There may be a lot of concerns about the upcoming midterm elections, but a market swing based on the outcome should not be among them.
“The market does not care who wins. The market does not care about the horserace. There may be some little reaction, but it dissipates quickly,” said Michael Townsend, managing director of regulatory and legislative affairs at Charles Schwab, to a packed room of financial advisors attending this week’s IMPACT conference.
Townsend pointed to annualized returns of the stock market going back to 1901. During years when Democrats controlled both the White House and Congress, annualized returns were only marginally worse, at 6.8%, than years when Republicans were in the same position, at 7.3%. Years with a Democrat in the White House and a Republican Congress saw annualized gains of 9.1%.
Yet there is a lot for advisors to keep in mind, he said. He pointed to sizable fiscal spending bills passed by Congress, including the Inflation Reduction Act, which contains extended tax credits for electric cars and energy efficient home improvements, a 15% minimum corporate tax rate on companies with over $1 billion in profits, and the 1% tax on stock buybacks.
There is also a provision for $80 billion in additional funding for the Internal Revenue Service, which has many investors, and advisors, worried about the agency unleashing an army of tax enforcers and auditors on Main Street clients.
“I’m not sure that’s going to happen. The first thing they are going to do is hire a bunch of people to answer the phone,” he said of the understaffed agency, referencing some 21 million unprocessed paper tax returns piling up around the agency’s offices.
“Over the long-term, the goal of the funding is to increase enforcement, which may mean more audits for higher income filers,” he said, but even so, the odds of an IRS audit will remain low. He pointed to Treasury Secretary Janet Yellen’s claim that no one with under $400,000 in income will need to worry about increased enforcement; for taxpayers above that threshold, the chances of a tax audit go from around 1.2% to perhaps 1.9%, he predicted.
One political issue that could impact markets in the near-term, particularly with a Republican-controlled Congress, Townsend said, is a looming fight over the federal debt limit. The federal government is expected to hit the debt limit in early 2023, and Republicans have vowed to use the threat of default to force spending cuts.
Townsend said the issue could be a replay of 2011, when the government was days away from exceeding the debt ceiling and credit rating agencies downgraded U.S. debt, roiling financial markets. “The market does not like playing games with debt ceiling,” he said.
But the biggest player in Washington to keep an eye on going forward, he said, was the Securities and Exchange Commission’s Gary Gensler, who has an aggressive and wide-ranging agenda for the regulator.
“It’s incredible. It’s enormous,” Townsend said, pointing to the 53 proposed rules on the SEC’s agenda. That includes proposals to update securities’ market infrastructure, addressing issues like “gamification” of trading on popular brokerage apps, bringing more transparency to payment for order flow and mandating corporate disclosures around environmental, social and governance factors.
The ESG proposal brought in nearly 15,000 comment letters, Townsend said, almost four times the average number of comment letters that come in on other proposals, highlighting the controversial nature of the potential rule.
Financial advisors and fund companies that make claims of using ESG in their investment policies would face heightened disclosure rules as well, as the SEC wants to ensure those who advertise themselves or their funds as “green” or “ESG” are not just using the terms as marketing ploys, but as a genuine part of their investment process.
The update to the so-called “names rule” would require funds that use an investment style in the name of the fund invest at least 80% of the assets in securities with the same characteristics. Townsend said the problem was the SEC wrote the rule to include investing styles like “value” and “growth,” inviting a lot of potential confusion.
The new marketing rule for financial advisors, which allows for the use of testimonials and investment performance in marketing, but with strict guidelines, will be a highlight of SEC exams going forward, he said. The new rules implementation date is today. “I hope you’re ready,” Townsend said.
Townsend brought up the SEC’s recent enforcement action on several firms for not properly monitoring their employee’s use of personal phones and messaging apps for business communications, and said it was something that RIAs needed to address in their own firms. “It is clearly an SEC enforcement priority,” he said.
Finally, he said advisors needed to pay attention to the proposed rule that advisors have a systematic way to vet their outside third-party investment managers to ensure they were providing a fiduciary service to clients.
“It does look like another compliance burden. Another set of boxes you are going to have to check,” Townsend said.
As for predictions about which way Congress will tilt after the mid-term elections next week, Townsend said it was likely the House of Representatives will go to the Republicans with a gain of some 40 seats or so, which is the average gain for a party when the president of the opposing party's approval rating is under 50%. “More than that would be a real red wave.”
The Senate is too close to call, as only a handful of states are competitive races, meaning a margin of a party victory was likely to be by only one or two seats.
The only scenario that Townsend said could roil markets is not likely in the mid-terms, but in the presidential election in two years if there were widespread disputes around the election outcome.
Federal money spent on infrastructure and via the Inflation Reduction Act will have long implementation periods which could be a boon to markets, Townsend said, but it would be a mistake for advisors or clients to make any portfolio moves based on a specific election outcome.
“That’s not an investing strategy,” he said. “There is no reason to do anything to a portfolio based on the election.”
