Our Public Policy Strategists Michael Zezas and Ariana Salvatore
break down key moves from the White House, U.S. Congress and
Supreme Court that could influence markets 2026.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Zezas: Welcome to Thoughts on the
Market. I'm Michael Zezas, Global Head of Fixed Income Research
and Public Policy Strategy.
Ariana Salvatore: And I'm Ariana Salvatore, U.S.
Public Policy Strategist.
Michael Zezas: Today we'll be talking about the
outlook for U.S. public policy and its interaction with markets
into 2026.
It's Wednesday, December 17th at 10:30am in New York.
So, Ariana, we published our year ahead outlook last month. And
since then, you've been out there talking to clients about U.S.
public policy, its interaction with markets, and how that plays
into 2026. What sorts of topics are on investors' minds around
this theme?
Ariana Salvatore: So, the first thing I'd say is
clients are definitely interested in our more bullish outlook, in
particular for the U.S. equity market. And normally we would
start these conversations by talking through the policy
variables, right? Immigration, deregulation, fiscal, and trade
policy. But I think now we're actually post peak uncertainty for
those variables, and we're talking through how the policy choices
that have been made interact with the outlook.
So, in particular for the equity market, we do think that some of
the upside actually is pretty isolated from the fact that we're
post peak uncertainty on tariffs, for example. Consumer
discretionary – the double upgrade that our strategists made in
the outlook has very little to do with the policy backdrop, and
more to do with fundamentals, and things like AI and the dollar
tailwind and all of all those factors.
So, I think that that's a key difference. I would say it's more
about the implementation of these policy decisions rather than
which direction is the policy going to go in.
Michael Zezas: Picking up on that point about
policy uncertainty, when we were having this conversation a year
ago, right after the election, looking into 2025, the key policy
variables that we were going to care about – trade, fiscal policy
regulation – there was a really wide range of plausible outcomes
there.
With tariffs, for example, you could make a credible argument
that they weren't going to increase at all. But you could also
make a credible argument that the average effective tariff rate
was going to go up to 50 or 60 percent. While the tariff story
certainly isn't over going into 2026, it certainly feels like
we've landed in a place that's more range bound. It's an average
effective tariff rate that's four to five times higher than where
we started the year, but not nearly as high as some of the
projections would have. There's still some negotiation that's
going on between the U.S. and China and ways in which that could
temporarily escalate; and with some other geographies as well.
But we think the equilibrium rate is roughly around where we're
at right now.
Fiscal policy is another area where the projections were that we
were going to have anything from a very substantial deficit
expansion. Tax cuts that wouldn't be offset in any meaningful way
by spending cuts; to a fiscal contraction, which was going to be
more focused on heavier spending cuts that would've more than
offset any tax cuts. We landed somewhere in between. It seems
like there's some modest stimulus in the pipe for next year. But
again, that is baked. We don't expect Congress to do much more
there.
And in terms of regulation, listen, this is a little bit more
difficult, but regulatory policy tends to move slowly. It's a
bureaucratic process. We thought that some of it would start last
year, but it would be in process and potentially hit next year
and the year after. And that's kind of where we are.
So, we more or less know how these variables have become
something closer to constants, and to your point, Ariana now it's
about observing how economic actors, companies, consumers react
to those policy choices. And what that means for the economy next
year.
All that said, there's always the possibility that we could be
wrong. So, going back to tariffs for a minute, what are you
looking at that could change or influence trade policy in a way
that investors either might not expect or just have to account
for in a new way?
Ariana Salvatore: So, I would say the clearest
catalyst is the impending decision from the Supreme Court on the
legality of the IEEPA tariffs. I think on that front, there are
really two things to watch. The first is what President Trump
does in response. Right now, there's an expectation that he will
just replace the tariffs with other existing authorities, which I
think probably should still be our base case. There's obviously a
growing possibility, we think, that he actually takes a lighter
touch on tariffs, given the concerns around affordability.
And then the second thing I would say is on the refunds
piece. So, if the Supreme Court does, in fact, say that the
Treasury has to pay back the tariff revenue that it's collected,
we've investigated some different scenarios what that could look
like. In short, we think it's going to be dragged out over a long
time period, probably six months at a minimum. And a lot of this
will come down to the implementation and what specifically
Treasury and CBP, its Customs and Border Protection, sets up to
get that money back out to companies.
The second catalyst on the trade front is really the USMCA
review. So, this is an important topic because it matters a lot
for the nearshoring narrative, for the trade relationship that
the U.S. has with Mexico and Canada. And there are a number of
sectors that come into scope. Obviously, Autos is the clearest
impact.
So, that's something that's going to happen by the middle of next
year. But early in January, the USTR has to give his evaluation
of the effectiveness of the USMCA to Congress. I think at that
point we're going to start to see headlines. We're going to go
start to see lawmakers engage more publicly with this topic. And
again, a lot at stake in terms of North American supply chains.
