Welcome to Insights Now, a series of conversations designed to shine a light of clarity on the complex world of investing. Earlier this month, Americans went to the polls in the midterm elections. Although the results were closer than many expected at the time of this recording, Republicans look like they will come away with a slim majority in the house, while Democrats have maintained control of the Senate. Following this election, America will have divided government, which in today's politically polarized environment could mean gridlock in Washington. As the country grapples with high inflation, the potential for recession and heightened geopolitical tensions, this will have important implications for the kind of government action or lack thereof, we may see over the next two years.
However, for investors, it's also important to put conversations about politics into perspective and to separate political preferences from true investment implications. So today, I've invited Michelle Mesack, who is head of federal government relations at JP Morgan Chase and who boasts extensive experience in government to public policy over her career, as well as my colleague Meera Pandit of global market strategy for JP Morgan Asset Management, to discuss the main takeaways for investors from the midterm elections.
Michelle and Meera, welcome to Insights Now.
So Michelle, let's first recap expectations versus results from the midterms. What have we learned from this election?
Thanks, David. I think it's fair to say that expectations on the Republican side were definitely not met last Tuesday night. Republicans, if you had asked them on Tuesday morning what they were expecting for that night, the term red wave was used over and over again and they were expecting to take upwards of 30 seats in the House of Representatives in terms of a majority. And there were thoughts that they could get up to even 54 seats in the Senate. In the house, it's almost certain right now that we are going to see a house Republican majority, but potentially, by only a handful of seats, up to maybe five seats max, but probably more likely a two seat majority. In the Senate, we definitely have a Democratic control at 50/50 with the vice president breaking the tie, and it could potentially be a 51/50 seat majority for the Dems.
I think that in terms of what led to that, we saw an increased Democratic turnout in terms of what was expected. But I also think that Republicans were truly hurt by candidate quality. We saw a number of candidates who were backed by Trump in battleground states who did not perform as expected. I look at two states in particular to see that dynamic play out, both New Hampshire and in Georgia, where the senatorial candidate on the Republican side did not perform as well, but the Republican candidate on the governor side, won. In New Hampshire, you had the Republican Senate candidate losing by nine percentage points, but the Republican governor won by 16. That's a pretty significant amount of ticket splitting if you think about it.
And in Georgia, where we still don't know the results, we have basically a statistical tie with Walker losing to Warnock by one percentage point right now, but the Governor Kemp won by eight percentage points. So again, a real example of where you're seeing the same voters vote differently even within the same party. I would also say just in terms of how that expectation touches down in divided government, that on the house side it is truly hard to govern if you only have a couple seat majority. It really empowers small factions of the conference because the leader has to get all of his party to agree on any partisan bills that they're trying to move that they can't get the other side to agree upon.
So you are going to see the Freedom Caucus exercise a lot more control in the house. In the Senate, that Georgia seat still really matters because if the Republicans win that seat and you're dealing again with a 50/50 Senate, Manchin becomes incredibly important just like he was over the last two years and wields an incredible amount of power. If the Democrats can get that extra seat majority, that one vote becomes less important and they have a little bit more breathing room to do what they would like to do without always having to get Manchin to get on board.
So now we do have divided government, even if the Democrats keep control of the Senate. What are the potential areas for policy collaboration between Democrats and Republicans over the next two years?
Yeah, it's going to be hard. Divided government is always hard. There are areas where there will be bipartisan success, will be places where people come together. We always think about them as the issues that aren't in the headlines. The issues that we consider not home run issues, but more singles and doubles, things that stay below the political fray and can actually get done. So I think we will see small issues move. In terms of the larger issues, that's where it does get a little bit tricky. There will be an attempt to try to come to bipartisan agreement on some very specific issue areas. Whether there is success or not, I still think remains to be seen.
So areas that I would put into that bucket include things like cryptocurrency. Very timely right now in terms of the FTX issues from last week. Whenever there is an issue, whenever we see big financial losses, we do see Congress lean in in terms of oversight and potentially legislation. I think that the chances of legislation on digital assets increased significantly after last week, and we're going to see a real effort to get to bipartisan agreement. On the stablecoin issue, specifically on digital assets, there already was close to bipartisan agreement in the House Financial Services Committee. Now I think that broadens to see if they can't even do something on the broader cryptocurrency space.
