Editor’s note: This article is part of InvestorPlace.com’s Investing for the Next Decade.
With the 2020 election on people’s minds, many are asking: will granting Puerto Rico (P.R.) and Washington, D.C. statehood impact U.S. markets?
It’s certainly happened in the past – the addition of midwestern and mountain states in the late 19th century spurred an economic boom that would last through the roaring 20s.
And adding states hasn’t always been politically motivated. When Congress attached Alaska and Hawaii as the 49th and 50th states in 1959, there was broad consensus that the two additions would politically balance each other out and that Alaska’s massive oil reserves would benefit the nation’s economy.
But today’s conversation looks far different. The addition of Puerto Rico and Washington, D.C. will expressly provide Democrats four likely Senate seats, making it far easier to compete against Republican lawmakers.
More importantly, however, the additions would grant hundreds of thousands of taxpaying American residents fundamental rights. D.C. residents, for example, pay more in total federal income tax than residents of 22 other states, but have no say over how those tax dollars are spent.
If successful, will it move the markets in a meaningful way? What will that mean for investors?
The 2020 Election: Here We Go Again
This isn’t the first time a party has added states for congressional seats. Much of the Midwest, including Nebraska, Kansas and Idaho, owe their statehood to Republicans, who sought to reduce Southern influence after the Civil War.
These additions had an outsized impact on the U.S. economy. Though the new states had little in population, they had vast natural resources and spurred an investment boom. Between 1871 and 1890, total miles of railroad track almost quintupled as firms rushed to link the U.S. together. By 1920, one-third of Americans lived west of the Mississippi.
But then, things started to slow down as each new state added less in relative terms. By the time Hawaii and Alaska joined as states in 1959, marginal returns had diminished to the point where they barely registered on a national economic level.
Today, Hawaii and Alaska combined have 0.7% of the U.S. population and generate just 1% of U.S. GDP. As for Alaskan oil? The state is a distant 7th in oil production, with Texas producing almost ten times more per day.
That means the addition of P.R. and D.C. won’t add much from an economic standpoint. Despite Puerto Rico’s manufacturing capacity (a holdout from 1980s tax breaks), its GDP is still not as sizable than New Mexico’s. Washington, D.C.’s economy is about the size of Arkansas.
How Much Will Four Extra Senate Seats Matter?
If adding two new states won’t change the U.S. very much from an economic standpoint, could four Senate seats open the floodgates for Democrats to legislate the U.S. to financial nirvana or ruin?
History tells us probably not.
While significant changes *have* happened under a one-party Congress/White House (i.e., the 1964 Civil Rights Act), it usually takes bipartisan support to pass major economic bills. For instance, the 1986 Reagan Tax Cuts, the most significant U.S. tax overhaul of the later-20th century, was passed with a 253-182 Democratic majority in the House.
In other words, don’t overestimate the power of adding Senate seats. Today, House Democrats range from left-leaning Elizabeth Warren [D-MA] and Jeff Merkley [D-OR], to moderate and right-leaning ones like Joe Manchin [D-WV] and Jon Tester [D-MT]. That makes it unlikely that the wildest pieces of far-left legislation will ever pass, no matter the Democratic majority’s size.
The “Green New Deal,” a climate change and inequality plan endorsed by far-left Democrat lawmakers, sees little support even from Democratic centrists like Mr. Biden.
It’s the same reason why Republicans failed to enact significant legislative change between 2016-2018 when they controlled both Congressional houses and the White House. Besides passing a tax cuts bill (which mostly sunsets by 2024), Congress mostly bickered.
Mr. Trump’s most prominent “white whale,” the Affordable Care Act, still stands, thanks to more moderate Republicans, including Susan Collins [R-ME], Rand Paul [R-KY] and the late John McCain [R-AZ]. The Republican party isn’t a monolith either.
What Should Investors Do After the 2020 Election?
That means investors betting on two new states shouldn’t look at macroeconomics or politics to profit. Instead, they should look at Puerto Rico itself. The territory has constantly lagged its peers. Average income comes in at just $12,451, compared to $32,621 on the mainland. That’s mostly because the territory operates under arcane rules that prevent it from righting its past sins.
“Today, the Commonwealth of Puerto Rico stands in stark contrast to most American states because it has no meaningful constitutional limits on central government deficits and debt accumulation,” reports authors at Mercatus Research, “while at the same time it operates a number of public corporations that have unsustainable debt loads.”
Also, despite receiving billions in grants and tax breaks over the years, residents receive fewer federal benefits than the average American. For instance, Puerto Ricans are ineligible for the Earned Income Tax Credit (EITC) and Supplementary Security Income.
That has meant that P.R.’s businesses have consistently underperformed. Bank Popular (NYSE:BPOP) and First Bancorp (NYSE:FBP) have lower returns on equity (ROE) than JP Morgan. That’s despite the two sharing an oligopolistic banking business on the island. Loss ratios are high, and both banks trade at 0.7 times price-to-tangible-book.
A transition to statehood could change that almost overnight. As a state, Puerto Rico might finally get to default on unpayable debts, paving the way for an economic revival. Real estate prices, like those in 1960s Hawaii, will benefit. Share prices in BPOP and FBP will also likely rise over the long run as loss ratios improve.
In other words, investors looking at statehood for Puerto Rico and Washington, D.C. shouldn’t turn to Capitol Hill (or prognosticate based on overall U.S. economic data). Instead, the benefit of statehood will be felt most distinctly by the two new states. And that’s precisely where investors should start their search for great investments.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.