So that's going to be a really interesting development to keep an
eye on next year too.
Michael Zezas: So, what about things that
Congress might do? Recently the President and Democrats have been
talking about the concept of affordability in the wake of some of
the off-cycle elections, where that appeared to influence voter
behavior and give Democrats an advantage. So are there policies,
any legislative policies in particular, that might come to the
forefront that might impact how consumers behave?
Ariana Salvatore: So a really important starting
point here is just on the process itself, right? So, as we've
said, one of the more reliable historical priors is that it's
difficult to legislate during election years. That's a function
of the fact that lawmakers just aren't in D.C. as often. You also
have limited availabilities in terms of procedure itself because
Republicans would have to probably do another Reconciliation Bill
unless you get some bipartisan support.
But hitting on this topic of affordability, there really are a
few different things on the table right now. Obviously, the
President has spoken about these tariff dividend checks, the
$2,000. They've spoken about making changes on housing policy, so
housing deregulation, and then the third is on these expanded ACA
subsidies.
Those were obviously the crux of the government shutdown debate.
And for a variety of reasons, I think each of these are really
challenging to see moving over the finish line in the coming
months. We think that you would need to see some sort of
exogenous economic downturn, which is not currently in our
economists’ baseline forecast, to really get that kind of more
reactive fiscal policy.
And because of those procedural constraints, I would just go back
to the point we were saying earlier around tariff policy and
maybe the Supreme Court decision, giving Trump this opportunity
to pull back a little bit. It's really the easiest and most
available policy lever he has to address affordability. And to
that point, the administration has already taken steps in this
direction. They provided a number of exemptions on agricultural
products and said they weren't going to move forward with the
Section 232 tariffs on semiconductors in the very near term. So,
we're already seeing directionally, I would say, movement in this
area.
Michael Zezas: Yeah. And I think we should also
keep our eye on potential legislation around energy exploration.
This is something that in the past has had bipartisan support
loosening up regulations around that, and it's something that
also ties into the theme of developing AI as a national
imperative. That being said, it's not in our base case because
Democrats and Republicans might agree on the high points of
loosening up regulations for energy exploration. But there's a
lot of disagreements on the details below the surface.
But there's also the midterm elections next year. So, how do you
think investors should be thinking about that – as a major
catalyst for policy change? Or is it more of the same: It's an
interesting story that we should track, but ultimately not that
consequential.
Ariana Salvatore: So obviously we're still a
year out. A lot can change. But obviously we're keeping an eye on
polling and that sort of data that's coming in daily at this
point. The historical precedent will tell you that the
President's party almost always loses seats in a midterm
election. And in the House with a three-seat majority for
Republicans, the bar's actually pretty low for Democrats to shift
control back. In the Senate, the map is a little bit different.
But let's say you were to get something like a split Congress, we
think the policy ramifications there are actually quite limited.
If you get a divided government, you basically get fiscal
gridlock. So, limits to fiscal expansion, absent like a recession
or something like that – that we don't expect at the moment. But
you really will probably see legislation only in areas that have
bipartisan support.
In the meantime, I think you could also expect to see more kind
of political fights around things like appropriations, funding
the government, the debt ceiling that's typical of divided
governments, unless you have some area of bipartisan support,
like I said. Maybe we see something on healthcare, crypto policy,
AI policy, industrial policy is becoming more of the mainstream
in both parties, so potentially some action there.
But I think that's probably the limit of the most consequential
policy items we should be looking out for.
Michael Zezas: Right, so the way I've been
thinking about it is: No clear new policies that someone has to
account for coming out of the midterms. However, we definitely
have to pay attention. There could be some soft signals there
about political preferences and resulting policy preferences that
might become live a couple years down the line after we get into
the 2028 general elections – and the new power configuration that
could result from that.
So – interesting, impactful, not clear that there'll be
fundamental catalysts. And probably along the way we should pay
attention because markets will discount all sorts of potential
outcomes. And it could get the wrong way on interpreting midterm
outcomes, which could present opportunities. So, we'll certainly
be tracking that throughout 2026.
Ariana Salvatore: Yeah. And if you think about
the policy items that President Trump has leaned on most heavily
this year and that have mattered for markets, there are things in
the executive branch, right? So, tariff policy obviously does not
depend on Congress. Deregulation helps if you have fundamental
backing from Congress but can occur through the executive
agencies. So, to your point, less to watch out for in terms of
how it will shift Trump's behavior.
Michael Zezas: Well, Ariana, thanks for taking
the time to talk.
Ariana Salvatore: Always great speaking with
you, Michael.
Michael Zezas: And to our audience, thanks for
listening. If you enjoy thoughts on the Market, please leave us a
review and tell your friends about the podcast. We want everyone
to listen.
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