Four Simmering Issues That Could Soon Boil Over

MIKE TOWNSEND: We're a couple of months into the new Congress now, and if it feels like not much has happened yet, well, that's because when it comes to high-visibility items, not much has happened yet.

And that isn't unusual. It typically takes a new Congress a month or more just to get itself organized, doing things like making committee assignments for each legislator.

Now the organizing is done, and the new Congress has started moving into the legislative process. The first step is introducing bills, and that's one thing that every member of Congress excels at. As of last week, nearly 1,400 bills have already been introduced in the House of Representatives, and another 653 in the Senate. Thousands more will be introduced throughout the year.

Now, many bills are serious proposals to address real problems, but many others are introduced not with the intention of actually becoming law, but to show a member's interest in a particular policy issue, or to lay down a marker on something that can perhaps be included in a larger bill down the road.

Others are more commemorative, like a bill to name a post office after a local hero or bills to designate National Almond Day or National Bike Month. And, yes, those are real proposals.

For those of you old enough to remember the video "I'm Just a Bill" from Schoolhouse Rock! in 1976, you know that the legislative process is a long and tedious one. In order to get to a vote in the House, those bills usually need to be the subject of one or more hearings in a subcommittee or a committee, and then they're debated, amended, and voted on by the relevant committee before they can even get to be debated on the House or the Senate floor.

Truth is, most bills never make it to a vote, or even to a committee hearing―they die quietly for a variety of reasons: They're too broad or too narrow. They don't have enough support from colleagues. Maybe they're solving a problem that no one really thinks is a problem. Some are just plain weird. But there are so many that it's impossible for investors to keep track of which ones matter and which ones don't.

While this Congress is just barely out of the starting gate and hasn't actually passed many bills yet, there is a lot going on that investors are curious about.

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.

In this episode we're going to do something a little different. We're going to look at the intersection of what Congress is actually working on and what investors would like Washington to be doing. To do that, I'm going to answer some of the most common questions I've been getting recently when I talk to investors face-to-face.

But first, I want to give an example of the kind of thing that Congress does that can fly a bit below the radar but have a far-reaching impact.

Last week, both the House and Senate passed a "resolution of disapproval," which is a mechanism that Congress can use to overturn a rule from one of the regulatory agencies in Washington.

In this case, the agency is the Department of Labor, and the topic is ESG investing―investing focused on environmental, social, and governance factors. Here's the background.

The Labor Department is responsible for overseeing employer-sponsored retirement plans, like 401(k)s. During the Trump administration, the department approved a new rule that said plan sponsors could not consider ESG factors when selecting investment options for employees as part of the company retirement plan.

When the Biden administration came into office, it immediately began working to reverse that rule. Last fall, the Labor Department approved a new rule that basically does the exact opposite of the old rule―it allows employers to consider ESG factors. Now, companies don't have to include ESG factors in their considerations, but under the new rule, which went into effect at the end of January, they can if they want to.

Congress stepped in last week to block that rule. The resolution of disapproval passed the House, and then it passed the Senate when two Democrats joined with all the Republicans to support it.

But of course, when Congress passes something, there's one final step―the president has to sign it into law. And, as you might imagine, since this is a Biden administration rule, President Biden is going to exercise the first veto of his presidency.

To override a presidential veto requires a two-thirds majority vote in both the House and the Senate. But with the narrow margins in both chambers, that just isn't going to happen on this resolution. So the bottom line is that the rule won't change. But at the end of the day, the important thing here isn't the battle over this one particular rule.

The key takeaway for investors is that this is just the latest skirmish in what is becoming an existential battle over ESG investing―one that's taking place both in Washington and in the individual states. The debate is over whether the government and companies should be pushing what some perceive as political agendas.

We're seeing this play out with a controversial SEC proposal to require public companies to disclose more to investors about their impact on climate change. At the state level, states like Florida and Texas are pushing back against asset managers who manage state pension funds and are perceived to be advocating an ESG agenda. And some states are challenging companies directly for their political positions, as has happened in Florida with Disney.

The entire notion of ESG investing is going to be a big issue in the 2024 campaign, at the presidential level, at the House and Senate level, and even at the state and local level. It's an issue that resonates with a lot of voters on both sides of the question.

For companies, it's creating a tough environment for planning, because where things stand really depends on which party is in charge. Approaches differ wildly and policies can be reversed when there is a change in leadership. It creates a kind of whiplash effect that's going to be hard for companies to manage going forward.

