U.S. policy uncertainty is likely to spike and take a toll on the stock market this year. The election will have significant macroeconomic consequences. But when will investors react?
The S&P 500 is up 16 percent since December 13, when the Federal Reserve implied it would shift toward cutting rather than hiking rates. Excluding the top seven stocks, the market is up 15 percent. Normally, stocks underperform during the first half of presidential election years (see chart).
An obvious negative catalyst would be an extended government shutdown — especially during an election year in which the president has a net approval rating of -16 percent and unemployment is likely to rise.
A shutdown itself would not be a big hurdle for markets, but any further drop in support for the Biden administration would trigger significant policy uncertainty.
Over the past two weeks, investors have started feeling hopeful that Washington will clear the way for the stock market rally to continue.
Two developments are behind the optimism. For one, on January 18, Congress passed a continuing resolution to fund the government. The government will not shut down in February. Republican House Speaker Mike Johnson obtained a majority from his caucus after turmoil last year when backbenchers ousted his predecessor.
Second, tax committees of both chambers announced a bipartisan deal consisting of tax breaks for businesses and an extension of the child tax credit to offer relief to poor families.
Ultimately, however, Congress will not boost the economy, reduce uncertainty, or improve animal spirits this year.
To understand Washington today, investors need to take a geopolitical rather than a merely political approach. The U.S.’s deep domestic divisions are inviting foreign challenges. Without reducing the divisions, the U.S. will struggle to manage the challenges.
Specifically, the U.S. is reaching the climax of a generational struggle over how to distribute the gains of the past 40 years of prosperity. Presidents Joe Biden and Donald Trump represent the last men standing of the baby-boom generation.
Biden and the Democratic Party hope that the incumbent advantage, combined with a soft landing of the economy arranged by the Fed, will enable them to defeat Trump’s anti-establishment movement. They expect congressional gridlock if they win, but they could still tighten federal regulation of business and let taxes rise on the highest income earners next year.
Trump and the Republican Party hope that the economy will slip into recession, as it usually does after monetary policy turns restrictive. They expect single-party control if they win and will aim to keep income taxes low while raising taxes on trade and restricting immigration.
In this context, bipartisanship will falter. Political polarization will retest the post-Civil War peaks reached in 2020.
Consider the appropriations process. The latest deal merely moved the deadline from February 2 to March 8. Johnson passed the measure with a one-vote majority.
His overall majority in the House has fallen to zero — at 218 seats, he cannot spare a single vote — because of retirements, accidents, and expulsions.
A single lawmaker can make a motion to vacate. If Johnson cooperates too closely with Democrats, he will be ousted like his predecessor.
Johnson will need to prove his loyalty to the hardliners before he can pass a bill to fund the government through the election. He can do this by walking away from any unsatisfactory deal, even if that causes a temporary government shutdown.
Past government shutdowns have weighed on the president’s approval rating. Biden has no margin of safety. Democrats will need to compromise by cutting nondefense discretionary spending.
True, shutdowns also weigh on the obstructionist party’s support. But only Democrats can lose both the White House and the Senate in 2024. They have more to lose.
With a shutdown, Johnson’s party will support him in subsequent negotiations. He will have proved his loyalty to the hardline Freedom Caucus, while conventional Republicans will insist that a shutdown cannot last forever.
Hence Democrats will not receive a last-minute boost to federal spending in time to help the economy in the final innings of the election campaign.
At the same time, the bipartisan tax deal would spend $79 billion over ten years but would initially be offset by removing Covid-era tax credits to companies that retain employees. If it passes, it will not stimulate the economy in 2024, though it could increase layoffs on the margin. Any rise in unemployment is certain to harm the administration.
True, there is potential for new fiscal spending in support of Ukraine, Israel, Taiwan, and border security, most of which would be spent within the U.S. But this spending would exacerbate conflicts with foreign powers. So far, Biden’s foreign policy doctrine of solidarity with allies and partners has not delivered for him in opinion polls.
The upside for Democrats is that they can compromise to avoid a shutdown, and a shutdown alone cannot cause a recession. The economy would make up for the lost growth in the subsequent quarter. The Fed will cut interest rates as much as it can, depending on inflation. And stealing Republican thunder on immigration would give Biden a marginal boost among independent voters.
The downside is that a recession may happen anyway. The Fed has never achieved a soft landing before. And Biden’s executive powers are limited. Student loan forgiveness of $4.9 billion will not move the needle.
With a weak approval rating, a softening labor market, and several geopolitical risks — including an escalating crisis in the Middle East — Biden is standing on the verge of becoming a lame-duck president.
It is too soon to make that call. But the stock market will need to correct to capture rising policy uncertainty.
Matt Gertken is chief geopolitical strategist at BCA Research, an independent macro investment research shop founded in 1949.
