Policy, Politics & Portfolios

Topics in this report:

• National implications of the midterm elections
• What’s at stake in the midterm policy debate?
• The state of state elections

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The midterms are generally viewed as a referendum on incumbent leadership. We believe voter dissatisfaction about sticky inflation and a slowing economy is likely to register against the majority party in November.

• Midterms are generally viewed as a referendum on incumbent leadership.
• Our base case for the midterms is for split government.
• We believe divided government coupled with a weak economy and earnings will leave the economy as the main driver of asset prices.

Midterm elections generally play out as a referendum on incumbent leadership, but other factors are in play and will likely attract investor attention this year. With slim majorities in both chambers of Congress, a wide variety of national polls predict that Republicans will retake the House. Considering the heightened divisions — between and even within the two parties — markets will be watching whether the Republicans can retake the House and, if so, with a large enough majority to overcome internal factions.

As for the Senate, we expect that markets will be watching key races in Georgia, Pennsylvania, and Arizona. Voter turnout is invariably key to watch but could be more difficult than usual to predict this year. Turnout historically has been lower in midterm elections than in presidential elections, but Gallup found that 50% are more enthusiastic than usual about voting this year.¹

Whether a single party controls both chambers or one, we see two reasons why the midterm election results may rank lower than the economy as market movers in the coming months. First, divided government traditionally has hampered legislative actions, meaning that government policy on taxing and spending is unlikely to move markets in the coming Congress. Second, and more important, even if Congress could find consensus on economic support, the economy’s strong negative momentum is likely to resist fiscal policy remedies. We expect that the strong prospect for divided government and the trend toward a weak economy and earnings will leave the economy to drive asset prices into year-end.

Moreover, we believe presidential action is unlikely to move policy into first place as a market mover. President Biden has issued 92 executive orders to date and may continue to do so. If the pace continues, the number of orders issued by President Biden by year-end could exceed those issued by Presidents Trump and Obama in their first two years in office at 92 and 74, respectively. But presidential action also has been increasingly likely to face judicial challenges in recent years.²

Nevertheless, some basic contours of the midterm elections are worth remembering. In November, 469 seats in Congress are up for regular election — 34 in the Senate and all 435 in the House. The Senate currently has 48 Democrats, 2 independents, and 50 Republicans. The House currently has 220 Democrats, 209 Republicans, and 6 vacancies. Since 1974, the president’s party has lost, on average, 23 congressional seats in the midterms. But that number has been higher in recent midterm years when the White House and Congress were controlled by a single party. In 2006, Democrats picked up 31 seats; in 2010, Republicans gained 64 seats; and in 2018, Democrats gained 40 seats.³

Not surprisingly, according to Gallup, the top issue for voters today is the economy — 85% of likely voters say the economy is an “extremely or very important” issue.

In recent decades, about 60% of eligible voters voted in presidential elections and 40% voted in midterms.⁴ Low turnout is typically attributed to political disengagement and the view that voting will do little to change policy. More recently, turnout has trended upward.

One factor for the uptrend is young voters. Turnout for 18- to 29-year-olds rose from 20% in 2014 to 36% in 2018.⁵ Younger voters generally lean Democrat and helped reclaim the House in 2018. Another factor has been dissatisfaction with incumbent leaders. President Biden’s approval rating is in the low 40s, and Congress’ stands at 18%.⁶ President Biden's current approval rating mirrors President Trump's in 2018 when Republicans lost 40 House seats. In addition to young voters, engagement extended across racial and ethnic groups, marking the first time since 1982 when midterm turnout exceeded 50%.⁷ High inflation and an economy teetering on recession could persuade disenchanted voters to show up in November.

In the following two sections, we consider how we prefer to think about investment strategy before and after the midterm elections.

We expect a split government after the midterm elections. Our analysis focuses on four policy topics that tie to the economy, the midterms, and investment strategy.

• Tax increases and targeted spending are back on the table in the form of a compromise Inflation Reduction Act filling in for the defunct Build Back Better proposal. The latest proposal focuses on clean-energy tax credits and extended subsidies for Affordable Care Act health insurance, financed by a 15% corporate minimum tax and savings from drug-pricing reforms.
• A seemingly sleepy legislative session has been abruptly revived by the proposed Inflation Reduction Act following close on the heels of a bipartisan $280 billion package of subsidies and research funding for semiconductors and other advanced technology industries.
• Once the new Congress convenes in January 2023, our view is that infrastructure spending may remain the most significant source of investment opportunities from public spending.