Similarly, data privacy is an issue that Congress has wrestled with for a very long time and tried to do something under this. This is keeping how do we keep consumer data private and confidential and safe from cyber attacks and from being shared in ways that consumers don't want it shared. There's been a lot of attempts to get this done. They haven't really been successful at it over the last few years, but I think there will be an attempt to do that again.
In terms of bigger issues, I think there's going to be an attempt to actually work out immigration as a big issue. That one is going to be a really hard hurdle to overcome because it is very contentious, but there is a negotiation to be had between people who want to see our border more secure and people who want to see our legal immigration policy expanded, especially when it comes to skilled workers. So I think that's an area where you will see people try to join in, but it will be a big heavy lift to get into.
And then I would also add about areas where we may not need bipartisan agreement, but Democrats can still act given the current construct of the Congress. So for example, nominees, judges, the Senate can actually pass any judge and confirm them with only 50 votes. Same thing with Biden appointees. So the Senate being in Democratic control will still be able to act on that without bipartisan support. And that is very critical to Democrats in order to get their judges who are more politically aligned with their views into seat, as well as Biden being able to round out his cabinet as we see people flow in and out.
And finally, I would add on that at administration side, there are a number of things that the Biden administration can continue to do that doesn't need Congress, and so you won't have the divided government issue. That includes things like enforcement actions, regulations, as well as executive orders coming out of the White House.
So Michelle, those are some of the things that might get done. Where do you think there's going to be complete gridlock and a standoff and nothing's going to get done?
Yeah, that's a great question. Anything big, that stuff that I was talking about that lends itself to more headline risk or that tends to be more partisan. I don't think we're going to see any agreement on taxes. We have income taxes expiring in a couple years. The new income levels that were set by the Tax Cuts and Jobs Act, that's something they're not going to be able to get agreement on. Anything dealing with the Democratic agenda coming in two years ago. So think about everything that was left on the cutting room floor when it comes to Build Back Better. So the social care infrastructure, universal pre-K, elder care, paid leave, also anything, and most of those fall in this bucket, anything that's going to cost money. I think in this environment right now with rising inflation, there is newfound fiscal conservativeness coming from the Republicans and any big programs that cost a lot of money is going to be very difficult to get any Republican support for. And I think some moderate Democrats are going to have concerns around that as well.
So I think those are probably the big areas of gridlock. You're also going to see a lot of areas from the Republican house that are focused on messaging. So maybe not trying to truly get a legislative win, but you'll see a lot of bills coming through the house, investigation hearings on Biden administration actions, probably some investigations around big tech and how they may be, or maybe not censoring the internet. You'll see a lot of movement in the house there, but will have no actual ability to get signed into law given the partisan nature of those topics.
So some things that may get done, plenty of things that just can't get done. But when it comes to actually running the country, what actually has to get done between now and the next presidential election?
Yeah, there's a few things that have to get done and Congress will get them done, but it could be a little bit more painful than we've seen in the last couple of years. So debt ceiling has to get raised most likely by Q3 of next year. Appropriations bills, which is the funding of the government, which has to be done on an annual basis, has to get done. There's a couple other things, including the National Defense Authorization Act that has to be get done on a yearly basis to make sure that our military has the funding that it needs. These are all items that are going to fall in that must-pass category.
You are going to see a little bit more pain and contention around these issues than you have in the past because in divided government, the only leverage that the minority party will have, being the Republicans being only holding the house, is around these issues because when you have a bill, it has to get passed, that means you need Republicans and Democrats to both come to the table, and Republicans will see what they can extract in exchange for bringing their votes to the table. Especially on something like raising the debt ceiling, which although everybody, I think, almost everybody in Congress acknowledges is something that has to get done, you can't have the United States defaulting on its debt, they also understand that it causes so much consternation in the markets that they have a lot of leverage here and it plays a bit for a lot of them into the fiscal conservativeness message that they're trying to push.
So you can see that being a big area where Republicans really try to make this painful for the Democrats. I think though on the debt ceiling, there is a chance that the current Congress tries to resolve that before the end of the year. They know this is going to be a big problem in divided government and they would rather just clear it off the decks before next year. Secretly, I think some Republicans would also like to get it cleared off of the deck because they don't want to have to deal with the political issues that the debt ceiling would raise in the coming years.
