Markets, Strategy And Gridlock: Key Midterm Considerations

This feels entirely trite, but I’m compelled to mention it anyway as the US midterms are set to dominate the news cycle for the next several days: Divided government in Washington is ostensibly bullish for equities.

That’s the conventional wisdom, and the rationale is straightforward. Gridlock serves as a check on each party’s “worst impulses” and less volatile fiscal policy is conducive to lower volatility in markets. That could be particularly useful in 2022 and 2023 to the extent it calms rates vol, the sponsor of this year’s historic cross-asset malaise.

There are a number of caveats and problems, some specific to markets, some related to political strategy and others more existential. A comprehensive account is beyond the scope of any single article, no matter how long. Rather than endeavor an exhaustive take, I’ll run briefly through what I believe are the most important considerations for markets, political strategy and the country’s future. (Note that I deliberately omit the most existential discussion of all, having covered it last week here.)

Markets

Rates volatility in 2022 is a function of monetary policy, not fiscal policy, and a Republican Congress is obviously more amenable to additional, aggressive Fed tightening than a Democratic Congress, particularly when a Democrat occupies the Oval Office. At the least, more rate hikes and a higher terminal rate could be conducive to persistently elevated rates vol, which has the potential to destabilize risk assets (like stocks) at annoyingly regular intervals.

The assumed incremental benefit to markets of less volatile fiscal policy as a result of divided government may be diminished by the fact that fiscal policy was already hamstrung by intra-party divisions. Most obviously, Joe Manchin effectively vetoed Joe Biden’s most ambitious initiatives to the chagrin of Progressives. On the other side of the aisle, the right-most wing of the Republican party is drifting ever further away from what roughly two thirds of the country still identifies with reality, which makes bipartisanship difficult, to put it politely. When you can’t agree on what’s real and what isn’t, cooperative policymaking is very challenging.

Strategy

If you’re a GOP lawmaker, cheering (or at least not jeering) Fed hikes serves two purposes:

1. It lets you pretend to care about inflation, and also to pretend you’re doing something about it by not obstructing Jerome Powell’s efforts. That’s the best kind of “work” if you’re a politician: The kind that doesn’t require you to actually do anything. Of course, Republicans were wholly unconcerned with preserving the veneer of central bank independence during the last administration, but that’s water under the bridge I suppose. (Or at least until 2024, when the water rises, sweeps the bridge away, spills over the banks and drowns the village).
2. It encourages a policy bent that’s likely to push the US into a prolonged economic downturn which, if you’re lucky, will drag into 2024, giving your party’s presidential candidate a recession to pin on the incumbent.

That latter assumption could backfire, though. If the rates hikes work too “well,” the recession may come too early and the Fed pivot could coincide with the 2024 election cycle. You don’t want that if you’re a Republican.

If, as an unbiased market observer, you take the middle ground between market pricing for rate cuts (i.e., commencing in the back half of 2023) and the Fed’s pretensions to holding terminal for longer than that, it’s pretty easy to imagine cuts starting in early 2024. Assuming any recession is shallow, that could well mean markets are storming higher and the economy recovering just as Americans prepare to choose (hopefully it’s a choice) their next president.

Existential

It’s a wholly unfortunate state of affairs when the best possible outcome of an election is the calcification of partisan gridlock. But it mirrors what counts as “strategy” among the party leadership (particularly Mitch McConnell who, in a sign of the times, went from being mercilessly maligned as a turtle-Palpatine hybrid to being begrudgingly accepted as clinical, in the coldly dispassionate sense of the word, but at least not clinical in the padded room sense).

Ostensibly, Americans elect lawmakers based on the policies would-be leaders plan to pursue. It’s a popularity contest, sure, but it’s not supposed to be purely about charisma. Elections are supposed to be about competing visions for the country, and a vision without action is merely a dream. Actions are policies.

More than ever — or, for the historians among you who might be inclined to quibble with the idea that our times are truly unprecedented, we can say “increasingly” — engineering gridlock is a policy goal all its own. In fact, you could argue it’s often the only policy goal.

Unfortunately, many voters support the notion that if their party can’t govern, the best strategy is to ensure the other party can’t either. So, nothing gets done. The less that gets done, the more distrust there is in government. That’s conducive to more partisan rancor, which means even less gets done, and so on, in a spiraling, ruinous institutional credibility crisis.

That sort of petulant, internecine political warfare is viewed in Beijing as a fundamental weakness of democracy. Xi Jinping is keen to exploit it. More and more, America’s approach to China’s hegemonic ambitions revolves around stymieing Xi and buying time. That’s only viable if America plans to get something done eventually. Otherwise, buying time is tantamount to delaying the inevitable.