In some ways, September and the pending arrival of fall marks new beginnings. Schoolchildren are back in the classrooms. Massive crowds have returned to college football stadiums on Saturdays. For your podcast host, these recent weeks have been dominated by getting two of my children ready for and then safely delivered to their respective college campuses, where classes are in person once again.
But for investors, it feels like there are a lot of issues to be worried about this fall―and none of them are new. The pandemic continues to dominate life, disrupt supply chains, and contribute to higher inflation. The Federal Reserve is sending signals that it may begin tapering its bond-buying later this fall. Consumer confidence, after spiking earlier this year, is dwindling again. The August jobs report was a disappointment.
And on Capitol Hill, battles are coming in the weeks ahead over a quartet of issues that could have significant market impact. There are a lot of moving parts to keep track of at the same time.
Welcome back to WashingtonWise Investor, an original podcast 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.
Congress is back in Washington now, facing a daunting list of critically important issues―the four primary issues are happening simultaneously and with overlapping deadlines. This is setting up one of the most complex and unpredictable periods Congress has faced in my 28 years in Washington.
Two of the issues have deadlines that the markets are watching carefully―the potential for a government shutdown on October 1, along with a debt ceiling crisis that will need to be resolved sometime in the second half of October.
And the other two issues are massive pieces of legislation that represent the heart of President Biden’s domestic agenda: a bipartisan infrastructure bill of more than $1 trillion and a second package of $3.5 trillion in spending focused on health care, social programs, and climate change, coupled with tax increases on corporations and wealthy individuals to pay for it all.
On today’s episode I’m going to focus on these four big issues and try to answer some of the key questions on the minds of investors: Can all these get done? How will they get done, given the razor-thin majorities for Democrats in both the House and Senate and the wide spectrum of political ideologies that exist just within the Democratic party? What sorts of compromises will have to be made? And what should investors be watching for as this drama unfolds over the next several weeks?
Right now, proposed tax increases are dominating the headlines, and we’re certainly going to talk about those today.
But I want to start with the two issues that have the biggest potential to most quickly and directly affect the markets: the debt ceiling crisis and the threat of a government shutdown. I’ve talked about these on past episodes of this podcast, but now the deadlines are nearly here, and Congress still has no clear plan for addressing them. A serious, potentially market-moving crisis is looming.
As I have discussed before, funding government operations on an annual basis is one of the most basic responsibilities of Congress. By October 1, the start of the government’s fiscal year, Congress is supposed to have passed the 12 appropriations bills that fund every federal agency and every federal program for the year ahead. So far in 2021, Congress has passed exactly zero of those appropriations bills. That means lawmakers, in what has become something of an annual rite of the fall, will need to pass one of those temporary funding measures, known as a “continuing resolution,” to keep the government open and operating. If they don’t do so, we’ll have a government shutdown on October 1.
The even bigger issue is the debt ceiling, or debt limit, which is the total amount of debt that the United States can accumulate. That cap is set by Congress, and once it is hit, the Treasury Department is no longer able to borrow money to pay its obligations. At that point, Congress must either raise the debt limit or simply suspend it for a period of time.
That’s what happened in 2019. Congress suspended the debt ceiling for two years, so there was no limit at all on how much could be added to the national debt during that time. But that suspension ended on July 31, and the United States was instantly at the debt limit, with no more borrowing capacity. Treasury can only use the cash it has on hand to pay its bills.
On August 1, the Treasury Department began using its so-called “extraordinary measures,” a series of steps that allows it to preserve some of that cash on hand and avoid the United States defaulting on its debts. Now, Treasury has done this many times before, but those measures are temporary. Last week, Treasury Secretary Janet Yellen wrote in a letter to Congressional leaders that she expects those measures to run out sometime in October. She did not put a specific date on it, citing uncertainty about incoming taxes this month, the pandemic, and other factors.
But the bottom line is that sometime in October, if Congress does not act to raise or suspend the debt ceiling, the United States would default on its debt for the first time in its history.
These debt ceiling battles come around every couple of years or so, and what we know from recent history is that market volatility picks up significantly whenever there is uncertainty about when and whether Congress is going to act.
Think back to the summer of 2011, when Congress dithered and bickered and failed to act on the debt ceiling until the U.S. came within a few days of defaulting. The market reaction was very negative. Volatility spiked. Standard & Poor’s downgraded U.S. debt for the first time ever. In the end, it was the negative market reaction―and lawmakers’ fear that it would get worse, and the blame would be on them―that finally spurred a last-minute compromise that averted a calamity.
