Roads to Nowhere: Politics, Policy & Markets Today with Dan Clifton

Great. Thanks for having me today. Exciting time to be talking about politics.

First, thank you for having me. My name is Dan Clifton. I work at Strategas Securities. We're a macro investment research organization. We do investment strategy, economic strategy, technical analysis, fixed income. And I have the great pleasure of just trying to understand what's happening in Washington and what the economic and financial market implications are of political and policy changes that are happening. When I got into this business in 2007, I was the lowest guy on the totem pole in the firm. But since the financial crisis in 2008, Washington has had a much greater impact over financial markets. And I think investors are paying a lot more closer attention to what's happening here in Washington. So this is a nice blend of politics, policy, economics, stocks, all the great things that we get to combine in one. But ultimately, at the end of the day, we have to have an investment conclusion or we're no better than the pundits that are on TV. And that's really what we're trying to get at by analyzing public policy issues. And really a quick plug for you guys. It is one of our go-tos in terms of trying to help make sense of the crazy world of markets and politics and how they intersect. So it is some good stuff and you're going to hear a little bit, just a little bit of that here today. But before I get down to business, how did you get into this business? Did you always love politics?

Great question. I always loved politics. You know, I was senior class president in high school. I represented the student athletes at the first college I attended before I transferred over to Rutgers. And so I always loved politics and I started on campaigns. I basically helped people get elected at the local level that eventually rose all the way up to the state level. Worked on a few presidential campaigns. As I got older, I started to get much more involved in public policy changes and really kind of migrated from the political world into the policy world. I served in government. I served as a senior staff member for two gubernatorial administrations working on economic policy issues. And you know, over time that began to mold again as I began to embark on a lobbying career where I lobbied. I ran a nonprofit called the American Shareholders Association and we lobbied on behalf of individual investors. It was a great nonpartisan organization that was very focused on policy, but it was a great blend of the interaction between financial markets and public policy and eventually it merged into this type of Washington analysis that we do. I was fortunate enough to meet the Strategas founder Jason Trennert years ago before he started this firm. And when he made a decision to start Strategas in 2006, he asked me to run the Washington office. And I said, "Look, you know, here's about 20 people who are more qualified than me." And he said, "No, I'm not going to let you off the hook that easily." And so, we were able to not only start a firm, but really start that firm from the ground up while we were going through the financial crisis. And I think that formed the culture of the firm in terms of being understanding of what our clients' needs are and being a very client-centric organization.

I think that's a great place to start because we're so focused on the day-to-day activities and it changes every day. We need to take a step back and say, what are we going through in the US? And what we're going through in the US right now is the single greatest period of political volatility we've had since we've come out of the Civil War over 150, 160 years ago. What we have found is that you've had eight federal elections since the financial crisis and the voters of this country have removed the party in power in seven of those eight elections. And so we've had all Republican, we've had all Democrat, we've tried to mix it up. We said, "Okay, let's try this Trump guy in 2016." And if you look at where the data is today, it looks like we're going to change political parties again next November. And so that means eight of nine. So now think about if you're an investor and one year Congress is passing the Affordable Care Act and the next year the Republicans are trying to repeal it. Or just four years ago, literally to today, Trump was cutting the corporate tax rate. And I spend my day very much involved in, are we going to raise the corporate tax rate today? Right? So it's much harder to have certainty if you're changing political parties. And we believe that this is a function of low economic growth. We've had 2% GDP growth since the financial crisis. Voters know there's something inherently wrong and they're demanding political change. And so that's the backdrop by which this legislation and many of the issues that they're going to be debating is actually going to fall within. And there are a lot of Democrats right now who know that they're very vulnerable in their re-elections and yet they're being asked to raise taxes, do a very big spending bill. And I think that's why the process has become much more contentious and much more important for investors.