The bottom line―don't expect the debate over ESG investing to go away anytime soon.

Now let's look at some of the most common questions I am hearing from investors who are wondering what is going on in Washington and how it will impact the markets.

At the top of that list of questions is, "What will the Fed do next?" Well, the Fed has been unwavering in what it plans to do, but there has been a real disconnect between what the Fed is saying and what the markets are expecting.

As 2023 began, investors became optimistic that inflation would continue coming down and that the economy was going to be strong. That investor optimism contributed to the S&P 500^® rising more than 6% in January alone.

But Fed leaders kept reminding the public that despite some progress, inflation remained frustratingly sticky. They were clear that their singular focus was getting back close to their traditional inflation target of around 2%. While the inflation rate has declined for six straight months, it remains elevated at 6.4%. The Fed also said it was concerned that the jobs market was too hot, with the unemployment rate at a 50-year low.

Neither of these messages seemed to make much of an impression on the markets. In fact, according to the CME Group's FedWatch tool, which uses interest rate traders to forecast where the fed funds rate is headed, traders in January thought there was a roughly 60% chance that the Fed would be cutting rates by the end of the year.

At their first meeting of 2023 in February, Fed governors approved a quarter-point hike in the fed funds rate, to between 4.5 and 4.75%―and reiterated that their job of taming inflation was far from over. They signaled that at least two more rate hikes of that size were likely and that there was a chance even more hikes would be needed. Then they indicated that there would be a leveling off for an extended period of time. There was no mention of the Fed beginning to lower rates by the end of the year.

Just days later, a blockbuster January jobs report came out, showing that nonfarm payrolls added more than 500,000 workers, more than double Wall Street's expectations. The number stunned Wall Street. And that's when the markets started to believe the age-old adage: You can't fight the Fed.

The message was strengthened earlier this week when Fed Chair Jerome Powell testified before Congress. He told lawmakers that the Fed may have to raise rates faster than expected and to a higher level than expected.

So how do we know the markets got the message? By looking at that same FedWatch tool. In the hour surrounding Powell's initial comments on Tuesday, the forecast for a 50-basis-point hike later this month went from 31% to 66%.

And one month after the forecast of a 60% chance that the Fed would cut rates by the end of 2023, the odds are now less than 1 percent that there will be rate cuts. Forecasters are now saying there is an 87% chance that the rate at the end of 2023 will be north of 5%― that's much more in line with the Fed's thinking.

The Fed has been pretty unified in this approach. After last month's meeting, 17 of the 19 Fed officials—comprising the seven governors and the heads of the 12 regional banks―indicated that they too expect the rate to be above 5% at the end of 2023.

In fact, as my colleague at the Schwab Center for Financial Research Kevin Gordon points out, the market has readjusted its expectations so quickly in the opposite direction that it now expects a higher peak in the fed funds rate than the Fed itself is projecting.

Kevin told me that he thinks the Fed will lean towards sticking with a series of smaller, 25-basis- point rate hikes this year, but it may up the pace and size of hikes if inflation and jobs numbers come in hotter over the next several months. Not only that, but the Fed may adjust its estimate upward for where the peak will be―something officials have voiced as an option more recently. That is likely more important for investors to monitor for the rest of this year than the size of individual hikes.

As these monetary policy decisions are unfolding this year, there's an interesting change coming. Fed Vice Chair Lael Brainard stepped down last month to become the president's top economic advisor and chair of the National Economic Council. As a Fed governor, Brainard was considered by many to be the most "dovish," meaning she was an advocate for less-aggressive rate hikes so as not to disrupt the jobs market.

This being Washington, there's endless speculation about who President Biden might choose to fill that vice chair seat. Will he pick another dove, to continue the perspective that Brainard brought to the Fed's internal deliberations? Or will he choose someone more hawkish, comfortable with bringing the rate as high as necessary to squash inflation? We should have an answer soon. And remember, whomever the president chooses can remain in that position until well after the next election. Fed governors serve no matter who is in the White House, and the term of this vice chair vacancy runs until January of 2026.

Speaking of who is in office and which party holds power in Washington, another of the common questions I get is, "Does the market care about the political configuration in Washington?" And the honest answer is … not really.

That's illustrated best by one of my favorite statistics about the intersection between the markets and Washington―a streak that has been carrying on for decades. I'm talking about the midterm election rally. A lot of listeners may not have heard of this, but it's pretty fascinating.

