A blue wave or a blue swell?

Two months ago, financial markets celebrated when the U.S. election appeared to yield a divided federal government in the U.S., with Democrats taking the White House and Republicans seemingly on track to keep their Senate majority. Now, following two Senate runoff races in Georgia, that equilibrium is being thrown off-kilter, with Democratic candidates Raphael Warnock and Jon Ossoff defeating their Republican opponents. The Senate will be split 50-50, with Vice President-elect Kamala Harris holding the tiebreaking vote – effectively giving Democrats a majority.

But the key word for investors to focus on here is “effectively.” As stunning as these come-from-behind wins are in a traditionally Republican-led state, the net result could be less disruptive than feared. The process of implementing policy is long and nuanced, and while the Senate majority will make it easier for President-elect Joe Biden to push through his agenda, Senate procedural rules will limit Democratic ambitions. Thus, rather than a blue wave crashing into the economy, the election results might be better thought of as a blue swell.

A majority forced to compromise

So, what are the potential implications of this swell? To start, Democrats could more easily achieve key aspects of their agenda, such as stricter regulation, higher taxes and clean-energy spending. But given the slim majority in the Senate and a similarly narrow lead for Democrats in the House, compromise will be necessary. Senate procedural rules require 60 votes to end a filibuster.¹(The one exception is legislation related to the budget, which only requires a simple majority through a process known as reconciliation.) Even then, within the Democratic Party, views vary widely. Sen. Joe Manchin III, a Democrat from West Virginia and well-known centrist, has said he will not support doing away with the filibuster or packing courts. His vote and that of other moderate senators, including Republicans such as Susan Collins of Maine and Mitt Romney of Utah, will be key to passing legislation. “It behooves everybody to start working together,” said Sen. Manchin in an article with the New York Times in late November.

To be clear, partisan fighting is far from over. But if compromise can’t be reached through debate, it could be forced. Take health care reform. While progressive Democrats have pushed for a dramatic overhaul of the U.S. medical system with proposals such as Medicare For All, such legislation would require the 60-vote supermajority to pass – a slim prospect. As such, reform could center on more achievable goals, such as improving the decade-old Affordable Care Act. To do so, the Biden administration may, for example, revise waiver approval criteria that would expand Medicaid programs in states and possibly lower the age for eligibility (potentially benefiting managed care companies that administer such programs).

With more compromise, some aspects of the Democratic agenda could also be tempered. We do not believe Democrats want to be viewed as the party of more “red tape” and will find it both easier and more appealing to their base to be focused on advancing infrastructure spending, clean energy and other social programs. While this does raise the specter of higher taxes, we think tax hikes may be postponed and/or be less than the market fears, as a result of the inevitable compromises and the challenges the global pandemic still presents to economic growth.

Speaking of growth, we do think the Senate election could result in more fiscal stimulus. Democrats broadly support additional stimulus and even some Republicans could get on board after President Trump’s recent efforts to champion $2,000 stimulus checks for individuals. But we also expect the total stimulus package is unlikely to match the highest headline estimates and may prove to be more targeted and, thus, more favorable for the long-term growth prospects of the economy.

Market implications

U.S. stock indices have largely reacted positively to the election results, with the Dow Jones industrial average notching the largest gains and the tech-heavy Nasdaq Composite Index initially selling off before paring losses. These moves are not surprising: Infrastructure spending and other fiscal stimulus would benefit economically sensitive sectors such as industrials and materials. A boost to growth could raise the prospects for higher inflation, putting upward pressure on rates and benefiting areas such as financials (as higher yields can boost profit margins). Conversely, higher rates would make the future cash flows of fast-growing tech companies less appealing, while the tech sector could also face stricter data privacy laws and other regulation.

However, with the Federal Reserve committed to ultra-accommodative monetary policy for the foreseeable future, rates are unlikely to move substantially higher in the near term. At the same time, secular trends such as digitization of the economy continue to gain momentum. Thus, going forward, we could see wider distribution of equity gains, with both growth and value stocks (companies whose growth tends to be tied to the economic cycle) participating in market rallies. This widening of returns would be a welcome shift from the narrow markets of 2020, when gains were often concentrated in large-cap tech companies and valuations became distorted. Stocks hit hard by pandemic-related lockdowns and slower growth could finally begin to recover.

U.S. Treasuries also anticipate a recovery, with the 10-year yield breaking above the psychologically important level of 1% the night of the election. However, the 10-year yield rose nearly a quarter of a percent in the fourth quarter of last year as the market priced in increasing optimism about an economic expansion and fears of higher inflation. This trend toward higher yields, and a steeper yield curve, could well persist through the first half of 2021, as additional fiscal stimulus coincides with higher year-on-year inflation resulting from particularly low inflation in the first half of 2020. But in our view, rising inflation is likely to prove short-lived, given the degree of slack remaining in the U.S. economy and the prospect of higher tax rates.