Over the course of the summer, what we noticed was that stocks were at an all-time high. Investors were like, "Hey, I'm vaccinated. I'm going to the beach. Wake me up when things get important." And it was a nice summer, I'll say, but we saw this storm coming from Washington and we wanted to make it very clear that you have to stand up and pay attention. And that's why we termed it the September to remember. Our point was that the risks from Washington are changing. For the last 18 months, we've had unlimited fiscal and monetary policy. It didn't matter who was fighting with who in Washington or this or that. As long as the system was being pumped with stimulus, we were going to be okay. What the September to remember is really about is that that liquidity is now being drained and we have to figure out how we're going to drain that liquidity. And so we have a laundry list of catalyst items that need to be dealt with. Is Jay Powell going to be renominated for the Federal Reserve? How is the Federal Reserve going to do its tapering? Additionally, are we going to have a government shutdown? Is Congress going to be able to raise the debt ceiling? What are we going to do about the infrastructure package? Congress is trying to pass the largest spending package when you adjust it for inflation, it's actually bigger than the New Deal by which we started. And then you have all this geopolitical tension happening at the same time, the Afghanistan withdrawal, and you have a lot of tensions building with China. That is just way too much bandwidth for Washington to be able to execute perfectly. And we felt that there was going to be a speed bump involved until we can resolve those issues. We were basically informed by the experience of 2013 where we had a very similar situation than we do today. And if you actually take the stock market and you take the S&P 500 and you overlay today with the S&P 500, it is trending almost perfectly. So we had a 10% drawdown in September of 2013 right into mid-October. We had about a 7 or 8% drawdown now and now we're recovering. The big difference between September of 2013 and September of 2021 is that we resolved the issues eight years ago. We just did the kick as you mentioned. And so now it's the October to remember, the November to remember, and possibly going to be the December and January to remember. So those are things that we need to think about because we're still going to have to deal with these issues. But the great thing about markets is they're very efficient. They now understand the risks and the bookends around what those risks are and they're able to digest it better. So, we're going to go through earnings season. We're going to get through earnings, probably more important, and then investors are going to be able to book out what their consensus forecast is for next year, and then it's going to be Washington all the time as we begin to debate these issues and we start to see some of these issues coming to resolution. By the way, it's exciting and we love it, but we just urge that there's got to be a little bit of caution here for investors.

What I would say is that the original proposal, which was 3.5 trillion over 10 years, when the House passed this bill through committee, we estimate it was over 4.5 trillion over 10 years. We haven't seen the cost estimate for that and there's a reason because it was 4.5 trillion. Okay. And their goals really are severalfold. They looked at the pandemic response and they said, where were the holes in the safety net during COVID? So number one was child care. Number two was universal pre-K. Number three was the child tax credit so that consumers have more income. And so the largest portion of what the Democrats are trying to do is on this social safety net. That's about a trillion dollars. Their second largest is on health care. You know, President Obama passed what is called the Affordable Care Act or Obamacare. During the pandemic, we made those subsidies more generous to purchase health insurance. So their first goal was to lock that in. Their second goal was to get Medicaid to people in states that haven't expanded Medicaid. About 13 states haven't done that. And then you'll see Bernie Sanders talking about getting dental, vision, and hearing and Medicare for senior citizens, which isn't very costly. We think there will be a one-year voucher for people to go out and buy dental within Medicare. And then on top of that, to pay for those health care initiatives, the Democrats have long wanted to get tough on drug pricing. And so they have a proposal that would basically allow the government to negotiate. I'm saying that in quotes, negotiate, where if you don't negotiate, then you get hit with a tax of 95% on your drug sales. It's negotiation by Hugo Chavez type of way of saying that, right? But, you know, my point here is that the Democrats see health care as a big priority. This is a bigger health care bill than Obamacare was, and it's just one sleeve in this bill. And then the third big priority is climate change where the Democrats are increasingly believing that we need to be more aggressive on climate change as we start to figure out how can we reduce emissions here in the United States. And so they had a number of proposals in there to reduce emissions such as a clean electricity standard requiring utilities to provide more renewables and then lots of tax credits for wind, solar, storage, battery storage, nuclear, EVs, electric vehicles, electric vehicle charging stations, right? The list goes on and on. Even biofuels are big winners in this bill. And so their goal is to have this bill passed before Joe Biden leaves for Europe, which is November 1st or October 31st. That seems very unlikely, but that was their third priority. And then their fourth and fifth priority, which I don't want to minimize, are education and housing. And what I would argue to you, if you're going to try and jam this down into a smaller package, one that's going to fit more with the political environment that we're in, that education and housing provisions are likely going to get thrown out. And then the Democrats are going to have to figure out how to narrow down a lot of their child tax credit or their health care proposal. So, let me give you one example. In the original bill, those health care provisions were for 10 years. Okay? Now, they're going to be for three years. So just on the Affordable Care Act alone, that's going to save you $400 to $450 billion by changing the length of the program. They're also going to put income limits on who can qualify for these programs. Do we really want rich people getting a $12,000 benefit to go buy a Tesla? Probably not. But do you want a middle-income person who's thinking about buying a car to be able to go and buy an electric vehicle with an increased subsidy? That's probably more in line with Democratic goals. So you'll see that. And then when you pull all that together, they're probably going to get somewhere close between 1.5 trillion and two trillion. And then you look at that and say, "Okay, well, they got the package size lower." If I actually take those provisions and extend them out over a period of time, we're probably going to be right back to where we started, probably around $3 trillion. And so, you know, it's a lot of budget gimmicks. It's a lot of games. Both parties do it. Senator Manchin is saying, "I'm not sure I'd want to be part of this." And thinks, you know, that more time is needed to get this bill done. But that's the essence of what the Democrats are trying to do in terms of this. Where they're running up against some speed bumps though is inflation is going up and voters are increasingly blaming government spending for inflation. Supply chain issues are a big issue that aren't being focused on because we're so focused on this spending package. And as you know, it's a very, very limited majority where the Democrats can only lose three votes in the House, zero in the Senate. And so this is a very complicated process that we're going through in trying to get a lot of this spending passed.

