OCBC OneWealth App– When blue brings joy

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Georgia Senate runoff elections

When blue brings joy

5 January 2021

Georgia on my mind

Raphael Warnock and Jon Ossoff, the Democratic hopefuls in the race for Georgia’s two Senate seats, are keeping hopes of a blue wave alive. Both Democratic candidates must emerge victorious at the polls on 5 January (US time) if the Democratic party is to wrest control of the Senate from Republican hands.

Currently, Republicans control 50 seats in the 100-seat chamber, while Democrats occupy 48 seats. Winning the 2 seats in Georgia means Democrats will have 50 seats as well, but because they control the White House, Vice President-elect Kamala Harris wields the tie-breaking vote. As a result, the potential outcome of the Georgia Senate runoff, have caught the market’s attention.

Recent market jitters reflect many things: concerns about the spread of a more contagious strain of Covid-19, worries of another spate of severe lockdowns, profit taking after a record 2020 market run and nerves about a potential blue wave outcome should Warnock and Ossoff succeed in winning their respective races, hence giving Democrats control over all levers of power: the White House, the House Representatives and the Senate.

Having both the legislative and executive branches of government unified under one political party theoretically increases the probability of sweeping changes to policy. This would not matter much to markets if Joe Biden had campaigned on an overtly market friendly, pro-business agenda. Surprise, surprise, not all the line items in Joe Biden’s policy agenda is particularly market friendly. There are proposals to reverse President Donald Trump’s tax cuts, which would essentially raise the corporate and personal income tax rates, alongside other more politically progressive proposals, including increasing the minimum wage, imposing a financial transactions tax and strengthening oversight on various industries.

Concerns about higher taxes are valid

The control of the Senate provides flexibility for the Biden administration to pass significant spending bills and change the tax code via the budgetary reconciliation process. Essentially, through this procedure, bills that are primarily fiscal in nature can be passed with a simple majority in the Senate. In fact, the Republican-controlled Senate used the reconciliation process to pass President Trump’s signature tax cuts in 2017. If the Democrats control the Senate, they could very well use the same procedure to reverse it. As such, market concerns about potential changes in the tax rate are valid.

However, focusing squarely on the threat of higher taxes alone misses a broader point. After all, tax revenue appears on just one side of the fiscal ledger. Aggregate spending also matters, especially in a demand deficient economy (check your Keynesian textbooks). In this case, on aggregate, the net effect of Biden’s fiscal agenda is expansionary as tax increases will be used to fund a significant increase in federal spending for clean energy, infrastructure and Covid-19 relief. What’s good for the economy should therefore be good for the markets.

Also, it is still unclear if changing the tax code is a year-one policy priority for the Biden administration. For starters, stalling economic recovery and the high unemployment rate may discourage the Biden administration from pursuing any legislation that might hurt business sentiment, at least not until the economy is on more stable ground. In addition, changing the tax code is a complicated affair and may not be passed immediately, given other legislative priorities. This could buy the market some time. Of course, these are just speculations. Clarity will come with time.

Meanwhile, there are limits built into the reconciliation process to curtail its use. For one, it is limited to just one spending or revenue bill per year and the bill cannot increase deficits outside the 10-year budget window. Working within these confines and adjusting the bill to win over the support of centrist or moderate Senators (i.e. the marginal voter or the 51st vote) would necessarily result in a scaled down or less ambitious tax and spending plan.

Essentially, the market will get over the “sticker shock” as the process of politics tend to whittle down the most ambitious of plans. Just look at the current dysfunction in Congress for evidence. It’s naïve to think that one election could upend what has been business-as-usual for years.

The dreaded F-word

Beyond the budget, Democrats will face an uphill task in passing meaningful policy reforms because, in the best of outcomes, they will only enjoy a razor thin majority in the Senate. This means the dreaded f-word – filibuster – becomes all the more important to Senate Republicans. The party in the minority position can always make use of the filibuster – any action such as a prolonged speech that obstructs progress but technically within acceptable procedure – to debate a piece of legislation endlessly, hence delaying or preventing a vote on a bill. The Senate requires 60 votes to end the filibuster or cut off debate on most measures and force a final vote on a piece of legislation.

In an ideal, non-partisan world, Democrats and Republicans should be able to negotiate and compromise on a final bill that receives ample bipartisan support, such that it organically ends the filibuster. Alas, this is political fantasy in the modern era. Voting along partisan lines will likely remain a fixture of the current political climate.

As such, even in the best of scenarios, Democrats will not be able to block the filibuster unilaterally and will have to work across partisan lines to push through meaningful policy changes, especially in the areas of regulation, which is not covered under the reconciliation process. Minimum wage, anti-trust legislation, financial regulatory reforms and energy and environmental regulatory proposals would fall within this category, requiring the endorsement of at least 60 Senators to pass. Consequently, legislation on these fronts will likely be softened to garner bipartisan support. Admittedly, this itself is an optimistic thought amid a deeply partisan climate.

Indeed, if backed to a corner by an uncooperative and obstreperous Republican party bent on blocking major legislation, a Democrat-majority in the Senate could simply trigger the “nuclear option” to override an existing procedural rule with a simple majority. Essentially, with 51 votes, Democratic Senators can eliminate the filibuster procedure entirely, such that they will be able to pass any major policy changes and legislations with a simple majority in the Senate. This already has precedents. The “nuclear option” was triggered by a Democrat-led Senate in 2013 to push through executive branch nominations and judicial appointments. It was later used again in 2017 when a Republican-led Senate sought to push through a Supreme Court nomination.

This is a controversial move as it could lead to erratic changes in policies in future election cycles. Others would argue that the filibuster has been abused to block important legislative action in recent years, hence eroding the usefulness, credibility and trustworthiness of Congress and should be removed if the Democrats gain a sizeable majority in the Senate, the operative word being sizeable. However, with such a small majority in the Senate, it seems rather unlikely that the Democrats would move ahead with such a controversial move. Indeed, few have the political chutzpah to bend procedural rules like the current Senate Majority Leader, Mitch McConnell.

A lot of bark, very little bite

Unfortunately, a blue wave – if it happens – seems to lack the sort of clear mandate that single party election sweeps tend to enjoy in the past (think President Obama in 2008 and President Trump in 2016). As it is, the Democrats were not able to hold on or increase their majority in the House of Representatives during the recent election. In fact, their majority shrunk in the lower chamber.

Even if Warnock and Ossoff are successful, Democrats will still face a razor thin majority in the Senate. At the same time, the Democratic party continues to struggle with the ideological divide within the Democratic umbrella itself. It is a wide ideological spectrum stretching from a Social Democrat like Senator Bernie Sanders all the way to a fiscal conservative like Senator Joe Manchin. In a deeply partisan environment and in a position without a clear majority, the marginal voter will have a great deal of leverage. Corralling such a diverse group together will be an uphill task especially without some margin of flexibility. This political dynamic will doubtless play out in negotiations of important legislation.

In 2020, polls infamously predicted a blue sweep. They could be right after all. We could get a blue wave, but one with a lot of bark but very little bite.

If anything, a blue wave might not be a bad outcome for markets as decisive fiscal action will help to accelerate the economic recovery. This will be broadly bullish for risk assets, particularly equities, credit, commodities, and emerging market securities. Meanwhile, a 50-50 Republican-Democrat Senate mix removes the threat of sweeping legislation on key regulatory issues. After perhaps a short-lived period of volatility should Democrats win Georgia, investors will probably heave a sigh of relief, wondering why they ever viewed a 50-50 Senate as bad news.

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