A divided Congress is likely to mean policy gridlock for the Biden administration, though the direction of monetary policy will be of more significance to markets
US voters went into November’s midterm elections worried about the economy and inflation. Within days, we had further evidence of slowing consumer prices and a shifting political landscape. The Biden administration’s next two years in office will face more challenges with a split Congress: the Republicans now enjoy a thin majority in the House of Representatives while the Democrats keep control of the Senate.
The Democrats’ performance was much better than expected. The president’s party historically loses seats in the midterms, and Joe Biden’s low approval levels were expected to weigh on performance. A summer boost to the Democrats’ chances following the passage of the Inflation Reduction Act (IRA) and the Supreme Court decision on abortion was thought to have faded. The Republicans were expected to see significant gains on a number of concerns – not only on the economy and inflation, but also crime and immigration. Yet the Republican Party, and particularly candidates favoured by former president Donald Trump, underperformed expectations of stronger gains.
Policy gridlock
The key impact of a divided US Congress will be greater policy gridlock. There will need to be more bipartisan compromise, on areas from defence to reducing supply chain dependence on China. Still, there is already broad agreement on the latter, and we do not expect significant changes in taxes, environmental legislation or technology firm regulation following these elections.
We do expect a tougher line on fiscal discipline from a Republican-controlled House, including curbs to any stimulus the Democrats might seek to launch during the coming recession. Tighter control over fiscal spending may raise the risk of government shutdowns, should Congress not renew annual government funding, which typically falls around October (and 16 December this year). Republican gains may also see more opposition to US military and financial aid to Ukraine.
A thin Republican House majority will reduce the risk that the party uses the US debt ceiling to try and force the Democrats into spending cuts and concessions. Republican Patrick McHenry, the likely new chair of the House Committee on Financial Services, has highlighted the risks of using the ceiling as a bargaining chip. We believe the chance of a technical default is very slim. Democrats are reportedly discussing ways to raise the ceiling – potentially as far as 2024 –before a new Congress is sworn in.
That said, the Democrats have frontloaded many key policy initiatives and stimulus into their first two years, including the IRA, almost $1.9tn in spending on infrastructure, clean energy and semiconductors, drug pricing and Medicare reform, and changes to heads of regulators and other agencies.
The Biden administration’s next two years in office will be marked by little legislative progress. The Republicans may launch probes into Democrat actions. However, poorer-than-expected results for the Republicans, and a resounding win for Republican rival Florida governor Ron DeSantis, may complicate Mr Trump’s run for the 2024 presidential elections.
Avoiding monetary mistakes
The bigger market driver of course remains the trajectory of US monetary policy. Markets saw outsized gains on 10 November, after October data reinforced the idea that US inflation may have peaked, adding to justifications for the Federal Reserve to slow its pace of rate hikes, a change in approach the central bank had already signalled at its November meeting. With more time and data to better assess the impact of hikes, we are more confident now that a monetary policy mistake can be avoided.
For now, pressure remains on the Fed to tighten policy. The labour market is still very tight and wage growth uncomfortably high. We expect a 50 basis points hike at the December meeting, and lower increments in the opening months of 2023, to take rates to a peak of around 5 per cent. This is still a material tightening of financial conditions, and we expect three tough quarters ahead for the US economy and real GDP growth of just 0.7 per cent in 2023. A first half recession may see unemployment rise to around 5 per cent.
In terms of our portfolio positioning, we have recently increased our exposure to US Treasuries, where we are now overweight. We also retain our overweight to the dollar, where we expect current strength to continue in the months ahead, in light of liquidity tightening, global growth slowing, rate differentials, and the US’s terms of trade advantage.
Meanwhile, we remain underweight in US equities, favouring quality stocks and the healthcare and energy sectors within our holdings.
Stéphane Monier is chief investment officer at Bank Lombard Odier
