This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
This week, my 11‐year‐old son has been studying for an American history test. We were discussing the “Great Compromise,” which took place at the Philadelphia Convention in 1787. State delegates were trying to figure out how to strengthen the national government and came up with a compromise which created our structure for Congress. Two houses: the Senate, with two representatives for each state; and the House of Representatives, with a number of representatives based on the population of the state. This compromise allowed small and big states to feel as if they had more equal power in decision making. A timely discussion given last week's event.
On Nov. 6, the mid‐term elections took place and determined which political party will control those houses in Congress, as well as in state houses and legislatures. I imagine if you're a casual observer of stock market behavior, the last two weeks may be confusing. On Nov. 7, the day after the election, the stock market rallied more than 2%. It seemed investors, because Congress was split between parties (despite the ongoing machinations in Florida and Georgia, this looks like it will remain the case), were excited about the possibility of gridlock.
While maybe not exactly what our forefathers had in mind, the split Congress reduces the likelihood that big policy initiatives will take place. As an example, tax reform, of the nature passed in December of 2017, would not likely have passed in January of 2019. Policy initiatives of that type can be game changers for investors because they may alter the calculus for future corporate earnings growth.
Since that post‐election rally, the stock market has declined by about 4%. Looking at the sector performance for the last week provides some insight into how stock investors are viewing the potential effect of the mid‐term elections.
With the rise of social media and the concern surrounding how it may be used to impact election outcomes, the drumbeat from Congress to regulate the companies that dominate the internet has grown. As a result, companies like Facebook and Twitter appear as though they may be targets for regulation. Facebook's stock is down almost 5% post‐election, and the technology sector has declined by more than 4%. Whether Congress passes legislation that will meaningfully impact these platforms remains to be seen; however, it is likely that the split houses will try to find something to agree on, and this may be it.
Tech stocks have been the second weakest sector, down more than 7% during the last three months. This isn't surprising, as many of these stocks were priced for perfection. When risk rises in the market, tech stocks tend to be the ones hurt most. However, given the 67% rally in this sector over the last three years—more than double the average performance for the other sectors—some weakness isn't too surprising either.
The Democrats and Republicans may look for something to agree on when the new Congress is seated next January. Both parties have indicated that they would like to control drug prices. While their solutions are different, there is room to come together. More importantly, President Trump has indicated some interest in the Democrats' proposals. This includes the Department of Health and Human Services negotiating lower drug prices for Medicare recipients, blocking anti‐competitive arrangements, and making it easier to reimport drugs at a lower cost. This could have an impact on the earnings of pharmaceutical companies.
The health care sector is down about 3% since the election. Pharma stocks in general have declined by about 2% since then. Year‐to‐date, however, this has been one of the best performing sectors, up more than 10%. Even if Congress agrees to curb the cost of drugs, the wave of aging boomers will continue to increase the allocation of resources to the health care sector of our economy. Weakness may present an opportunity to acquire good companies at a better valuation.
There's another area where the parties may find common ground: defense spending. President Trump has asked for more spending and, in this year's fiscal plan, received it. In an effort to show progress prior to the 2020 election, both parties may continue to increase funding here. However, the more progressive arm of the Democratic party is resistant to more spending. If they begin to control party policy, much like the tea party did to the Republicans several years ago, this could be difficult.
The administration was able to negotiate a new deal with Canada and Mexico earlier this fall. That deal must now be passed in Congress to become effective. It is possible that the new House will use this as a measure of their power to try to alter the deal. However, Mexico too has a new administration, and they would be opening a new negotiation with different players. It is likely that they will ask for modest changes, but given the benefits to labor, auto labor in particular, it will pass.
The administration and Democrats will agree on taking a hard line with China. The rhetoric we've seen surrounding trade here will likely continue, and those companies in the tariff crosshairs will continue to grapple with the increased cost of materials and goods from China. A resolution to this issue is a long way off.
The forefathers created a system of checks and balances. Stock investors sometimes appreciate when that system makes it more difficult to pass big policy initiatives that could be detrimental to their investments.
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