Examining the Constant Regulatory Push and Pull

At this point, it is a bit of a hackneyed truism that stocks hate rising uncertainty and like falling uncertainty. So what are we to do with a study, highlighted in The Wall Street Journal this week, showing the Biden administration has been rushing to complete “economically significant” regulations this spring—at the same time court cases challenging several rules are ramping up?^[i] And that is just in America. What about Britain, where the new climate and energy secretary has been testing a novel approach to North Sea oil permitting? How should investors view the ongoing regulatory tug of war? In our view, a lot like taxes. Let us explain.

Regulations, like taxes, are one of those areas where conventional wisdom and biases tend to cloud people’s thinking. In general—and obviously with exceptions—investors tend to see low or falling taxes as good and high or rising taxes as a headwind. Similarly, investors tend to perceive stricter and more abundant regulations as choking investment and profits and deregulation as an unalloyed good (notwithstanding the need for guardrails protecting private property, truth in advertising and other bedrocks). And, “economically significant” regulation—those with an estimated impact of $200 million or adversely impacting a specific group in a material way—likely alarms some.

We tend to see all this a bit differently. We may have our personal preferences, but the idea there is some pre-set magic level of taxes and regulations for stocks is a fairy tale. In reality, throughout history, businesses (and stocks) have proven, again and again, they can grow and thrive through all sorts of tax and regulatory environments. Businesses may not like high taxes, but if they are stuck with them, they are creative and learn how to deal. Similarly, companies might not like what they see as onerous regulations, but if those regulations are the law of the land, the incentives to find ways to navigate them overrule the other headaches.

Both of these hinge on businesses’ simply being able to forge long-term plans with a reasonable degree of confidence that the rules at the end, when it is time to press the launch button and start reaping returns, will match the rules at the outset. Confidence that things won’t change (or not much) helps enable risk taking. When there is a higher likelihood that things will change, it can trigger the wait-and-see approach, which can weigh on investment, economic growth and stock returns. In a perfect world, which will never exist, we would get some big, bipartisan, permanent agreement on taxes and regulations, businesses would know forever what they will be dealing with, and society could take risk to its heart’s content. The level and particulars would matter less than the elimination of uncertainty.

And so we can see why the latest regulatory rumblings have investors a bit on edge. On our shores, the Biden administration is trying to finalize a bunch of rules before ceding the Oval Office to either Vice President Kamala Harris or former President Donald Trump next January. As businesses determine whether they would be winners or losers from these rules, they launch court challenges to get them enjoined or overturned. The more success the early filers have, the more challenges they tend to attract. With the Supreme Court overturning the Chevron Deference doctrine earlier this year, it may soon become open season.

Meanwhile, the UK is getting its own taste of this, particularly in the Energy industry. Climate Secretary Ed Miliband, whose brief includes energy, announced the North Sea Transition Authority (NSTA) won’t grant permits to drill the 257 production blocks the prior government put up for bid. Given companies had already spent millions of pounds preparing their pitches to the regulator and that NSTA has traditionally been an apolitical entity, legal challenges are a foregone conclusion. More recently, Miliband announced he won’t defend against a court challenge arguing prior permits were awarded illegally because they didn’t account for so-called Scope 3 carbon emissions (meaning, emissions generated by the end user), which risks effectively ending new drilling. Though this is sector-specific, investors see shifting sand and wonder what will change next.

But for investors, we think the question is simple: Is shifting sand new? Or is it so long-running that it has become part of the structural backdrop, a pulsing, headache-inducing constant that markets have begrudgingly priced in as the cost of doing business? We see a strong case for the latter.

Recent US history is one point of evidence for this, as the country’s regulatory approach has shifted with each new administration throughout this century. Executive orders tend to stir a lot of angst, but the simple truth is that what one administration does via executive order, the next can cancel. And so we had the Obama administration trying to accomplish a lot through executive orders and regulatory agencies. Then the Trump administration trying to undo a lot of it and issue its own regulatory edicts. And then the Biden administration trying to undo a lot of the Trump administration’s moves and put its own stamp on things. We have seen it with the on-again, off-again, on-again of Net Neutrality, oil well permitting on federal lands and a host of others.

Regulations have been a moving target for as long as there have been regulations. Over 15 years on, financial authorities are still working on the final regulations aimed at preventing a repeat of 2007 – 2009’s global financial crisis. We had Dodd-Frank (which took years to flesh out and implement), Basel III, Basel IV (aka Basel III endgame), various accounting rule changes, and and and. Britain had its own version, overhauling its regulatory agencies and approach. Along the way, some things were watered down from initial proposals, while some things were tightened. Round and round and round it still goes. Yet bank stocks haven’t suffered. Perhaps one could argue they might have risen more without 15 years of uncertainty, but that sort of thing isn’t provable. The counterfactual never is.

Same with energy. For all the shifting regulatory sand on both sides of the Atlantic, Energy sector profits have continued rising and falling with oil prices. Regulatory uncertainty may be a headwind at the margins, but businesses have gotten on with things. UK-based Energy firms long ago diversified outside the North Sea, making Miliband’s actions (and the pending legal blowback) less relevant to profits than you might think.

Then, too, the very concept of “economically significant” regulations is squishy. Citing data from George Washington University’s Regulatory Studies Center and White House definitions, the Journal counts 34 finalized by the Biden administration in April and another 27 in May. Nor is it clear how the broader data series is accounting for rules that were subsequently abandoned, like the temporary pause on oil permits for federal lands. Or those the courts enjoined, like the ban on noncompete clauses in employment contracts. Or the pause on approving new liquefied natural gas export terminals, which formally ended this week when one new terminal got a five-year permit to export.^[ii] Or those that were watered down, like the SEC’s emissions disclosure requirements, which abandoned Scope 3 disclosure, effectively gutting them. You can’t really glean much—if anything—from a broad tally without knowing this.

But the fact there are so many counterpoints speaks further to how much these things are in flux—and how markets have gotten used to it. Throughout all the uncertainty over domestic energy policy, financial regulations, emissions disclosure requirements and the like, stocks have enjoyed a rollicking bull market that began in October 2022. It seems to us cyclical factors have simply outweighed regulatory actions, rendering them part of the structural backdrop.

This is how these things normally go. Over a decade ago, during the eurozone debt crisis, we noted regulators there had a long road ahead of them to decide what the eurozone wanted to be when it grew up. There was ample uncertainty over whether it would become a tight fiscal union, whether it would have a strong banking union and how regulators would handle the perpetual dilemma of having shared monetary policy without being a fiscal transfer union. We suggested these questions—and the measures to resolve them—would fade into the structural backdrop as the economic cycle took over. That proved true. The eurozone is still dealing with a lot of these questions, but its economies continue growing (with the occasional contraction along the way), and stock markets across the bloc are rising.

Same with Britain post-Brexit. Same with US Financials after the crisis. And same with broader markets throughout decades of politicians’ constantly changing their minds or getting replaced by politicians with different agendas.

Now, none of this is to say regulators can’t deliver a wallop in the form of a sudden, misguided regulation that takes effect and wreaks havoc on profits or the cost of doing business before markets can gradually digest it. The financial crisis is one example, as markets had to price in real-time the deleterious effect of applying mark-to-market accounting rules to illiquid, hard-to-value assets. Nor does this rule out problematic legislation, like 2002’s Sarbanes-Oxley Act, which took a stricter-than-expected form rapidly amid Congressional talks. But these are risks regardless of how “in flux” regulations appear to be. And it is the kind of thing investors must evaluate on a case-by-case basis, not simply from looking at the broad total of new, pending or court-challenged rules.