Orlando's Outlook: Going nuclear

04-11-2017

Bottom Line After a powerful 15% rally in stocks from the November election to the State of the Union speech in late February, stocks have been mired in a relatively tight trading range of late. President Trump has admittedly stumbled with his early efforts to reform immigration and to repeal and replace Obamacare, which has raised legitimate questions about when—or even whether—his fiscal-policy plans will eventually pass into law.

But during the first week of April, President Trump has enjoyed a reversal of sorts, generating some much-needed positive momentum. His introductory summit with Chinese President Xi Jinping at Mar-a-Lago went relatively well, and his decision to launch a missile strike against Syria in retaliation for its use of chemical weapons to kill innocent children was met with bipartisan approval. In addition, Senate Republicans went “nuclear” to confirm Judge Neil Gorsuch as a Supreme Court justice to fill its open seat, and we are expecting first-quarter corporate earnings to kick off later this week with the strongest results in more than five years. Finally, Congress has returned to district for a 2-week Easter recess, and we’d note that stocks usually perform better when our elected officials aren’t in Washington gumming up the works.

Let Congress stay home permanently? According to a study by Professors Michael Ferguson of the University of Cincinnati and Hugh Douglas White of the University of Missouri, 90% of all capital gains over the life of the Dow Jones Industrial Average have come when Congress is on recess. Between 1897 and 2004, the Dow generated an annualized return of 5.3% when Congress was not in session, but only a 0.4% return when senators and representatives were hard at work in Washington. A “do-nothing” Congress? Investors should be so lucky.

First-quarter earnings kick off this week Just-completed first-quarter results will be reported starting this week, with banking behemoths J.P. Morgan, Citibank and Wells Fargo on Thursday. We are expecting the best quarterly results overall since the fourth quarter of 2011. After seven consecutive negative year-over-year (y/y) quarters through the middle of last year, the earnings recession is officially over, and we’re now expecting our third consecutive positive quarter.

FactSet is forecasting a 9% y/y gain in profits, S&P Global is expecting a 10% increase and RBC Capital Markets is predicting a 13-14% improvement. What’s behind RBC’s more bullish assessment? A 7% jump in revenues, 2% gains in both profit margins and share buybacks and another 2% or so from the usual beats that company managements engineer into their guidance.

To be sure, year-ago earnings comparisons are easy to beat, with crude oil prices bottoming at $26 per barrel in the first quarter of 2016, down 75% from $108 per barrel in mid-2014. So we expect that energy and financial companies likely will be the quarter’s best performers, and the stocks are cheap, having underperformed the broader market thus far in 2017. Moreover, it’s been a very quiet confessional season—crickets and tumbleweed, actually—which leads us to believe that the first-quarter earnings season will be stronger than expected. If true, this positive development could spark a rally in stocks.

Full court press Last Friday, the Senate voted 54-45 to confirm Judge Neil Gorsuch as the 113th Supreme Court Justice, and he was sworn into office Monday. So for the first time in 14 months after the death of Justice Antonin Scalia, the Supreme Court is back at full strength with nine justices.

Who is Neil Gorsuch? Gorsuch, 49, was on the U.S. Court of Appeals for the 10th Circuit in Denver since 2006. A native of Colorado, he graduated with a B.A. from Columbia University, a J.D. from Harvard Law School and a Ph.D. from University College, Oxford. He spent 10 years in private practice at a prestigious law firm and was a deputy associate attorney general in the Department of Justice. Gorsuch is thought to be a brilliant jurist with impeccable credentials, and he clerked for justices Byron White and Anthony Kennedy.

Going nuclear After Scalia’s unexpected death last year, President Obama nominated appellate court judge Merrick Garland to fill the opening, but the Republican-controlled Senate refused to schedule hearings. While that controversial strategy eventually proved successful after Trump’s stunning victory and the Republicans held onto their Senate majority, their decision was very unpopular with Senate Democrats, who filibustered Gorsuch’s full-Senate vote.

The Senate Judiciary Committee voted along party lines, 11-9, to refer Gorsuch’s nomination to the full Senate, which required a supermajority of 60 votes to confirm. This is where Gorsuch’s one flaw came to light—his name wasn’t Merrick Garland. The Wall Street Journal reported that 36 of the 48 Senate Democrats were so incensed with the way that Senate Republicans had treated Obama and Garland last year, they planned to block Gorsuch as a matter of principle. So when Senate majority leader Mitch McConnell (R-Ky.) could not persuade enough Democrats to end the filibuster and join the Republican majority to reach 60 votes, he had no choice but to invoke the nuclear option. Needing only a simple majority vote, Gorsuch was confirmed 54-45.

What about the next court opening? We had long believed that last year’s presidential election was one of the most important in our lifetimes, in part because the winning party could reshape the ideological balance of the Supreme Court for a generation, given that appointments come with lifetime tenure. That view is now amplified with the Senate having gone nuclear, because there are three sitting justices who may retire in coming years:

  • Ruth Bader Ginsberg, 84 (liberal wing)
  • Anthony Kennedy, 81 (swing)
  • Stephen Breyer, 79 (liberal wing)

Needing only a simple majority vote for confirmation could set the stage for Trump nominating more conservative judges in the future. With a supermajority, he would have needed to nominate more moderate judges, like Gorsuch, to appeal to moderate Senate Democrats to gain enough votes for confirmation. So Senate minority leader Chuck Schumer’s (D-N.Y.) risky filibuster gambit on an eminently qualified candidate such as Justice Gorsuch may end up shifting the Supreme Court further to the right than it might have otherwise.

Implications for the 2018 midterms Senate Democrats find themselves behind the demographic eight ball in their bid for re-election and control of the Senate next year. Of the 33 Senate seats up for grabs in November 2018, only eight are held by Republicans versus 25 by Democrats. So Democrats have many more Senate seats to defend. In addition, of those 25 seats, 10 of them are in states that Trump won—six by sizable margins—which means that Republicans could expand their Senate majority in the midterms.

For that reason, Joe Manchin (D-W.Va.), Heidi Heitkamp (D-N.D.) and Joe Donnelly (D-Ind.), who all come from solidly Republican states, voted to confirm Gorsuch. Moreover, with Congress back in district for the next fortnight, we expect many Senate Democrats to get an earful from their constituents about why they failed to support such an qualified and mainstream judicial candidate.

Back to the original drawing board on legislation McConnell wants to return to a supermajority vote with the minority party’s use of the filibuster for legislation. Their rightful concern is if they go nuclear for everything—and pass legislation with just a simple majority—the Senate will just be a smaller version of the House of Representatives. They believe that big legislative decisions in this country, such as changes to health care, tax policy or entitlements, should enjoy broad bipartisan support to have success.

Moreover, aside from the far-left and far-right minority wings in the U.S., most voters would like to see Congress achieve fiscally prudent and socially responsible compromises for the benefit of the entire country, rather than the polarization we have suffered through recently.

Businesses and investors generally want lower tax rates, deregulation, repatriation, the immediate expensing of capital investments and more infrastructure and defense spending to boost the economy and wages. Hopefully, after a messy confirmation process, the successful elevation of Justice Gorsuch to the Supreme Court will get everyone in Congress focused on the same page, shelve the intransigence and work together to fully vet and implement President Trump’s fiscal-policy ideas into law. 

We wish everyone a blessed Passover and Easter holiday!