We could be looking at a similar kind of market disruption as we head into October if this standoff continues. And right now, it’s very unclear how this gets resolved.
Almost every Republican, in both the House and the Senate, has signed a pledge not to vote for a debt ceiling increase. And almost every Democrat has said that they won’t raise the debt ceiling without Republican support. That’s not exactly a recipe for collaboration. It’s more like a game of chicken … and the markets are waiting to see who flinches first.
Democrats could’ve put a debt ceiling increase into the $3.5 trillion spending package, because that’s going to be considered under a special set of rules that would allow the bill to pass the Senate with a simple majority of 51 votes and prohibits Republicans from using a filibuster to block the bill. Under that scenario, Democrats could have passed a debt ceiling increase or a suspension without a single Republican vote.
But they chose not to do that, arguing that addressing the debt ceiling should be and always has been a shared responsibility. And that means that a debt ceiling suspension or an increase will have to get 60 votes in the Senate, including the support of at least 10 Republicans.
One strategy under consideration by Democratic leaders is packaging these two issues together: a suspension of the debt ceiling combined with a bill to temporarily fund government operations to avert a government shutdown. To sweeten the deal, and to attract Republican support, Democrats are considering attaching billions of dollars in emergency federal aid for states affected by natural disasters in recent weeks, including the wildfires in the west and Hurricane Ida. Democrats hope to make it difficult for Republicans whose states need that federal aid to vote against the package.
Will it work? Well, one way or the other, it has to work. While the issue of a government shutdown would be modestly disruptive to the markets and the economy, it’s usually no more than a short-term blip. But failure to address the debt ceiling would be devastating for the markets. Treasury Secretary Janet Yellen has warned that failure to raise the debt ceiling would be “catastrophic” and could affect financial stability.
In the end, I think Congress finds a way, just as they have always found a way. But I’m more anxious about it than usual, given how dug in the two parties appear to be. And investors should be prepared for market volatility to pick up the further we go into October without a resolution.
Let’s turn to the two big spending bills. Now two things happened in August. The first is that the Senate, after months of negotiations, finally agreed to a bipartisan infrastructure bill, a package that devotes a little more than a trillion dollars to what is usually thought of as “traditional infrastructure,” meaning roads and bridges, rail, public transit, airports, waterways, the electrical grid, broadband expansion, and the like. In the Senate, 19 Republicans joined with all 50 Democrats to pass the bill, a rare glimpse of bipartisanship in the narrowly divided Congress.
Infrastructure is popular―it creates jobs, it’s easy for people to understand, and it’s something where voters can see tangible results in the form of visible projects in their community or their state. Polling in recent weeks has consistently shown that more than 60% of voters support the bipartisan bill, which is a strong result in these divided times.
The second thing that happened last month is that both the House and the Senate approved what’s known as a “budget resolution.” It’s basically a framework that outlines the total amount of spending that can go into the bill, in this case that $3.5 trillion figure that you’ve been hearing about.
Importantly, the fact that both the House and Senate have now passed the budget resolution triggers the “budget reconciliation” process―that’s the special set of rules that allows the bill to be approved with a simple majority in the Senate and prohibits a filibuster by the Republicans.
But passing the framework was the easy part. The hard part is filling in all the details. There are far more ideas for what should be included in the bill than there is room in the bill. So what’s in and what’s out will force some hard decisions.
House committees have been working to come up with parts of the package that fall under their jurisdiction―and then the House Budget Committee will assemble it all into one giant bill.
But there’s another level of complication here―the size of the bill itself. Two moderate Democratic Senators―Joe Manchin, of West Virginia, and Kyrsten Sinema, of Arizona―are on record saying that they will not support a package as large as $3.5 trillion. In fact, Manchin said last weekend that he envisioned a package of just $1 to $1.5 trillion. Progressives, on the other hand, would like to see a bill larger than $3.5 trillion―they feel like they have already compromised significantly.
The intersection of the two bills has created an interesting divide within the Democratic Party. Moderate Democrats are refusing to move forward with the larger spending bill until the infrastructure bill is approved. And progressive Democrats don’t want to pass the infrastructure bill without assurances that the larger package will pass, too.
After an internal standoff last month, House Speaker Nancy Pelosi agreed to hold a vote on the bipartisan infrastructure bill by September 27. But it’s not a binding deadline and it may slip. For now, the infrastructure bill is on the sidelines in the House, waiting for the larger bill to come together.