As we know, past performance does not guarantee future results; however, historically since 1950, the market has gone up the year after every midterm election. That's 19 times, and on average the markets have gone up in those years by a whopping 18.6%! Now we've got a long way to go to see whether 2023 will keep that streak alive, but since Election Day 2022, the S&P 500 is up about 5.7% as of when this podcast was recorded―so that's a pretty good start.

A big reason that market rallies have consistently followed midterm elections is that the market likes to have a clear picture of what the political and policy landscape is going to be.

After a midterm election, the market knows what Congress is going to look like for the next two years, and what the agenda is likely to be. For instance, last year's midterms resulted in a divided Congress for 2023 and 2024, and the markets recognized that big tax and spending legislation would be unlikely, or, more to the point, dramatic policy changes of any kind would be unlikely. Divided government tends to act as a brake on either party taking policy too far in one direction. Instead, the only issues that might pass are smaller items that can garner bipartisan support. With a low chance of sweeping legislation that will affect companies or the economy, markets are free to focus on issues that could have a direct impact―like the Fed's monetary policies.

When it comes to the winning streak continuing here in 2023, the markets can't ignore the proverbial elephant in the room―the debt ceiling―which could skew everything.

Perhaps the most common question I get from investors these days is "Do we really need to worry about the debt ceiling―doesn't Congress always figure it out eventually?"

As a quick reminder, the debt ceiling is the cap that Congress sets on the total amount of debt that the United States can accumulate. We hit the current ceiling of about $31.4 trillion in January, which means Treasury can no longer borrow to pay the country's bills.

Treasury began taking "extraordinary measures" to manage its cash and keep paying the bills, but those steps are expected to run out this summer. Congress will have to raise the debt ceiling before that happens, or the U.S. will default on its debts.

So a couple of thoughts about the debt ceiling. Congress has raised or temporarily suspended the debt ceiling 78 times since 1960, including 20 times since 2001, most recently in December of 2021. And it's true that Congress has never failed to raise the debt limit―the country has never defaulted.

But there is a sense that things are different this time. The political divide is really stark right now. Republicans, who control the House, have said that they'll only support a debt ceiling increase that is paired with spending cuts. Democrats, who have the majority in the Senate, have said that they'll only support a clean debt ceiling increase, with no strings attached. How that standoff gets resolved is anyone's guess.

This is shaping up as a repeat of the debt ceiling battle of 2011, when Congress was unable to reach agreement until the very last moment, just days before the country would have defaulted. Markets grew increasingly volatile as that deadline approached, and Standard & Poor's downgraded the U.S. credit rating for the first time ever―and 12 years later it's still one notch below the top rating of AAA.

The key throughline between 2011 and 2023―the political configuration in Washington was exactly the same then as it is now―a Democrat in the White House, Democrats with a majority in the Senate, Republicans holding the majority in the House.

A couple of weeks ago, the non-partisan Congressional Budget Office came out with its budget projections, noting that the federal deficit had grown more than expected. It also said the default date would come sometime between July and September, but they couldn't be more precise until after April tax receipts come in. A strong tax receipt season could push the default date off into that August-September timeframe, while a poor tax season could mean default more in that late June to early July period.

So there's not likely to be much movement on the debt ceiling until late April, once a more specific timeframe for when the ceiling has to be raised to avoid a default is established. At that point, activity on Capitol Hill will really start to pick up. So how worried should investors be?

Well, call me a glass-half-full kind of a guy, but, at the end of the day, I do think Congress will get a debt ceiling increase done before the deadline. Even though there is, and will continue to be, a lot of posturing and threats and proverbial lines in the sand, both parties know two things: One, they can't let the country default; and two, they don't have to decide what to do until summer.

So there's no incentive to reach a solution yet. Expect this debate to be very complicated, with lots of twists and turns, in the months ahead. Investors will be watching carefully to see if Congress can resolve the debt ceiling without sparking market turmoil. There's another debt ceiling question that I hear a lot, and that is, "If Congress can't come to an agreement, what about some of the various alternatives that have been kicking around in the media? Why aren't these being considered?"

So let's look at three of the most talked about ideas that are floating around.

First is the idea of minting a trillion-dollar coin. Proponents believe that Treasury Secretary Janet Yellen has the authority to direct the U.S. Mint to produce a trillion-dollar platinum coin―or any amount, really―and deposit that coin with the Federal Reserve. The federal government could pay its bills with those funds while negotiations for a longer-term solution continue.

There's a growing sense that doing so would be technically legal. But there is a much larger question about whether the Fed would accept the coin.

