportive of the extension, while Senate Republicans appear to be looking for a middle ground.
Highway Bill: The federal highway program is financed out of a trust fund that takes in gasoline taxes, which are used to make payments to state governments for public transportation infrastructure projects. The highway program actually faces two deadlines: first, the program expires September 30 and must be renewed before then. However, Congress will probably need to act even sooner: gasoline taxes have not kept up with spending and the fund is expected to be depleted by August. To avoid disruption through year-end, Congress will need to transfer around $10bn from another source. However, lawmakers have not yet agreed, in either chamber, on how to finance this and time is running short. The Department of Transportation has indicated it may begin to delay payments to states for infrastructure projects if the situation has not been addressed by late July. In similar situations in the past, states have pulled back somewhat on construction spending as a result of the uncertainty, and could do so again if the issue is not resolved soon.
Spending Authority/Continuing Resolution: Congress must once again renew “discretionary” spending authority—i.e., spending on government operations, including defense, but excluding entitlement and credit programs—before it expires at the end of the current fiscal year on September 30. The top-line spending level was already negotiated as part of the agreement in late 2013 to partially reverse sequestration, so the debate now hinges mainly on the distribution of that spending and, more importantly, on disagreements on extraneous issues.
While allowing any of these three items to lapse would be somewhat disruptive, the key concern is enactment of a continuing resolution before September 30, to avoid another government shutdown. Until recently, this did not appear to be much of a possibility, but the growing dispute over the Ex-Im bank has raised the risk somewhat. In particular, there is a risk that several of these issues could be rolled together, forcing a single vote on all of them. Our best guess is that Congress will avoid a shutdown, either by allowing a shortterm extension of all three measures, or reaching some other arrangement that at least allows short-term extension of spending authority. That said, there appears to be a good chance that the decision will be left until the last minute in late September, which could lead to some renewed uncertainty ahead of the deadline.
Following the November election, Congress is likely to return for a “lame-duck” session before year end, to wrap up work on a number of deadline-driven items. This may include action in the areas noted above, along with a few other measures such as the extension of mainly corporate tax incentives that expired at the start of 2014. However, we don’t expect any significant policy changes.
...And Could Rise a Bit Further Next Year
The more important test will come in 2015, once the election result has taken hold. Our expectations for major policy changes over the next couple of years have been low because divided government is likely to persist under any of the likely election outcomes. That said, the form of divided government could potentially change.
Most observers do not expect the majority in the House of Representatives to shift, but the Senate appears much more competitive. For example, online prediction markets imply only a 5% or so chance that Democrats will gain the House majority, but slightly better than a 50% chance that Republicans will win the majority in the Senate. With 45 seats currently, Republicans need to win six seats to gain the Senate majority. At the moment, Republican candidates lead by double digits in three seats held by Senate Democrats, while another six Democratic and two Republican seats are essentially even in the polls. Depending on the outcome on November 4, the uncertainty regarding the Senate outcome could last beyond November. Two states with nearly even Senate races — Louisiana and Georgia — must hold a runoff election if no single candidate reaches 50% of the vote in November. Those elections would be held in December 2014 and January 2015 respectively.
The main domestic political risk for markets in 2015 seems likely to be the debt limit once again. Congress suspended the debt limit earlier this year until March 15, 2015. Similar to previous extensions, once the limit is reinstated it will be increased by the amount of debt issued to pay obligations during the suspension. The Treasury will once again use a variety of “extraordinary measures” to extend its borrowing capacity, which should allow operation under the debt limit until at least August and probably October before borrowing authority becomes constrained. If tax receipts are particularly strong, an increase might not be necessary until later in Q4 (Exhibit 2).
[11]
Over the last few years, the various fiscal debates that have at times proved disruptive to markets—debt limit deadlines, the government shutdown, sequestration, and the “fiscal cliff”—have all taken place with a Republican House and Democratic Senate. If the status quo prevails following the midterm election, the next debt limit may pose some risk but most market participants are now better able, we think, to anticipate the path to eventual agreement. This usually involves the House passing a measure with mostly Republican votes, the Senate passing a different measure with votes from both parties and the House then passing that bill shortly before the deadline, often with at least as many Democratic votes as Republican ones.
However, if Republicans win control of the Senate, markets will probably need to adjust to a new routine. In a scenario where Republicans hold majorities in both chambers, one possibility would be use of the budget “reconciliation” process to pass a debt limit increase coupled with other Republican priorities. Since only 51 votes are needed to pass legislation under this process, rather than the 60 votes often required in the Senate, this could in theory allow congressional Republicans to present the President with a debt limit increase, forcing him to either sign or veto it. While we have little doubt that the debt limit will be increased as necessary, this would add a new twist to what is already a potentially disruptive issue.
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As Goldman concludes, this uncertainty is not priced in...
As the global election cycle begins to slow down... but 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 Miterm 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.