Okay, so Meera, let me turn it over to you. So it sounds like it's going to be pretty contentious over the next two years. Where do you think this puts us in terms of the outlook for fiscal spending more broadly? And good question I think is if we do find ourselves in recession over the next year, do you think that divided government precludes any fiscal stimulus?
So if we take a step back and look at fiscal year 2022, which just ended at the end of September, the deficit was about $1.4 trillion and this is about 5.5% of GDP. Now, this is still high by historical standards, but it is a huge improvement from the last two years when we saw 15% deficit as a share of GDP in 2020 and 12.3% in 2021. So we are seeing that we're likely to see deficits stabilize and even fall a little bit further over the next couple of years, particularly in the case of divided government. As Michelle said, nothing that costs money, that's going to be really important over the next two years. So if we think about the implications for this, it's important for three reasons.
One, if deficits start to stabilize, if they fall a little bit further, that's a good thing in the long run for our federal finances. But two, if we think about how much deficits, spending, borrowing really juiced up economic growth over the last two years, that could have the opposite impact going forward where this is all of a sudden a drag on our economy. And then three, to me, most importantly, we know that fiscal policy and monetary policy work best in concert. So while we've all been focused on the Fed aggressively raising rates this year, we also have to pay attention to the fact that fiscal tightening is working in concert with that. And that is really the best combination when we think about wanting to see inflation start to get under control.
Now, as you alluded to in your question, the flip side of this is if monetary tightening and fiscal tightening together can try to bring inflation down, it could also bring about an economic recession. And if we do have an economic recession, not only are you going to see the Fed not want to massively cut rates, maybe they do a bit on the margins, but we're not going to see that zero lower bound, but we'll also see through a divided government, that they don't want to do a lot of fiscal spending. So we won't see that stimulus like we did over the last recession, and that could mean that all of a sudden we have a mild but lingering recession.
Now the other question we get given the recent rise in rates is, "Okay, fine, that's the deficit story. What about the debt?" We're sitting on a mountain of debt. Before the pandemic, it was about 80% of GDP. Now it's nearly a hundred. So how sustainable is our debt? Now we don't think we're going to default on our debt. We don't think there's this magic level where everything falls over, but debt service is a key issue in terms of how expensive it is to pay for all of this debt. So if we think about that rapid rise in rates going forward, this is not necessarily going to impact our debt tomorrow, but over the next couple of years as things need to be refinanced, as more borrowing takes place, it's going to get more expensive. And the longer term economic consequences there are slower growth and probably higher inflation. So we do pay eventually from an economic perspective.
So you mentioned inflation and obviously the key reason the Federal Reserve has been tightening so aggressively this year is inflation. Indeed, exit polls show that voters were extremely frustrated about inflation. What can Congress do about inflation though, if anything?
So in the short run, the Fed is the major actor here. It's all about the monetary policy tools and the Fed is raising rates and the Fed is reducing its balance sheet. We have to remember that when we look at the inflation data, monetary policy does act on a lag, so it could be some time before we see the full economic impact, not only in terms of inflation, but also in terms of growth. But in the short run, it's all about the Fed. In the longer run, there are certain things that Congress can do. One of the things that we have talked a lot about are what are the structural disinflationary forces in our economy that are peeling on the edges as of more recently? How can Congress work to bolster some of those disinflationary forces?
So I'll give you three examples. The first one, energy. We are seeing that while the US underneath the ground has a massive supply of energy, it's become more and more tricky to surface that supply in recent years because we haven't had as much investment in the energy space when we think about traditional fossil fuels. Look, the administration wants to shift to a more renewable future that is likely going to be a transition that does take place over many decades but having some sort of sensible balance where we invest in both traditional energy sources to keep that source of energy going, but also invest in the future and renewable sources could be a really nice balance because ultimately, who pays for higher energy prices? The consumer. So that would be from a inflation standpoint, a good longer term play.
If we think about globalization. That has made everything a whole lot cheaper over the last couple of decades. And what you're seeing more recently is more protectionism, countries across the world turning inwards. We don't want to lose some of the cost-benefits of globalization. Let's certainly invest in areas where we can be strategically competitive, but also rely on some of our key global partners to have productive relationships in terms of trade.