And there are concerns that even if the Fed accepted it, doing so would violate the independence of the Fed by mingling fiscal and monetary policy in a way that Congress has said is not permitted.

The uncertainty could undermine confidence in the U.S. dollar and create upheaval in the bond markets.

Treasury Secretary Yellen threw cold water on the idea earlier this year, calling it a "gimmick." And Fed Chair Powell has said that there is only "one way forward here, and that is for Congress to raise the debt ceiling."

The second idea, which has picked up a lot of support recently, is payment prioritization―meaning the Treasury would pay some bills first and hold off on paying others, prioritizing the most important payments.

But Treasury has no authority to do this. And even if Congress granted Treasury authority―and there have been several bills proposed that would do just that―who would pick the winners and losers; who gets paid and who doesn't?

Operationally, Treasury secretaries going back more than a decade have said that there is no simple way in the government's payment systems to pay some bills and not other bills―the system is set up to pay bills in the order in which they are due, with tens of millions of payments made each month.

But the biggest criticism is that payment prioritization is just another term for default, since, by definition, it would mean the United States is not paying some of its bills.

No one really knows what the broader economic ramifications of that would be, but it would put the full faith and credit of the country into question.

Another option is for the president to invoke the 14th Amendment of the U.S. Constitution, which says that the "validity of the public debt of the United States … shall not be questioned."

Some legal scholars interpret this to mean that the debt limit itself is unconstitutional. And they say that the result is that the president could just ignore the debt limit and direct Treasury to continuing borrowing.

Of course, the president simply ignoring the wishes of Congress, which set the debt limit in the first place, would probably have to be determined by the courts―a scenario that could leave the United States on uncertain ground while the case made its way through the legal process.

Skeptics say that uncertainty itself would be disruptive to the financial markets, to the dollar, and to the United States' credibility around the world, and they argue that it's just too risky to test what would happen.  

All three of these options come with enormous unknowns, and that makes them unlikely choices. But we can expect these and other alternatives to get more and more attention if we get close to defaulting and Congress remains deadlocked.

Finally, I rarely have a conversation with a group of investors that doesn't include questions on cryptocurrency. The main one I've been hearing recently is, "Will Congress and the regulatory agencies create a better regulatory structure for cryptocurrency—one that includes the kinds of investor protections that are in place for investing in stocks or bonds?" There are a lot of investors who are hesitant about cryptocurrency because of the risks and the lack of protections.

Shortly after the election last November, when it was clear that we would have a split Congress in 2023, political analysts began thinking about possible areas of bipartisan compromise―issues that could break through the partisan divide on Capitol Hill and find the two parties working together.

I was among many who put cryptocurrency regulation near the top of that bipartisan list. It's still near the top for me, but I am much less confident now. Members of both parties continue to express a strong interest in legislating in this area―but finding consensus on exactly what that would look like appears less and less likely.

When the crypto exchange FTX collapsed last November, that added fuel to the conversation. FTX was a key player in the interconnected crypto space, and its implosion affected other trading platforms, as well as a lot of investors who may never get their money back.

The FTX collapse also increased skepticism on Capitol Hill about the crypto industry in general.

When it comes to crypto, Congress breaks into two camps.

One group wants to utilize a light touch to regulate the crypto space because it sees digital assets as the future, and it wants to be sure that these companies can continue to innovate and thrive.

The other camp sees crypto as a fraud scheme, and they want to regulate the space to ensure that ordinary investors don't get taken advantage of. These goals are essentially opposites. And it's hard to see how the two viewpoints find any common ground.

Expect the debate over crypto to be vigorous on Capitol Hill over the next several months. The Senate Banking Committee held a hearing on the topic last month.

And new House subcommittee on digital assets―the first subcommittee ever to have this focus―holds its first hearing this week as it begins gathering perspectives from supporters and skeptics about the cryptocurrency ecosystem.

What I've tried to do today is offer some perspective on four of the top issues in Washington that I think will most directly impact investors in 2023―the Fed's monetary policy decisions, the debt ceiling debate, the growing battle over ESG investing, and the question of whether Congress will take steps to create a better regulatory framework for cryptocurrency.

No doubt there will be lots of other issues popping up that could affect the markets. If there is one certainty in Washington, it's that you never know what will happen next. But these four are known concerns, and I'll provide updates as things unfold.

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 won't miss an episode. And if you like what you've heard, leave us a rating or a review—that really helps 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."