We believe that the prospect of divided government after the midterm elections and the short time remaining for Congress to work before November narrow the field of policy options but reinforce particular elements of our investment outlook.

From Build Back Better (BBB) to the Inflation Reduction Act: The Democrats managed an eleventh-hour win a week ahead of their August recess by negotiating a modified Build Back Better bill renamed the Inflation Reduction Act. Stealth negotiations and the timing of the announcement by Senators Schumer and Manchin may have helped in a double win for Democrats, coming on the heels of a $280 billion bipartisan package of subsidies and research funding for semiconductors and other advanced technology.

Our view is that the significance of the Schumer-Manchin compromise is less in its namesake inflation reduction than in its infusion of funds to the renewable-energy industry and in a proposed deficit reduction of over $300 billion, achieved through $739 billion in tax increases and savings that exceed proposed spending increases over the plan’s 10-year horizon. Key features of the Inflation Reduction Act are summarized below:

We believe clear winners under the new act are the renewable-energy industry, likely receiving most of the $369 billion in proposed tax credits, and taxpayers benefiting from drug-pricing reforms allowing Medicare to negotiate with large pharmaceutical firms. However, the impact on pharmaceuticals, overall, would be limited, according to our Health Care analyst in Global Securities Research. Multinationals stand to gain from the absence of earlier tax proposals targeting foreign income. Ditto for small-business owners and wealthy Americans dodging earlier income-tax surcharges under previous BBB proposals. Less fortunate would be private equity and hedge fund managers most exposed to a proposed cutback in the carried-interest tax break allowing a portion of their income to be taxed at the lower 23.8% capital gains rate. Additionally, more than 45 companies, including several multinationals, face a new 15% federal minimum tax if the announced compromise makes it through both houses of Congress.

The bill still has to run the gauntlet of potential opposition from Senator Sinema, a past defender of the carried-interest proposal, and from House members pressing for increased state and local tax (SALT) exemptions. The proposal also will have to navigate favored spending proposals by Republicans and Democrats that would eat into more than $300 billion in savings earmarked for deficit reduction.

Support from the Inflation Reduction Act and the $280 billion tech relief legislation are supportive of our favorable ratings on both the Energy and Information Technology sectors. Multinationals dodging earlier tax proposals targeting foreign income reinforce our favorable rating on high-quality, large-cap U.S. stocks, despite the proposed 15% corporate minimum tax. And drug-pricing reform’s limited industry impact does little to affect our favorable view of the economically insensitive Health Care sector. Likewise, our view is that closing the carried-interest loophole would affect private equity and hedge fund managers, not tax-sensitive investors.

Infrastructure spending: Irrespective of the midterm results, we believe spending from the Bipartisan Infrastructure Law and the existing American Rescue Plan should increase economic productivity and partially cushion the recession we expect. We recently published an in-depth report on infrastructure investment opportunities over the law’s 10-year horizon.⁸

Energy policy: Our view is that intra- and bi-party differences over energy policy complicate a deal to expand fuel supplies, despite recent assurances given to Senator Manchin. Executive orders, such as limiting U.S. energy exports, run the risk of further disrupting global supply and keeping upward pressure on prices. We expect rising energy prices generally through 2023 and favor the Energy equity sector as well as a tactical overweight allocation to Commodities.

Reducing tariffs on China: Reduction of U.S. tariffs on imports from China could come from the president but may dent inflation by only a few tenths of a percentage point. However, we believe the impact would be magnified by likely price action of U.S.-based competitors to cost reductions on Chinese goods and should be supportive of those consumer-based companies with sizable operations in China.

Conclusion — Limited government policy help for inflation: We believe divided government after the midterms should make bipartisan action against inflation very difficult. For now, we anticipate aggressive credit tightening by the Federal Reserve will be the main anti-inflation weapon, by dampening demand and exposing the economy to a recession.⁹ Thus, we have downgraded our 2022 global equity earnings expectations. Our outlook for 2023 anticipates higher earnings and equity index values into year-end, in large part because we expect the recession to squeeze inflation lower.

Many state legislative bodies are up for election this year, and we focus on issues with post-election investment impacts.

• 124 out of 149 total state government bodies are having elections in 2022.¹²
• Major areas of legislative debate are in affordable health care, affordable housing, and state budget surpluses.

In November, 36 governors, 43 state senates, and 45 state houses of representation will be up for election. We will discuss potential state legislative and executive outcomes and how those changes might affect policy and investments.