You're absolutely correct. There's another trillion dollars here, right? And the word trillion just makes my head spin, right?

Now, now it's real money. But this is like a traditional highway bill like you referenced, but then we put it on steroids and then we modernized it at the same time. And so the incremental spend that investors will see is about $550 billion. And it's a historic investment. $55 billion for water. There's like four publicly traded water companies. It's a very small industry. And you're going to go dump all of this money in there. $75 billion for grid spending because if you're going to have all this plug-in charging stations and all this kind of renewable energy, you're going to need to upgrade and modernize the grid system. And so the industrial companies that are very focused on grid-type spending are going to be huge beneficiaries of this. Then $110 billion on highways, money for broadband. We often joke there's $20 billion for port dredging. How many port dredging companies are there? But that allows bigger ships and tankers to come through, rails which are different than Amtrak. So you know, it's across the board. It's a pretty big investment. It shouldn't be a very complicated bill to pass the House. But what we have going on right now is what I call mutually assured destruction. The bipartisan moderate Democrats in the House are saying, "Let's pass this infrastructure bill." And the progressives are very worried that if this bill passes, the appetite for all that social spending that we talked about will fall. So today, there's not 218 votes in the House that you need to pass a bill for the infrastructure or for the social spending. And everybody's holding each other hostage. And so it all goes or nothing goes. And there's a real push from the president to try and see if he can get an agreement on everything so that he can at least get this infrastructure bill passed before he goes to Europe and then he can claim that he's making progress on his agenda. But I got to tell you, you have 90 members in the progressive caucus. You had the president who was really with them for most of the time and they're saying absolutely not. And so they're going to have to figure out how to resolve that. But even the no-brainer stuff like the infrastructure is running into complications today.

Again, I have to say that the tax bill that is being proposed is by far anything that we've seen over the last 50 years. And so what happens is, you know, people will say, "Hey Dan, we raised taxes in 1993 and everything was okay." Or, "We raised taxes in 2013, everything was okay." And I say, "Not all taxes are created equal." One, the size of this is much larger. The original Biden proposal was about 1.5% of the gross domestic product of the country. All the tax increases we've done over the last 40 years are somewhere between three-tenths and four-tenths of a percent of the nation's economy. Okay? So, one on size. Two, what we are taxing. We are taxing capital formation and savings and that tends to have the most negative effect on the economy. And so what Biden had proposed is really a couple of tax increases. The first is a major change to the US corporate tax system. One, a higher corporate tax rate which got a lot of attention. But what he was proposing was taxing worldwide income of US companies. So as a company earns profit overseas, they would not only have to pay tax to the host government, they would also have to pay tax to the US government. We would be one of the few countries in the world that double taxes foreign source income like that and put the US companies at a major disadvantage. On the individual side, he was proposing to tax individual income tax rates at 39.6. He was trying to tax capital gains and dividends at ordinary income tax rates. So, you're talking about an over 40% capital gains and dividend tax rate and a major restructuring of the estate tax, one that would move the effective tax rate on estates from 37% to 61%. And so when you look at the totality of the proposals, Biden was not trying to repeal the Trump tax cuts. He was not trying to repeal the Bush tax cuts. He was literally trying to repeal the Reagan tax cuts from 1981. And there's a lot of similarities between what Biden proposed and what happened in 1968, 1969, and 1976 tax bills. And so what you were starting to see is that that was probably a bit too much for Congress. That Congress is going to take these proposals and say, "This is new. I don't understand this. My constituents are upset over it. How do we do a tax bill?" And the more traditional tax bill came out of the House of Representatives. That tax bill raised corporate tax rates to 25%, raised the tax on multinationals, but didn't create a multinational worldwide tax system. It had a top marginal tax rate consistent with what Biden wanted, but the capital gains rate was raised to 25% with a 3.8% Obamacare tax at 28.8 and just a simple lowering of the exemption for the estate tax. So the House bill was very what I call plain vanilla, very different than what Biden was trying to do. And we looked at it and we said, "Look, this is going to hurt earnings. This is going to hurt growth. But a lot of what's in this bill is somewhat manageable and can be dealt with by financial markets. What you are seeing today and what you've been seeing over the last couple days is that the Senate and the Biden administration didn't get what they wanted. So now they're saying, "Okay, we want all these new tax increases. How do we do an unrealized capital gains tax on billionaires? How do we do a stock buyback tax?" And you know, when I pull all that apart and I say to myself, okay, what is likely going to happen? That 90% of what's going to happen is in the House bill. If you have to give something to the Senate, then it will likely be the restoration of an alternative minimum tax both at the individual and corporate level. I've been calling these kind of like backdoor tax changes. Maybe you're going to tighten up the tax credits on the foreign tax credit in the corporate tax code. I think there's going to be less focus on the rate moving forward and more focus on the deductions. And if you do that, you could probably get a more generous reinstatement of the state and local tax deduction as an offset to some of the income tax rate increases that are going to be put into this bill. But I just want to say I've seen smaller tax bills move financial markets. This is a bigger tax bill and it is one that goes after multiple forms of capital taxation at once. So a company is going to be less profitable after taxes and your after-tax rate of return on stocks is going to be lower. Both of them are going to be done at the same time. And people say, "Oh, it's not a big deal." We haven't done that since like 1952. Okay? So I'm not going to use the example of 1952 to say that everything is going to be fine. It just warrants some caution because this is a whole new territory that we're in.