And then maybe the last example, and Michelle alluded to this one when she mentioned immigration and how that might be a topic of conversation, a very challenging one. Labor supply is a key challenge, and if we think about the Fed watching wage growth so carefully, part of that is we don't have enough workers, so businesses have to raise wages in order to attract the right people. Now, we can't do anything about our demographics, they're not necessarily moving in the right direction. But if we consider, again, some sensible immigration policy to try to bring the right workers in to fill some of the gaps that we have in the labor market, that could help alleviate some of those pressures.
So now again, these are multi-year, multi-decade solutions. When it comes to Congress, there really is no silver bullet in terms of helping inflation in the short run, but we could certainly help promote some of those longer term disinflationary factors over a multi-year time horizon.
So Michelle, so far we've been talking about the federal government and federal elections, but we probably don't pay enough attention to what's going on at the state level. What are the key takeaways from the governor's races that we've seen around the country and their implications for future state legislation and elections?
Thanks, David. I think when I'm looking at the states, what really strikes me is how many states are in control, fully, by one party. We call them state trifectas. In the election we didn't see a huge shift in the number of trifectas, but they're still extremely large. So prior to this election, we had 37 state trifectas. We now have 39. That's 22 fully controlled Republican state governments, and 17 fully controlled Democratic state governments. And why does that matter? It matters because as we're seeing gridlock in the federal side, we're not seeing it in the state side. You have state legislatures that typically, for the vast majority of states, only are in session for about six months and legislation moves extremely rapidly.
And when you're dealing with one party control, things can move quickly. And we've seen over the last few years, as we've seen more and more gridlock in the federal level, the states used to be more of incubators for federal policy, incubators for policy ideas. We're now seeing actual real policy coming from the states and growing across the country in state governments when it's never even being touched at the federal level. So we're really seeing significant changes in policy at the state level.
One other thing I'll mention in the states is specifically in California and Florida, we had saw Newsom in California and we saw DeSantis in Florida win very large majorities in terms of their own vote, and they sit in super majority states now, in terms of the legislatures. Again, you should see them pushing into the national conversation because they were going to be able to pass legislation with a national attention profile around a lot of issues that are important to both parties, obviously, the Florida state legislature and governor being Republican and California being Democrat. So we're keeping our eyes very close on those two states.
Michelle, sticking with you, geopolitics has obviously been a very big focus this year, given the horrible war in Ukraine and the continued tensions with China. What do you think we could see from the new Congress when it comes to geopolitics?
I think one of the biggest changes is going to be just the attention that's played on Biden administration's handling a foreign policy by a new house Republican majority. The biggest change that we see in terms of the house flipping over to the Republicans is what we call the change in gavels. That means that you're going to have committee chairmen who are now Republicans and are going to have different agenda and be able to push different messages than we saw under Democratic control. And one of those agenda items is going to be oversight of the Biden administration and specifically, oversight of how they're handling foreign policy. I would look for oversight in some of our more challenging geographic regions, including Asia, the Middle East, Russia. I think you're going to see investigations around the Biden administration's handling of the withdrawal from Afghanistan.
And then specifically on China, the House Republicans have already talked about standing a select committee on China. I think there's going to be a huge focus around US competitiveness toward China, and that will probably get some bipartisan support in terms of looking at how the United States can position itself in a good competitive way against China. Finally, I would mention the war in Ukraine. I think that that is going to continue to enjoy support from Congress in terms of helping fund it, but there is a little bit of fatigue around spending the level of funding that we've seen towards that effort. It's not going to happen tomorrow where you're going to lose support for funding it, but we are seeing fatigue as government spending becomes under more screened in this new Congress.
Now that the midterms are behind us, the focus seems to be shifting almost immediately to the 2024 presidential election. Are we expecting another Biden versus Trump contest or what else do you think might happen?
I think Trump is clearly planning to announce this week that he is going to run for president. Whether he prevails in the primary, I think is still a big question. I think this election, one of the big takeaways was that his candidates didn't do quite as well as some might have thought. He had his base still turn out, but above that 40% base that's always with Trump it seems like, the types of candidates that he support did seem to lose some support. On the flip-side, DeSantis, who is running a Trump-like platform, but without some of the very specific Trump characteristics, DeSantis did very well. Not only did he do well for himself, Republicans did very well in Florida, partly carried by his coattails. So not sure that Trump does get the final nomination. DeSantis is going to be a very credible opponent if and when he does decide to run, and I think there's a lot of names also that probably haven't come out of the woodwork quite yet.
