2022 Election perspectives:
potential fiscal policy, monetary policy, and capital market responses
December 29, 2022
The 118th Congress convening on January 3, 2023, will see a two-seat majority for Senate Democrats and a nine-seat majority for House Republicans. What does such a divided Congress portend for fiscal and monetary policy, and how may the capital markets respond to such an election outcome?
The Mather Group, LLC (TMG) believes there are three important points to share arising from the 2022 election outcome.
- The incoming 118th Congress may have to cease advancing expansionary tax and spending programs. More limited fiscal initiatives, such as expanded retirement planning programs, may have to suffice.
- The Fed is now enacting stronger monetary policies to alleviate current inflationary pressures, as well as shrinking its pandemic-linked balance sheet. These actions may have adverse effects on the economy but will add further constraints to future Congressional spending.
- Prior market responses to midterm elections, while obviously not predictive of future results, offer investors a significant historical perspective.
This report explores in greater detail potential linkages between future policy initiatives and the markets.
What tax legislation might be under consideration in the 118th Congress? As shown in the graphic below, two major constraints on potential tax legislation will be the growing level of federal debt and the rising interest expense resulting from such debt. More specifically, while federal debt as a percentage of U.S. gross domestic product (GDP) has declined from its peak level at the outset of the COVID pandemic, it still exceeds 120% of GDP.
As our debt has increased, its annual interest expense has grown in parallel, and now exceeds $480 billion, or 7% of the entire federal budget. Unfortunately, it will continue this growth trajectory as older, lower-yielding Treasury bonds are replaced in the future with higher-yielding ones.
Fiscal Policy
With these potential fiscal constraints in mind, several fiscal policy initiatives affecting households were passed during the final days of the 117th Congress. More specifically, both parties had focused on expanding retirement savings programs, with the House passing its Securing a Strong Retirement Act (SECURE 2.0), and the Senate offering its Enhancing American Retirement Now Act (EARN). Many elements of these two bills overlap, and a compromise bill was reached, leading to changes for existing retirement plan participants that include:
- Further delaying required minimum distributions (RMDs) from tax-deferred assets, now required to begin at age 72, to rise to age 75 by 2032.
- Allowing the purchase of qualified longevity contract annuities (QLACs) within 401(k) plans and individual IRAs. The RMD age threshold for a QLAC would rise further to age 85, and existing funds within retirement plans used to purchase a QLAC could help to reduce RMD withdrawals in future years.
- Increasing 401(k) and 403(b) plan catch-up contribution limits to $10,000 per year for individuals aged 60-63, from the current levels of $6,500 for a 401(k) and $3,500 for a 403(b).
- Indexing the catch-up contribution limit for IRAs (currently $1,000 for individuals over age 50) to the annual inflation rate. This level has not changed since 2006, while inflation has risen by 48% in that time, effectively reducing the catch-up value of $1,000 to just $669 today.
Other tax initiatives desired by the individual parties appear less susceptible to bipartisan support, and the likelihood of their passage is uncertain. These include, for example, a renewal of the Enhanced Child Tax Credit of $2,000-$3,600 per child, which expired in 2021. Overall, barring a severe economic downturn or a significant natural disaster, any joint tax legislation arising in the 118th session of Congress may occur only on the margins.
Monetary Policy
Turning from fiscal policy to monetary policy, what might be the effect of the recent election on Fed policy? Let’s begin by looking at the paramount concern of the Fed today—inflation. During the early days of the pandemic, the administration and Congress undertook a significant level of stimulus spending, directed at both businesses and households. The sums included $6 trillion advanced through Congressional spending bills, and another $1 trillion offered directly by the administration.
Given that these sums had to be funded by deficit spending through the issuance of Treasury bonds, the Fed stepped in by purchasing $5 trillion of Treasuries and another $1 trillion of mortgage-backed securities to support the housing market. These securities were then added to the Fed’s balance sheet, raising its pre-pandemic level of $4 trillion to $9 trillion.
The graphic shown below identifies a potentially significant linkage between Fed balance sheet growth resulting from prior fiscal stimulus and subsequent inflation. While many causes of this recent inflationary surge have been offered—e.g., supply chain blockages and geopolitical strife—the Fed’s injection of $6 trillion of funds into the economy may have had a significant effect as well. While the Fed’s balance sheet size, the inflation rate, and the Fed Funds Rate moved in parallel prior to the pandemic, these diverged strongly once the Fed’s balance sheet surged.
More specifically, inflationary growth began exceeding its pre-pandemic level by March 2021, although the Fed labeled such growth as “transitory.” The Fed began an accelerated increase to its Fed Funds Rate in March 2022, which continued throughout 2022 and is expected to continue into mid-2023. In addition, the Fed began unwinding its bloated balance sheet through a $95 billion combined monthly sale of its Treasury bonds and mortgage-backed securities. This balance sheet runoff should suggest strongly to the incoming Congress that any substantive spending initiatives can no longer be funded through deficit spending via Fed Treasury bond purchases.
While a return to the Fed’s 2% inflation target is the objective of these actions, the economic costs have been substantial. For example, 30-year fixed mortgage rates have risen from 4.16% in March 2022, when the Fed began raising rates, to 6.64% in mid-December. Existing home sales, as one result, fell in 2022 from an annualized rate of 5.75 million in March to 4.43 million in October, a 23% drop. The future effect on unemployment has yet to be determined, but, if it rises as expected, the political pressure on the Fed may only increase.
Capital Markets
With the shift in party leadership for the 118th Congress, as well as the Fed's ongoing policies seeking to tame inflation, what might be their resultant impacts on our capital markets? While past market performance does not guarantee future results, it is interesting to review the market performance of the Standard and Poor’s 500 Index (SPX) after the 15 midterm elections that have occurred since 1962. (Note, the results shown in the table below include those outcomes through the 2018 election only.)
Among the many numbers found in this table, it is interesting to note that, on average, the SPX fell by 1.0% in the 12 months prior to each midterm election. However, in the aftermath of each midterm election, the average SPX total return was 7.3% during the following 3 months, 15.1% during the following 6 months, and 16.3% in the 12-month period after these midterm elections. These post-election returns were higher, in fact, than for similar time periods when a midterm election had not occurred. Apparently, midterm election results often boost investor outlooks, irrespective of which political party prevails.
TMG continues to employ its risk management tools in response to these inflationary and political trends, and clients who continue to adhere to their financial plan will maintain the strongest pathway through this uncertain period. Your trusted TMG advisor is ready to respond to any questions or concerns you might have, and to help ensure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.
Sources: Bank of International Settlements; Bloomberg; Bureau of Economic Analysis; Bureau of Labor Statistics; Congressional Budget Office; Federal Reserve Bank of St. Louis; Federal Reserve Board; Goldman Sachs; International Monetary Fund; KPMG; Mortgage Bankers Association; National Association of Realtors; Statista; US House Ways and Means Committee; US Senate Committee on Finance; US Treasury; Wall Street Journal; World Bank
The Mather Group, LLC (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov, or on the firm’s website at www.themathergroup.com. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG’s research and professional experience and are expressed as of the publishing date of this communication. All return figures and charts shown are for illustrative purposes only. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice. Investing involves some level of risk. Past performance does not guarantee future results.
An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Please feel free to contact us for additional information on any indices mentioned.
Indexes
- Consumer Price Index (CPI): The CPI is a measure calculated monthly by the Bureau of Labor Statistics that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
- Standard & Poor's (S&P) 500: A stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.
