BY MONTAG
The 2016 presidential race begins today.
As we put mid-term elections in the rearview, we move quickly on to the new legislative landscape with all eyes on 2016. What can we expect for these next two years? Policy uncertainty has fallen below pre-2007 levels and the “fiscal drag” – the headwind caused by declining government spending – is fading. Ironically, the hard fought battle for control of the United States Senate does not have as much impact on the markets as one might expect. But as we move out of mid-terms, expect to see more compromise in Washington (everything is relative!). Now that the Republicans control the Senate, we should see some legislation get through Congress and to the president’s desk. Senate Republicans are notably more moderate than their House compatriots, which may help pave the way for legislation that is palatable to the president. And the next two years is the last opportunity for President Obama to build/enhance his legacy.
At this juncture, for the first time in over 30 years, U.S. businesses are shutting down faster than new ones are being created. Washington needs to make some changes.
Five Key Issues are expected to dominate the political headlines, and potentially impact the market over the next two years. These are Tax Reform, Immigration, Healthcare, Energy and Defense.
TAX REFORM
The tax debate begins today. More than 75 expiring tax cuts need to be extended (or not) ASAP, so the IRS and tax professionals can prepare for the filing season. These tax provisions include business breaks (bonus depreciation, increased expensing, and R&D tax credit), as well as many individual tax breaks (itemized deductions for state and local tax, some charitable donations, educational expenses). Look for pharmaceutical and tech companies in particular to be impacted by whether R&D tax credit is extended. There is a bill on the table, the EXPIRE Act (Sen Wyden, D, OR), but it faces Republican pushback due to a $13 billion tax break for wind power.
Although not as time-sensitive, corporate tax reform is also needed to more fully address inversion. Inversion is the process by which U.S. companies acquire a foreign firm and then move their headquarters overseas to avoid U.S. taxes. At risk as tax reform is debated is the municipal bond interest exemption. President Obama’s recent budget request proposed capping the value of that exemption at 28%. Rep. Dave Camp, Republican Chair of Ways & Means, similarly has proposed a 10% surtax on muni interest for high earners – so it is coming from both sides of the aisle. The optimistic view is that any corporate tax reform that is accomplished by increasing individual taxes (even on wealthy muni bond holders) is likely unpalatable to politicians.
IMMIGRATION
A second area of emphasis is immigration. Contrary to popular thought, immigration reform is a bipartisan concern. An estimated 62% of Americans support a path to citizenship, and more than half of Republicans support some form of amnesty. President Obama has indicated that he may act unilaterally on immigration reform following mid-term elections, but he may decide that path is not necessary and might impair potential compromise on other issues.
Many U.S corporations would like to see constructive immigration reform; perhaps no industry more than Technology. The U.S. does a tremendous job educating top STEM (science, technology, engineering and mathematics) candidates, but does not currently have a path for foreign students to stay and work in the U.S. after graduation. If you have visited Northern California over the past year, you may have seen the billboards advertising jobs in Canada. The signs read “H-1B Problems? Pivot to Canada!” These top high-tech students educated in the U.S can just head north to find hassle-free visas and lower taxes.
HEALTHCARE
The next issue, which is not a new one, is healthcare. Even with Republicans taking control of the Senate, major changes in the Affordable Care Act (Obamacare) are unlikely. One sector that may benefit, however, includes medical device companies, because the controversial Medical Device Tax could be repealed. This is a ‘gross’ tax, which is not an editorial comment; it’s an accounting term. It is a tax that is applied to gross sales, not profits, so that even if a company is losing money on an innovative new medical device, it will still pay this hefty extra tax of 2.3%. Stocks of companies in this sector could outperform if this repeal looks like it has a reasonable shot. There is also likely to be a push to expedite drug and medical device approval through the Food & Drug Administration (FDA). So although healthcare companies are typically expected to outperform if Democrats lead, they may do well in this two year period either way.
ENERGY
Another issue at the forefront the next couple years is energy. It is likely that the U.S. ban on crude oil exports may completely end, or at least loosen further. There are already some exceptions, and production in the U.S. is up significantly. Our trade deficit is improving as we produce more energy domestically; there is a very real tradeoff between our increased production and lower imports. Approval of the TransPacific Partnership is also very possible, and would further benefit energy companies. The Keystone Pipeline has a comfortable range of support now and should get approved in this two-year period.
Why would President Obama consider going against some in his party to increase oil production and exports? Three reasons: 1) It would further boost the U.S. economy; 2) It could help our allies, South Korea and Japan, who need new energy sources; and 3) It would pressure Iran and Russia by depressing global oil prices. Russia needs an estimated $110/barrel Brent Crude to break even on budget. Brent is currently trading at $82/barrel. Keeping the price low by increasing world supply essentially puts Russia in fiscal hardship. And that is a very good thing. The potential benefit for our domestic economy is undeniable. Energy-focused states are driving U.S. growth as it is; recently housing starts in the city of Houston, Texas nearly equaled starts for the entire state of California.
DEFENSE
A final area of political/legislative emphasis is defense. This sector may benefit more with a Republican Senate, but spending was likely to increase either way due to geo-political events of the past six months. These hotbed areas are likely to remain a concern over the next couple years and prior deep defense spending cuts may be reconsidered. Even conservative legislators have been more influenced by ‘deficit hawks’ versus ‘defense hawks’ and consequently supported defense spending cuts in recent years, but the tide of public support is turning as Russia, Iran, Iraq, etc. dominate headlines.
EXPECTATIONS
So, what do we expect from the economy, politics and the markets over the next two years? There are several reasons to be optimistic. First, the S&P 500 has not declined over the twelve months following a mid-term election since 1946. In fact, performance on average has been very strong – average +16%. What is the reason behind this outperforming record? A few things: an end to Uncertainty, a general air of ‘political risk aversion’, and increased compromise. As the focus shifts to the general election in 2016, both parties may move to center and bipartisan collaboration is more likely.