If you look back into past elections, even going back to 2014, you probably wouldn't have predicted that Trump would've been the winner of that presidential. He really wasn't on anyone's radar. So as we're looking at candidates that are the top of mind names, but sometimes the candidates that emerge later in the process actually have more success because they haven't been taking arrows for quite as long as some of the front runners do.
On the Democratic side, I don't think we'll know whether Biden's going to run until later next year. I think it's possible, especially after Democrats had a pretty good election considering expectations last week, but I'm still not convinced that he runs. In terms of who could run on the Democratic side, I'm looking at a lot of governors like Hogan from Maryland, from Pete Buttigieg, who's the transportation secretary. I think there's a lot of names on the Democratic side still to come out. Kamala Harris, I'm sure we'll put in her name, but I'm not quite sure she'll end up prevailing in a primary.
Okay. And Meera, just turning back to you for our final question here. When it comes to markets, how did the markets react to the midterm results? And do you think there are any further risks to investors from presumably congressional gridlock for the most part, over the next two years?
Last week, markets rallied 5.9% during election week. But I do want to note that there was a lot going on under the surface here, and a lot of it was completely unrelated to midterms, which is why in four years time when we have another midterm election, let's take all these stats about market performance after a midterm election with a grain of salt. So last week, what did we see? First, leading into the election, we had this nice little pre-election rally in anticipation of divided government, but then the day after the election, markets sold off about 2.1% on the S&P 500. Now again, two reasons behind this. One related to the election, one not.
One, I think that markets don't like surprises and they don't like uncertainty. So the fact that we were surprised with not getting a red wave, I think factored into things. And also, there was uncertainty about the results, which are still being tabulated. But unrelated, we also had a big crypto meltdown that Michelle alluded to earlier, and I think that really spooked markets. Then the very next day, we saw one of these strongest days in the markets since April, 2020 because we had a softer CPI print. Now we know the Fed's watching CPI very carefully and different data coming in because that's how they're going to decide when's the stopping point of their rate hiking cycle. So that gave investors just a bit of optimism. But I think that's very instructive of how to think about returns over the next quarter and into next year. The Fed is the signal, the midterms are the noise. You can see how quickly any jitters or optimism or enthusiasm or upset about the midterms faded once we started to get more economic data.
And I think that if we look back at the past of midterm election years, the fourth quarter's almost always a pretty positive and strong quarter in a midterm election year. The two notable exceptions in recent memory were 2018 and 1994, and those are very instructive for this year because those were years in which the Fed was wrapping up a rate hiking cycle. And that's what we're facing right now. So that's going to continue to drive returns going forward.
Now, if we think about just the broader next two years in light of divided government, that's probably going to be a good thing as it has been in the past for the economy, for markets, of course, for deficits, when we think about spending overall being reigned in. So it should result in policy really taking a backseat overall. As Michelle mentioned, the two things that have to get done, we have to continue to fund the government over the next two years and we have to see some movement on the debt ceiling, so you could see some market jitters around those issues. But for the most part, again, I don't think policy is going to be as front page as it has the last two years.
But more broadly, I would say people are coming out of the midterms, some people feeling good, some people feeling bad about the results. But what we've seen over the long run is that markets, the economy tends to thrive irrespective of who is in the White House, of what the configuration of Congress is. So we do want to encourage investors to remember, don't let how you feel about politics overrule how you think about investing.
Well, that's a good note to end it on. So thank you, Meera. Thank you Michelle. And thank you all for listening. Please tune into our next episode where I'll be joined by Bob Michele, CIO and head of our global fixed income currency and commodities group, for conversation on the outlook and opportunities in bond markets after this year's surge in yields. Until then, I invite you to read or listen to my notes in the Week Ahead podcast where every Monday, I share commentary on the latest in the markets and the economy to help you stay informed for the week ahead. For even more timely insights, you can follow and subscribe to my content on LinkedIn.
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