Hurdles Mounting for Deeply Divided House

MIKE TOWNSEND: October was certainly one incredible month in the nation's capital.

In the final minutes of September, a deal was reached on Capitol Hill to temporarily avert a government shutdown. Less than 72 hours later, one of the architects of that deal, Speaker of the House Kevin McCarthy, was ousted from office by a vote of House members―something that had never before happened in the history of our government.

And for the next 22 days, the work of Congress was frozen in its tracks.

Candidates for speaker emerged from the wreckage as the choice of Republicans to be McCarthy's successor―Steve Scalise, Jim Jordan, Tom Emmer―only to become part of the wreckage themselves as it became clear that they could not muster the necessary 217 votes on the House floor to become speaker.

And while the House was in limbo, the world reacted in horror to the terrorist attacks in Israel―and prepared for a war that could engulf the Middle East, all while Russia and Ukraine enter the 21st month of their war, with no end of that conflict in sight.

And here at home, the economy surged as consumers continued to spend, the yield on the 10-year Treasury bond hit 5% for the first time in 16 years, and inflation remained stubborn.

Finally, last week, the House settled on a new speaker―the little-known and untested Mike Johnson, a congressman from Louisiana.

Now he is faced with the same puzzle that brought down his predecessor―how to navigate a fractious Republican caucus in the House, negotiate with the Democrats who control the Senate and the White House, and find a way forward on a host of tricky policy, political, and economic issues.

His ability to bring together the factions in his own party and to work the Senate will have reverberations across the economy, geopolitics, the markets, and the 2024 elections.

Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

On today's episode I want to take a closer look at the events of the last few weeks in Washington, offer some perspective on where things stand, and discuss the potential implications going forward for some key issues.

With the new speaker in place, Washington is ever so slowly making its way back toward normal, resuming debates, holding committee hearings and meetings, and taking votes on legislation.

Speaker Johnson is a relatively unknown figure in Washington, a low-profile conservative who is in his fourth term representing the mostly rural, northwestern part of Louisiana. He was no one's first choice as speaker, but after three other nominees were unable to garner the necessary votes on the House floor, he became the best option―someone whose most important attribute may have been the fact that he really did not have any enemies in Washington. After an embarrassing three weeks of paralysis, all 220 House Republicans in attendance united behind Johnson as the best way to get the chamber open and functioning again.

Now Speaker Johnson faces several fundamental questions.

The first is whether he can wrangle the House Republicans, plagued by bitter internal divisions, toward a cohesive governing strategy. And, while he hasn't made many enemies, he takes on the top leadership role without having built up years of good will among his colleagues via prodigious fundraising, deep expertise in particular issues, or a track record of leadership on top committees. Johnson is expected to get an extended grace period from his colleagues to prove he has what it takes for the role, but he is undoubtedly keenly aware that any single member of the House can call for a vote on his removal as speaker at any time―the same tactic a handful of Republicans used to bring down McCarthy. Despite calls to change that rule to make it more difficult to oust a speaker, no changes were made.

The second question is how the new speaker will navigate the dynamics with the Senate. The Senate's top Republican, Minority Leader Mitch McConnell, told reporters after Johnson's election that they had never met. Most Senate Republicans appeared to be in the same boat, with one top Republican telling the media that he had never heard of Johnson until last week. And that's just among Republicans―who don't even hold the majority in the Senate.

Ultimately, Speaker Johnson will find himself negotiating on any number of issues with Senate Majority Leader Chuck Schumer, the Democrat from New York, and President Biden. And there is no history at all there. Johnson met Biden for the first time at the White House last week.

But there won't be much time for the new speaker to figure it all out―the November 17 deadline for a government shutdown is less than three weeks away.

And the underlying dynamics of the government spending fight have not changed at all. Most House Republicans want to see significant spending cuts―something that the Senate and the president are just not going to go for. A handful of Republicans ousted former Speaker McCarthy because there were no spending cuts included in the temporary deal with President Biden to extend government funding and avoid a shutdown at the end of September. The new speaker faces the same situation with the looming November 17 deadline.

Over the last several days, the House has resumed trying to pass appropriations bills that fund every government agency and every federal program for the fiscal year that began on October 1. Prior to the speaker change, the House had passed just four of the 12 bills. They passed a fifth bill last week and are attempting to pass three more this week. The more appropriations bills they pass, the thinking goes, the better their leverage in negotiations with the Senate. The Senate still has not passed any of the 12 bills, though it has been debating a package of three appropriations bills this week, and that is expected to pass soon.

But clearly neither chamber is going to have passed all of the appropriations bills by the November 17 deadline, let alone worked out a final agreement that bridges the gaps between the two versions. Ordinarily, that would put a government shutdown very much on the table.

But there is a cautious expectation in Washington that the government is unlikely to shut down on November 17. Even the most conservative members of the House seem to recognize that it's just not realistic to expect the brand new speaker to negotiate some grand deal on government spending in his first three weeks on the job. Momentum seems to be building for another short-term extension that keeps the government open and operating through the holidays, with perhaps a mid-January deadline. While markets don't tend to overreact to government shutdowns, a shutdown later this month could be disruptive to the economy at peak holiday spending time and would add to some of the uncertainties that investors are wrestling with. Now it appears that the real battle over spending―and the risk of a government shutdown―will move to early 2024.