Governing body, party control	Current	Forecasted*
Governors, Republican	28	24
Governors, Democrat	22	20
State senates, Republican	32	32
State senates, Democrat	18	18
State houses/assemblies, Republican**	31	33
State houses/assemblies, Democrat	18	16
Trifectas, Republican	23	-
Trifectas, Democrat	14	-

Source: Data and forecasts from 270towin.com, as of July 7, 2022
*Table does not include toss-up elections.
**The Alaska House is considered Republican-controlled, as the majority of representatives are Republican-aligned. Total does not sum to 50, as Nebraska has one house in its state legislature.

Even with so many contested government bodies, only 15 appear competitive, and the elections with the most impact will be in states in which a trifecta (when all three bodies are controlled by the same party) is up for grabs.¹⁰ In Massachusetts and Maryland, the Democratic Party has a chance to earn a trifecta, while Republicans may win total control of Alaska, Kansas, Pennsylvania, and Wisconsin. Michigan, where both parties appear competitive, could become a trifecta for either party. Although legislation is more likely to succeed in trifecta states, important legislative matters will affect all 50 states. Here are summaries of three major issues and how new state governments might respond.

Increased health care access means increased health care spending: For instance, since the Affordable Care Act was enacted, uncompensated care costs in states that implemented an optional expansion of Medicaid programs fell 47%, while unexpanded states only fell 11%.¹¹ New legislative party distribution provides the 12 states that haven’t expanded Medicaid programming an opportunity to do so. Regardless, both parties aim to expand health care access, whether through private or public means. Other legislative acts on the agenda are the reduction of health care taxes and incorporating telehealth options into legislation — both of which would likely bolster the health care industry, reinforcing our favorable guidance on this equity sector.

Many state governments are also focusing on increasing access to affordable housing. For instance, politicians in Arizona have recently proposed laws that uncap the amount of units allowed in affordable housing projects and mandate a large portion of unclaimed property revenue be put toward the Housing Trust Fund.¹³ Nonetheless, housing supply may still fall short of demand, unless state legislatures pass laws working toward creating and maintaining affordable housing, a traditionally more Democratic policy aim. Since state governments are likely to remain largely Republican-controlled, we don’t foresee residential supply finding government support soon, benefiting our favorably rated apartment and single-family real estate investment trusts (REITs).

The last major item on most state legislative agendas is what to do regarding bulging budget surpluses. Injections of stimulus through the series of COVID-19 response bills and the distribution of funds from the Infrastructure Investment and Jobs Act have boosted total balances to record highs.¹⁴ New legislative bodies, no matter the winning party, are likely to spend the surplus on infrastructure, energy, and information technology, sectors in which we are favorable. States with Democratic leadership may spend extra money on environmental protection efforts and green energy, providing an opportunity for environmental, social, and governance (ESG) investments.

Another implication of strong state budgets is in the municipal bond markets. With strong finances, states will not have to raise as much money through the sale of municipal bonds. Prices of municipals are likely to rise in the future, potentially extending the investment opportunity.

A third major implication is that, with Republican leadership, the legislatures might take the budget surplus as an opportunity to decrease taxes, convert to a flat income tax, or remove the income tax altogether. In this case, “blue” states might lose wealthy residents to “red” states as investors chase tax benefits; this tax migration could redistribute populations before the 2024 election.¹⁵

¹ Gallup, July 8, 2022

² Federal Register, July 19, 2022

³ Piper Sandler, June 1, 2022

⁴ www.fairvote.org

⁵ www.census.gov, April 23, 2019

⁶ Gallup, May 2022

⁷ Pew Research Center, May 1, 2019

⁸ Please see, “Infrastructure: From a Shot in the Arm to a New Era,” February 24, 2022

⁹ For a primer on why energy companies are not reacting to higher prices with enough new production to lower prices, please see our report, “Will Oil Producers Produce More As Oil Prices Rise?” April 7, 2022

¹⁰ 270towin.com, as of July 7, 2022

¹¹ Center on Budget and Policy Priorities, as of March 19, 2019

¹² 270towin.com, as of July 7, 2022

¹³ The National Conference of State Legislatures, data as of July 7, 2022

¹⁴ JP Morgan, data as of June 21, 2022

¹⁵ Henrik Kleven, Camille Landais, Mathilde Munoz, and Stefanie Stantcheva, “Taxation and Migration: Evidence and Policy Implications,” 2020

Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.

Different investments offer different levels of potential return and market risk. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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