Politics & Your Portfolio: It's Complicated

With the emergence of the Graham-Cassidy bill to repeal Obamacare, I've been getting questions about what it means for portfolios. Some have said that the bill is likely to pass and that its passage makes tax reform before the end of the year more likely. The implicit assumption is that the passage of tax reform will impact markets as higher growth is factored in. I really don't have any insight into the various bills the Senate is considering but for investors that matters less than one might think. The key word in the previous sentence is "investors". Shifting your portfolio in anticipation of legislative action on economic policy is speculating, not investing. If you are a speculator and believe you have some insight that allows you to taste the sausage before it is made, then by all means speculate away. But if you are an investor, it is probably wise to keep your politics separate from your portfolio decisions.

I don't know if I'd call passage of Graham-Cassidy likely anyway. Republicans are still short votes with Murkowski, Collins and McCain not on board. Rand Paul was never on board. Even if they convince these holdouts and Pence breaks the tie, they have to come up with something that will pass the House and I haven't seen anything yet on the odds of this bill surviving the Freedom Caucus. Whether it can pass the House and make tax reform more likely may depend on the CBO score.

I have thought a lot about the potential for tax reform but it is hard to handicap since we don't know what form it will take. But I would venture a guess that any reform that is considered revenue neutral won't be very effective, especially in the short term. There are efficiency gains to be had from such a reform but the benefits will be long term and widely dispersed. As a Texan friend of mine used to say, it would be like the North Platte River - a mile wide and an inch deep. That isn't to say it isn't worth doing. I am in favor of incremental changes that move in the right direction; don't let perfect be the enemy of the good. But will it be enough to move GDP growth off the 1.5 - 2.5% growth path over the next two or three years? I'm a little skeptical, especially with other policies likely to come out of this administration, in particular on trade, the dollar and the deficit.

There is also the impact of monetary policy to consider. The Fed is likely to announce this week that they will start to unwind QE and let the balance sheet shrink. Conventional wisdom is that removing the Fed as a source of bond demand means interest rates have no where to go but up. But if that is true why haven't bonds already sold off? Aren't markets supposed to discount these things? Conventional wisdom was wrong when QE was implemented; why should we expect it to be right this time? The widespread expectation was that the Fed buying bonds would pull long term interest rates lower but that isn't what happened. Instead, the bond market sold off, interest rates rose.

There was always a bit of cognitive dissonance at the heart of QE. The Fed claimed that it would bring down long term interest rates and act as a stimulus. But if the bond market continued to function as it always has, as an indicator of future growth and inflation, then evidence of QE's success would be higher interest rates. I suppose in some economic model interest rates would fall, work their magic and then rise. The real world works a little differently and in this case the market skipped the "interest rates would fall" step entirely and moved directly to predicting the stimulative result of the interest rate decline that didn't happen.

When QE ended the expectation was that bond yields would go up because the Fed wasn't buying as much. And again the exact opposite happened. Interest rates fell, bonds rose in price. While tax reform of some kind may be positive for growth and push interest rates higher, shrinking the balance sheet would seem to produce the opposite effect. Will one be stronger than the other? Actually the better question is, will investors, in aggregate, believe that one is stronger than the other? I suspect, based on the market reaction after the election, that tax reform would be considered the stronger one, at least until proven different. But that is a guess based on not a lot.

So the question becomes, should we adjust our portfolios in advance? Should we attempt to predict the outcome of the legislative process? I don't know of any way to do that accurately. If you want tax reform to happen you are likely to assign a higher probability of its passage than someone with different political views. If you act on that impulse by adding risk to your portfolio - anticipating the passage and effectiveness of the tax reform - there are economic consequences if you are wrong. Basing portfolio changes on prospective economic policy changes is not a process with a high probability of repeatable success. I'd put the odds of being right about what passes and how it impacts the economy and markets at 50/50 at best. In fact, due to political bias and a host of other cognitive biases, the odds are probably a lot less than that.

The best course of action is to ignore the politics and stick to your investment process. If your process involves trying to handicap the actions of Congress, I have some bad news for you. You don't have an investment process. Indeed, if your process involves almost any effort to predict the future - efforts that I've found generally futile - you probably don't have much of a process. A good process starts with a good strategy - which most investors should translate to a good asset allocation plan - that changes only very rarely. With that in place you can develop a process that applies tactics to that portfolio - actions that change the portfolio on a temporary basis - based on proven techniques. But even tactical changes shouldn't require you to predict what will come out of the circus we call Congress.

Portfolio management can be a complicated, messy business. Don't make it more complicated than need be by trying to do the impossible. Predicting the future is hard. It is really hard when there is money on the line. It is really, really hard when it is your money on the line.