Democrats Take Control of the US Senate

Six days into 2021 and market consensus is already broken. There should be no illusion that this is a major macro event that challenges several policy assumptions underpinning the current economic and market outlook. Above all, US fiscal policy should be looser than expected, US corporate and personal tax rates are likely to rise and domestic regulatory tightening should be stronger over the next two years.

This policy mix implies a steeper yield curve with long-term rates rising faster, a weaker US dollar beyond current expectations and US equity returns narrowing compared with ex-US markets. Regarding the longer-term political implications for Georgia and the United States (US), the runoff election restated the demographic shift occurring in urban and suburban areas of the South (Figure 1).

Politics Still Matter in 2021

The Georgia run-off results are noteworthy given that Joe Biden won the state just very narrowly with a record-high turnout. Historically, Republicans have outperformed their results in runoffs versus the general election, even if this gap was declining in recent years (Figure 2).

The failure to win either of the Senate seats reflects long-term demographic shifts, where Georgia is clearly following other swing states in favor of the Democrats, driven by an increase in the voting numbers of college-educated whites who populate the suburban belts in metro areas. Figure 1 illustrates this demographic change with Colorado and Virginia simply being further along this path than Georgia or even Texas. Mr. Biden won the former two states with double-digit margins in 2020, while narrowly winning Georgia and losing Texas by 5.6%. But the net swing toward Democrats is incredibly similar in all these states.

This trend matters over the long term. However, for the upcoming electoral cycle, the Republicans remain the favorites to retake control of the House in 2022, based on 2020 redistricting and anti-incumbency sentiment at midterms. Senate control is also a possibility as one of the Georgia seats will face another election in two years.

Policy Implications

More importantly though, the current Democratic control of the Senate carries significant changes in policy expectations. First, it changes the intra-Democratic equilibrium by moving the party leftward as certain policy proposals could now come into fruition and more progressive nominees can expect Senate confirmation. Second, it also means that large parts of the Biden policy platform are likely to be enacted, in a reduced version of the Blue Wave scenario anticipated in November.

Taken together, the biggest macro implication is that there will be prolonged fiscal support and a smoother path toward fiscal tightening. The Democrats have learned the lesson that they reap no electoral rewards for fiscal conservatism and thus will maximize their two-year window for boosting public spending in priority areas. This would include continued fiscal support for the COVID-19 battered parts of the economy as well as infrastructure spending not only to promote the immediate recovery but also lift potential growth rates in the future. The last US infrastructure program in 2009-2011 was led by Mr. Biden and Senate control makes another infrastructure push a near certainty.

While the spending plans will be widely welcomed, the revenue plans are controversial. Tax increases are likely, particularly in the form of higher corporate and personal income tax rates as well as capital gains taxes for high earners. Regulatory tightening could also be more pronounced if more progressive nominees were to get Senate confirmation. However, the legislative corollary to regulatory changes will still be limited given that the reconciliation route is harder to apply to non-fiscal legislations.

Investment Implications

The yield curve moved only moderately in the two months since the election, but more rapid steepening can now be expected. The post-vaccine recovery will take hold in earnest over the course of 2021 and more expansive fiscal plans could further lift long-term rates even if there is less movement on the short end of the curve. Greater fiscal deficits along with easy monetary policy are likely to accentuate the weakening of US dollar. This will be partially driven by the relative return assumptions on US risk assets.

US equity sectors with greater tax exposure (those which benefited the most from the Trump tax cuts) and those less exposed to public spending may face lower margins. Another reason for capital to re-allocate to non-US equity markets is that the latter’s growth should recover nicely with the availability of cheaper vaccines. Europe and emerging markets should enjoy the upside of lower policy volatility on trade and the spillover from higher US fiscal spending.