And now we come to what is likely at the front of most investors’ minds: the potential for tax increases to offset the spending that is being proposed. Earlier this week, the House Ways & Means Committee released what investors and taxpayers have long awaited: formal proposals for tax increases.
It’s important to realize that the Ways & Means Committee proposal is the starting point of a long political process in the weeks ahead. These provisions are almost certain to undergo significant changes as the process moves forward.
Because of that, I’m not going to dwell too deeply on the details of these tax proposals on this episode. Next month I’ll be devoting an entire episode to the tax code changes, once we have more certainty about what’s coming.
For now, though, here are some of the quick highlights:
As expected, the proposal would increase the top corporate tax rate―President Biden had originally proposed a rate of 28%, while a number of Congressional Democrats wanted a more modest increase, to 25%. But the bill splits the difference, creating a new top rate of 26.5% for corporations with more than $5 million in income.
The bill would also return the top individual income tax rate to 39.6%. That’s back to where it was from 2013 to 2017.
Those two tax increases continue to have broad support among Congressional Democrats and, as a result, seem the most likely to be approved by Congress.
More controversial is a new proposal for a surtax on the wealthiest Americans. The bill would impose a 3% tax on income over $5 million. That caught a lot of us by surprise. It had not been a topic of much discussion over the last couple of months and it’s unclear at this time how broad the support in Washington is for the idea.
Then there are the two issues that investors of all types care deeply about―capital gains taxes and the estate tax.
On capital gains, the House committee has proposed a top rate of 25% for filers with more than $400,000 in income. The proposal would have the new rate be effective as of this past Monday, September 13. Gains realized before Monday would be taxed at the top rate of 20%; gains realized thereafter would be taxed at the new top rate of 25% under the proposal, if your income is over $400,000.
This is the only major tax proposal in the bill that is retroactive―most of the other tax provisions would not take effect until next year.
The plan significantly scales back the president’s original proposal to tax capital gains as ordinary income for the very wealthiest filers.
On the estate tax, the committee proposed reducing the amount of inherited assets that are exempt from the estate tax from the current level of $11.7 million to $5.5 million.
This is also very different from President Biden’s proposal on inherited assets, in which he called for an end to the step-up in basis that allows heirs to reset the basis of an inherited asset to the date of death of the previous owner. Due to significant pushback from key Democrats, that idea was dropped from the package.
Finally, I’m also watching what is proposed with regard to the state and local tax deduction, also known as the SALT deduction. As part of the 2017 tax bill, signed into law by then-President Trump, the deduction was capped at $10,000. That disproportionately impacted residents in high-tax states, like California, Illinois, New Jersey, and New York.
Nearly 40 lawmakers from both parties who represent those states have banded together to form what has become known as the “SALT caucus,” to advocate for an increase in the $10,000 cap. Several Democrats have drawn a line in the sand, saying, “No SALT, no deal.”
The package of proposals unveiled earlier this week did not include any changes to the state and local tax deduction. Hours after the bill was released, however, Democratic leaders on Capitol Hill issued a statement saying that they were still working on the issue and committing to “meaningful” SALT changes in the final bill.
Like so many issues, however, this one is also divisive within the Democratic party. Some progressives have called the SALT issue a giveaway to the rich, since the deduction tends to benefit higher-income individuals. This is yet another mini-standoff that will need to be resolved in the next version of the bill.
So what to make of all of this? Well, here are my four big takeaways.
Number one: It’s impossible to overstate just how fluid this is. The House plan is a starting point, particularly when it comes to taxes. But the Senate Finance Committee will weigh in soon, and its chairman, Democratic Senator Ron Wyden of Oregon, has already publicly unveiled a series of tax proposals that are not part of the House bill, including a tax on stock buybacks by companies and taxing unrealized gains on derivatives. Ultimately, all those differences will have to be resolved. Investors should expect countless changes, trade-offs, and negotiations in the coming weeks. The final bill could look very different than what we see today.
Second, the key here is going to be how the Democrats bridge their own internal divisions. The divide within the party is significant. Progressives think the spending plans are too small; moderates think they’re too big.
In the end, moderates like Senator Manchin and Senator Sinema hold the real power here. The Senate can only pass the bill if all 50 Democrats vote for it, producing a 50-50 tie that can be broken by the vice president. Ultimately, this debate is likely to come down to a simple question for the two senators―what’s the largest number in terms of total spending and tax increases that you could support? And then it will be up to disappointed progressives to bite their tongues and vote for a smaller amount than they would like or oppose the bill and see it completely go down to defeat.