Great question. And again, it all comes down to earnings. And so, if you look at the consensus 2022 forecast for earnings next year on S&P, it's going to grow about 9% next year. It's been relatively flat for the last two months. So, it's been stable, but those numbers are subject to change. So once you get all third-quarter earnings, you'll see a pretty robust revision of what earnings are going to be. And at that point, we'll start getting much more serious. But here's the way that we have identified it. We think there's going to be a 25% corporate tax rate. We think that there's going to be a 16.5% rate on multinational income. And when we pull that together with some smaller corporate tax changes, we find that the corporate earnings are probably going to grow 5% next year rather than 9% next year. Okay? So you're chopping off 4% off earnings. It's meaningful. But if you think growth is going to be good next year, then that's going to be okay. If for some reason the consensus is wrong and the economy starts heading south, then that 4% really becomes meaningful because then you could be close to 0% earnings next year. And I don't think the market is priced for that. Alternatively, if we go in the other direction and the economy just goes up tremendously, then that 4% becomes even more manageable. Right? So, what I'm arguing to you is that the tax changes are a hit and they should be paid attention to, but they also have to be viewed in context of what the economy is doing. At the same time, in terms of allocation, we actually think the market is completely offsides in terms of thinking about these tax increases because there's going to be two types of tax increases: one on the corporate tax rate and one on the multinational income. When Biden released his plan, 60% of the earnings hit was going to be faced by US multinationals, 40% by more domestic earnings. That House bill right now has a 13% hit on multinationals, not 60, 13. And most of the hit is on more domestic-based companies. In the give and take, that's probably going to change a little bit and that 13% is going to go a little bit higher. But as the odds of a corporate tax rate have come down over the last two days based on all the news, it's the multinationals selling off. And in fact, that should not be the case. It should be the other way around. And so I just think that the market is thinking about it a little bit differently because they're based on what happened in April and the plan is changing and the winners and losers are changing.

I think so. And now we have to raise the debt ceiling on December 3rd. The debt ceiling is a very powerful tool to mess with financial markets. Most of the stuff in Washington we can just figure out. But the debt ceiling is a serious game. It is something I learned in 2011 that process is more important than outcome. I told my clients in July of 2011, it will get raised. Here's the path for it to get raised. Here's how it's going to get raised. And everything just went crazy in the month of July, right? And then it got raised and there were all these other effects. So, I'm very focused on both outcome and process and it's the process that we worry about. The Republicans helped the Democrats raise the debt ceiling last time around. There are still a lot of Republicans who are upset at Senate Republican leader Mitch McConnell for allowing that to go through. So, McConnell has zero bandwidth, zero political capital to help the Democrats raise the debt ceiling. You need 60 votes to raise the debt ceiling. Or there's two other options where you can do it alone. The first is the budget reconciliation process requires 51

