Stocks recovered much of Monday’s losses yesterday in the runup to the Georgia Senate runoff elections. Those elections are now over. One seat has flipped to the Democratic side. In the other race, with 99% of the vote in, the Democratic candidate leads by about 16,000 votes, roughly the same margin of the Presidential race which has generated so much controversy, court challenges, and recounts. But unless there is a sudden shift or proof of misdeeds, it would appear that once the second race is officially decided, the Democrats will gain control of the Senate. That will mean they will head all committees and Chuck Schumer will become the Majority Leader who controls the agenda.
While some believed such a change would radically alter the economic outlook and cause stocks to crash, early action in the futures market suggests otherwise. Dow futures are actually up in the early morning hours. The tech-heavy NASDAQ is down close to 2% on the notion that Democratic control of Congress will result in tighter regulation of tech companies and higher taxes.
That may be true, but the story isn’t that simple or stark. First of all, regarding oversight of the tech companies, most of whatever lies before us is likely to emanate not from Congress, but from the Justice Department and other Executive branches. In addition, there is no reason to expect overly onerous restrictions on these companies simply because the services they provide are wildly popular. There has been and will continue to be efforts to constrain monopolistic practices like ordering search results in favor of company subsidiaries. But this has been going on for years. Companies like Google#, Apple# and Facebook# have been constantly modifying business practices to mollify government agencies. While oversight might tighten or get a bit more onerous in coming years, the shift will be much more subtle than the worst fears suggest.
As for higher taxes, the Senate has some limited ability to raise taxes within the reconciliation process that only requires a simple majority. If every Democrat signs on, then new legislation can pass. But the pending realities are that both parties are split. The Democrats have a progressive wing, personified by Elizabeth Warren and Bernie Sanders (an independent who aligns with the Democrats) and a more moderate center, perhaps personified by Joe Manchin. At the same time, Republicans have their own traditional conservative wing and a more moderate side with names like Mitt Romney and Susan Collins as examples. Getting 50 Democrats to agree on anything will be a Herculean task. The same will be true for Republicans. Just look at today’s sideshow related to the certification of Electoral College results to demonstrate that point.
That is not to say that a shift in control of the Senate is meaningless. It means a lot in terms of approving judicial appointments. It means more legislation passed by the House will get a vote on the Senate floor. But the real message is that to get anything done, bipartisanship will have to return.
There are many who scoff at that notion. The past two majority leaders, Harry Reid and Mitch McConnell, ruled with iron fists. Leadership controlled the agenda. Everyone beneath simply signed off yea or nay. While that may be a bit of an overstatement, it isn’t overstated by much. If there is any hope of getting legislation accomplished, the right wing of the Democratic Party and the left wing of the Republicans have to talk. Not only must they talk, they will have to lead. There already is such an entity in the House, the Problem Solvers Caucus, 48 members equally divided between the two parties. They were a major factor in bringing forth the most recent stimulus bill that had seemed dead in the water for so long. Joe Biden is a traditionalist at heart. He wants to work with a center coalition if it can be effective moving legislation forward. To find a dozen Senators, six from each party, who want to work to find common ground, isn’t a stretch.
Maybe something as formal as the Problem Solvers Caucus won’t emerge in the Senate. But given the need for bipartisanship to get anything meaningful done, success will have to come from the center. Which leads to the question, where might common ground be found?
Let me start by stating what won’t happen. All the hysteria propagated by both liberal and conservative media during the campaign like ending filibusters, expanding the Supreme Court, etc. have virtually no chance of getting anywhere. Biden’s first mission is to deal with pandemic issues, both in terms of health care and the economy. Faster vaccine deployment and support for those businesses and people displaced by the pandemic will be priority one. From there, the smart move is to focus on the least controversial agenda items. Those might include funding infrastructure, rebuilding research budgets, protecting against future pandemics, and yes, some tax increases. But these would be moderate and targeted. Biden has pledged to not raise taxes on those earning less than $400,000. That isn’t a pledge he will break on Day One. Will rates rise for those with higher income? Some increases are more likely today than they were before the Georgia runoff. But sharp increases in corporate taxes are not likely. Once again, getting 50 Democrats to agree on anything won’t be a simple task.
Back to the markets, the reason tech stocks look to open lower while the Dow opens higher may not directly relate to onerous regulation and higher taxes. Instead, it most likely relates to rotation within markets. Biden, fundamentally, will be a bigger spender with control of both chambers of Congress. Again, think of shades of gray, not stark black versus white. That means more fiscal stimulus. If that occurs it means the Fed will not need to be as stimulative. It also suggests faster GDP growth in the near term. With the likelihood that the pandemic will wane as the year progresses, the economic outlook for a robust economy improves. Economic acceleration strongly favors cyclical companies tied to the economic cycle. Money will follow that trend moving toward stocks of companies that will benefit from faster near term growth. Since that money has to come from somewhere, a logical place would be the high flying tech sector that may have gotten overvalued. Hence the rotation.
There is another factor in play that reinforces such rotation. Faster growth suggests inflation may be higher in the future than it would otherwise be without fiscal stimulus. This morning the yield on 10-year Treasuries has crossed 1% for the first time since March. Rising rates ultimately lead to lower P/E ratios. They also lead to P/E compression. That further supports a rotation to value and cyclical stocks, away from speculative names that sport little or no earnings.
Growth stocks have been persistent outperformers since the Great Recession. Such persistency is unprecedented. It doesn’t mean growth stocks are dead. But rotation, should it endure, suggests that leadership may rotate. With that said, earnings are the ultimate driver of stocks. Leadership companies need to generate greater earnings. In an accelerating economy, cyclical companies will have a lot of operating leverage to do just that. As investors, the focus should be on quality cyclicals that can lead the economy upward. By sector, this would include industrials, housing, transportation, banks, energy and other basic materials.
Rotation isn’t always smooth. There can be disruptions. We haven’t seen a 10%+ correction since last March. I can’t suggest a trigger, but when one occurs, it will most likely be short, violent, and scary. But long term positions need not be disturbed. As long as the economy continues to grow, any decline won’t endure.
One final point. The U.S. is growing its money supply twice as fast as Europe or China. That is reflected in a weak dollar and the rise in the price of gold. The beneficiaries will be multi-national companies with lots of earnings overseas, and commodity producers. The latter suggests emerging markets may do very well over the next year.
Today, Eric Trump is 37. Actor Eddie Redmayne turns 39.
James M. Meyer, CFA 610-260-2220