It begs a question in my mind: Why are the Democrats moving forward with the full $3.5 trillion plan if they know it will ultimately have to be slimmed down, perhaps by a trillion dollars or more? Why not figure out what the top line number is and build a package towards that number? It’s much harder to take a trillion dollars-worth of programs and priorities out of a package than it is to have never put them in at all. But the thinking by Democratic leaders here is likely to go as big as possible initially, to show that you gave it your best shot, before compromising to a lower number and being able to say that this is the best outcome that is achievable.
My third takeaway is that the big spending bill is going to be the last issue to get resolved―and it could be many weeks before that happens. The infrastructure vote is currently on the calendar for September 27 in the House. Government funding runs out on September 30. And the debt ceiling will need to be resolved sometime in the second half of October, at the latest. All three will be resolved one way or the other in roughly that order. While the $3.5 trillion spending bill and its potential tax increases are on the front page this week, there’s no deadline at all for getting that done. But don’t be surprised if the negotiating and the horse-trading continues through not only September, but much of October and even into November.
And that brings us to what investors should be prepared for. Volatility. All four of these big issues are likely to have setbacks and surprises, bumps in the road, and times when it looks like they’re going to collapse entirely―and the market is likely to react to those ups and downs over the next several weeks. Investors shouldn’t overreact.
My predictions for how all this plays out:
Number one: The infrastructure bill gets approved by the House and signed into law by the president sometime in October.
Number two: Congress passes a continuing resolution that funds government operations until Thanksgiving or a little after, kicking the can down the road and then revisiting the annual funding bills after these other issues are resolved.
Number three: The debt ceiling is suspended for a year or two, though not without some anxious moments when it seems like default is inevitable.
And number four: Democrats pass a slimmed-down version of the $3.5 trillion spending bill later this fall, shaving a trillion dollars or more off the size of the package in order to win the support of moderates. Tax increases are approved as part of that, but the smaller size of the spending package means less revenue from tax increases is needed, so some of the proposals put forward in the House earlier this week are dropped entirely.
I’ll be following all of this closely as the debate on all four of these issues unfolds. Stay tuned to the podcast for updates all fall.
Finally, on my Why It Matters segment, a brief update on an issue we’ve been following since last spring. SEC Chairman Gary Gensler, who took office in April, has continued to unveil a wide-ranging agenda of regulatory initiatives designed to enhance investor protection and improve the functioning of the capital markets. Testifying before the Senate Banking Committee earlier this week, Gensler outlined more than 20 different issues that he has asked SEC staff to produce research and recommendations on, with an eye toward new or revised regulations.
One issue that is already moving is the SEC’s focus on “digital engagement practices,” which has quickly become known in Washington as the “gamification” of securities trading. Gamification has become a hot-button issue in Washington in 2021, ever since the retail trading frenzy in “meme stocks” earlier this year. Congress and regulators have become increasingly concerned that prompts and visual cues, celebrations and scoreboards, and other features of trading apps are being used to lure inexperienced investors to trade more frequently or to make riskier or more sophisticated trades than they might otherwise make.
Late last month, the SEC issued a 78-page request for information from the public about the digital engagement practices of brokers and investment advisers. In announcing the request for information, Gensler said, “While new technologies can bring us greater access and product choice, they also raise questions as to whether we, as investors, are appropriately protected when we trade and get financial advice. In many cases, these features may encourage investors to trade more often, invest in different products, or change their investment strategy.” In its request, the SEC asked for feedback on dozens of issues, such as how e-mail and text notifications are used by brokers, whether games and contests are used to offer prizes, the presentation of investment ideas or suggestions to investors, and the use of “chatbots” instead of live humans to respond to customer inquiries.
So why does it matter? Well, in the wake of the retail trading frenzy earlier this year that saw low-priced stocks suddenly go on wild rollercoaster rides, Gensler said he wanted to take a closer look at the way our equity markets worked. He’s outlined several different ideas as part of that review, but the request for information about the gamification of stock trading indicates that this topic is one of his highest priorities. Requests for information from the SEC are usually precursors to a rule proposal, so don’t be surprised if we see a rule proposal later this year or early in 2022.
Well, that’s all for this week’s episode of WashingtonWise Investor. We’ll be back with a new show in two weeks. Please 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—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 Investor. Wherever you are, stay safe, stay healthy, and keep investing wisely.