The differences between the two chambers in their approach to the government funding bills are so vast that a government shutdown in January―or whenever lawmakers set the next deadline―becomes much more likely.

Speaker Johnson will also have to figure out how to navigate the president's recent $106 billion emergency spending request―a package that includes more than $60 billion in aid for Ukraine, $14.3 billion in military aid for Israel, about $14 billion for border security, $10 billion to create a humanitarian aid fund for Ukraine, Israel, Gaza, and other needs, and about $7 billion for Taiwan and other efforts in the Pacific to combat China's growing influence. Johnson has signaled that he plans to break the proposal into pieces, and he's planning a House vote by the end of this week on a standalone aid bill for Israel―a strategy that could force difficult choices in the Senate, where Democrats and some Republicans have argued for keeping aid to Israel linked with the more controversial aid for Ukraine.

However, rather than allowing the emergency spending bill to increase the deficit―which is common practice in Washington when these emergency spending requests come up―Johnson announced that he would seek to offset the cost of the Israel aid package, at about $14.5 billion, with corresponding spending cuts to the IRS budget. The IRS has been a Republican target ever since the Inflation Reduction Act of 2022 granted the agency an extra $80 billion in funding. But there is real concern, even among some Republicans, that offsetting the emergency aid for Israel by cutting spending elsewhere in the government sets a precedent that could complicate future emergency requests for disaster aid or money to respond to other global developments.  

So what does all this mean for investors? Well, here are my three takeaways.

First, as I mentioned a moment ago, concerns for a government shutdown have moved to early in 2024 rather than later this month. Government shutdowns have historically seen little market reaction―in fact, the S&P 500® has actually gone up during the last five government shutdowns. But that's not to say that an early 2024 shutdown does not have the potential to have consequential reverberations in the broader economy that could spill over into the markets.

Second, watch the fight over reducing the deficit. This is something of an existential battle on Capitol Hill. The federal deficit rose to nearly $2 trillion in the fiscal year that ended on September 30, nearly doubling from the previous year. We are all dealing with the impact of greatly increased interest rates, and that includes the government. Interest payments to service the nation's $33 trillion debt rose to $659 billion in Fiscal Year 2023. That's an 87% increase in just two years. Projections indicate that in the next three years interest payments on the debt will become the second-largest expenditure of the federal government, behind only Social Security. And, by the end of the decade, interest payments are projected to consume nearly one-third of all federal tax revenue.

One of the fundamental differences right now between the House and the Senate on government funding is that they are starting from different baselines on how much the government should be spending. The Senate's appropriations bills are using 2023 numbers, essentially keeping spending flat. But the House is using 2022 numbers, which represent about a $120 billion cut in spending.  

Heading into a presidential election year, however, lawmakers have taken off the table any cuts to defense spending or spending on social programs like Social Security and Medicare. That leaves a relatively thin slice of the spending pie to which cuts can be applied. Republicans want to slash spending on domestic programs, which Democrats strongly object to. How the House and Senate will resolve these fundamental differences is anyone's guess.

And remember, this is an argument over about $120 billion in spending for the current year. It's not an insignificant number, but it represents about 6% of the total budget deficit. The reality for Congress in the longer term is that there isn't enough cutting of spending that can be done to make a real dent in the annual deficit or the national debt. Sooner or later, Congress is going to have to make tough choices about raising taxes. Tax increases are not on the table with a presidential election year around the corner, but circumstances will force a major tax debate in 2025. That's when the 2017 tax cuts, including lower individual rates, the higher standard deduction, the higher exemption amount for the estate tax, and more, are set to expire. The biggest fight over taxes in nearly a decade is coming.

And third, keep an eye on the rating agencies. Among the three major agencies, Standard & Poor's downgraded U.S. debt as the 2011 debt ceiling crisis was being resolved. Fitch Ratings downgraded U.S. debt on August 1 of this year, saying the move "reflects the expected fiscal deterioration over the next three years" while also making pointed reference to Congress's inability to meaningfully address the long-term implications of deficits and the federal debt.

The third agency, Moody's, put the U.S. on notice in late September that it, too, was considering a downgrade. In a statement, it noted that "fiscal policymaking [in the United States] is less robust" than in many triple-A rated peer countries and added that a government shutdown "would be further evidence of this weakness." Don't be surprised if Moody's downgrades the United States in the not-too-distant future.

While downgrades by the major rating agencies are not and have not had an outsized impact overall, they are another warning sign that the political dysfunction in Washington is damaging the country's reputation around the world.

How the new speaker of the House navigates this tricky period will tell a lot about how the House will operate heading into what is sure to be a contentious election year in 2024.

Elsewhere, there have been some interesting developments in recent weeks on an issue we devoted a two-part episode of WashingtonWise to earlier this summer: artificial intelligence.  