votes. You got to go open up a reconciliation window. The Democrats have been hesitant to go down that route largely because it creates an open amendment process and largely because if they do it that way, they have to vote on a level of debt. Do I want $4 trillion of debt? Most members of Congress don't want to vote on $4 trillion of debt. They would just rather suspend the debt ceiling for a certain date. But you can't do that in reconciliation. So, they have been avoiding that. The other way to do that is you could break the filibuster for the debt ceiling and say the filibuster doesn't apply. That gives the Democrats greater flexibility, but there are certain senators who don't want to break the filibuster and that creates problems. So you are going to see a game of chicken. The White House believes that the Republicans will cave just like they caved last time. You're going to see that the Senate leadership do not want to go down the reconciliation route and the House says we don't care. We just want to get it up if we got to go to reconciliation. And so I see all three sets of players in a different universe right now. That tells me there's going to be some risk in the short-term credit markets as we start to approach that date. Now, we don't believe the date is December 3rd. One of the greatest stories that we've seen is the massive reduction in the budget deficit since March. Budget deficit's down about $1.4 trillion in the last 5 months. Okay, this is great news. And what we think is going to happen is that as we get into December, taxpayers are going to start pulling forward their income into 2021. And that's going to create some extra cash flow for the federal government. It's going to allow this to go into January. If that doesn't happen, there are some drawbacks. We pass the bipartisan infrastructure bill. We immediately got to do a transfer to the general fund and it will start to drain some of those reserves. And so if we have to raise the debt ceiling in December while we're debating this fiscal bill, you know, put your seatbelt on for this. And we think the market should more appropriately though be pricing the risk in January rather than December. And right now the market's pricing that risk in December.

What I call my market-leading clients, clients that tend to be ahead of the trends. They are more focused on the reappointment of Jerome Powell than they are on this big spending package. I'll tell you why. I mean, it's just you get these relationships sometimes that are just so beautiful, they're hard to ignore. And I'll be the first person to tell you that correlation is not causation. But you can go to the betting odds and you can look at Jerome Powell's odds of being Fed chairman and then you can take the 2-10 yield curve or you can take growth versus value stocks and they're literally the same chart. This is an amazing development in financial markets. What the markets are saying is that the most dovish Federal Reserve chairman of our lifetime is going to be more hawkish on inflation than if Joe Biden selects somebody else to be the Federal Reserve chairman. The volatility that is allowing us to see this relationship recently is all over these trading scandals going on at the Federal Reserve. And again, I'm not going to say whether people should have a right to do this or not, what the laws are. You're serving a government purpose. You shouldn't be doing that. That's the view amongst legislators. And so Janet Yellen is very committed to Jerome Powell being Fed chair. That's why Powell's odds are 70%. They used to be 85%. What has happened here is that Yellen has not been able to get Democratic buy-in for Powell's reappointment. Then you throw on the trading scandals and it basically just created another stain in the process. Interestingly, the people they want Powell replaced with, Lael Brainard, is actually in charge of overseeing the regional Fed presidents who were trading E-Mini futures during a pandemic. So like nobody is innocent in this and there's an equal amount of guilt and she's going to be faced with that if she's the pick. Okay. So, those are the issues that are going around right now. And what I would argue to you is that Powell has the votes in the Senate Banking Committee. He has the votes on the Senate floor, but he doesn't have the support of the Senate Banking Chairman. And that's where this volatility is coming from. And if Powell got replaced, it's over that fact. The way I think about it is that the Fed is going to be more dovish next year. Biden has a chance to remake the entire Federal Reserve because he will have at least one open seat. He's probably going to replace Richard Clarida, whose seat comes up in January. There's talk that Randal Quarles is going to step down in December. That would give Biden a third seat. And then if he gets a fourth seat, which is the chairman, he can really remake the Federal Reserve. And what the financial markets are telling you is that if those selections are made, particularly around the chairman, that that Fed is going to be more tolerant of inflation. They're more willing to keep short-term interest rates lower. And that has important implications from a sector basis on financials and energy relative to growth. And if Powell gets reappointed, then Powell will likely raise interest rates and that's probably going to flatten the yield curve. And historically, that's been good for the growth trade when the yield curve begins to flatten. So, it's counterintuitive to some of our clients largely because low interest rates have been good for say tech companies. And I just think the framework is changing in light of higher inflation. That pick has basically got to come in the next week or two to be honest with you because if you want to get Senate confirmation and the next person in when the seat opens on February 5th, it's going to take some time. So if Biden is thinking about putting somebody else in there, now is the time to do it. He may actually wind up doing it before he goes to Europe.