On Monday, President Biden signed an executive order on AI that features the first set of regulations for AI systems. The plan seeks to balance promoting innovation in what the president has called "the most consequential technology of our time" with creating regulatory guardrails focused on protecting national security, reducing bias, ensuring data privacy and cybersecurity, and labeling AI-generated content to help combat disinformation.

The order will require AI developers to submit test results on their new models to the government before releasing them to the public. But much of the order focuses on the federal government itself, requiring more than a dozen agencies to develop policies and regulations that govern both their own use of AI and to oversee the use of artificial intelligence in health, education, the labor market and many other areas of the economy. The Commerce Department, for example, is charged with creating a labeling and watermarking system for AI-generated content to help individuals discern what is real and what is fake.

The order came just days before British Prime Minister Rishi Sunak convenes a meeting of world leaders, tech executives, and other experts at the first AI Safety Summit in England. Vice President Kamala Harris will represent the White House at the event on November 1 and 2, which will also include the European Commission president, the UN Secretary-General, high-ranking Chinese officials, and executives like Elon Musk and Sam Altman, who founded Open AI and has been outspoken about the need for governments to get regulations in place for this technology. The summit will seek to jumpstart an international dialogue around rules and regulations.

Back here in Washington, even as the president unveiled the 111-page executive order, he acknowledged that Congress will have to become more involved―and that's where things may become more difficult. Senate Majority Leader Chuck Schumer said over the summer that he would convene a series of bipartisan education sessions this fall to help get senators up to speed on the issues surrounding AI in anticipation of developing consensus legislation by the end of this year.

This week, Schumer convened the third and fourth of those education sessions, with senators hearing from experts to discuss AI's impact on the labor market and job creation, as well as the role and risks of AI in areas like health care, financial services, and the legal system. These sessions have been well attended by members of both parties―but participants seem not much closer to crafting legislation than they were six months ago, and almost everyone seems to agree that it will be well into 2024 before a plan emerges, if one emerges at all.

Congress has struggled to find a bipartisan path on tech issues for several years now, whether it is social media, anti-trust issues, or privacy. And there's a growing fear that, despite all the positive talk on Capitol Hill right now about creating a better regulatory framework for AI, this, too, will be an issue where success eludes lawmakers. The next few months will be a critical period to determine whether AI will be an exception to Congress' recent track record of failure to find consensus on key tech issues.

The other big news of the week in Washington was the Fed's decision yesterday to keep interest rates steady. This was no surprise―Fed Chair Jerome Powell and his fellow governors had been telegraphing this for weeks. And, as expected, the Fed continued to keep the door open to one more rate hike if circumstances warrant. According to CME's FedWatch tool, which analyzes fed funds futures activity, the market is pricing in about a 20% chance of a rate increase at the Fed's final meeting of 2023, scheduled for December 12 and 13. That's pretty low and indicates that the market generally isn't anticipating a rate hike anytime soon.

But the market is divided on when the Fed might start actually lowering rates. The market currently seems to be focusing on June or July of 2024 for the Fed to begin lowering rates, though plenty of analysts think it could be even later next year than that. Clearly, the Fed's message of "higher for longer" is taking hold among traders.

Finally, a couple of notes from the campaign trail as next week we will be exactly one year out from the 2024 election. The presidential race saw one candidate exit the stage while a new candidate entered. Former Vice President Mike Pence suspended his campaign, saying he had come to realize it was "not his time." Pence's refusal to overturn the results of the 2020 presidential election during the formal count of electors, even as rioters entered the Capitol complex on January 6, 2021, won him many kudos among politicos in Washington, but made him an enemy of a strong swath of Republican voters. Pence's campaign never gained much traction. His exit still leaves nine major candidates vying for the Republican nomination, though former President Donald Trump remains far ahead in polling, both nationally and in the key early states of Iowa, New Hampshire, Nevada, and South Carolina.

On the other side of the political spectrum, Dean Phillips, a 54-year-old Democratic Congressman from Minnesota, announced in New Hampshire that he is mounting a long-shot primary challenge against incumbent President Joe Biden. Phillips, who doesn't differ much from the president on most policy issues, has been leaning into the age difference between himself and the 80-year-old president, an issue that is already seen by many experts as Biden's biggest vulnerability in the 2024 campaign. Polling has consistently shown that voters, including a healthy majority of Democrats, are concerned that Biden, who turns 81 later this month, is too old to be president. Republicans have been signaling for months that they plan to make this a central argument in their effort to make Biden a one-term president, and some Democratic leaders are worried that Phillips will be underscoring those efforts before the head-to-head campaign even starts.

A year out from the election, all signs point toward a Biden-Trump rematch, though the next 12 months are sure to be filled with twists and turns. Historically, election years are pretty good for the markets. The S&P 500 has gained 7.5%, on average, during presidential election years dating back to 1928. But elections are far from the only thing that impact the markets―and 2024 is likely to be no exception, with the economy, inflation, Fed policy, and corporate earnings certain to top the list of bigger factors that will determine the direction of the markets amidst political uncertainty in Washington.

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. Take a moment now to follow the show in your listening app so you don't miss an episode. And if you like what you've heard, leave us a rating or a review—those really help new listeners discover the show.

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.