Every four years, the US electorate gets the opportunity for a fresh start. On Election Day, Americans had a chance to review their instructions and the chance to replace the policy makers in Washington. On the surface, the status quo has been essentially maintained, but the interpretation of these results informs the base-case scenario of US policy.
The Good News
As a rule, markets hate uncertainty. At a basic level, uncertainty is what investors suffer through to warrant a return on their investment. Second, it’s hard to derive a logical price for a security if the inputs to a pricing model (e.g. tax rates or projections for GDP growth) are unstable. The good news is that some elements of US policy became much more certain on November 7th.
Broadly speaking, the government’s effect on the economy is primarily a function of monetary policy (i.e. how much money is in circulation) and fiscal policy (taxes and spending). As a result of the election, there is substantially more clarity on the direction for US monetary policy. Monetary policy is driven by competing desires for stable prices (i.e. controlling inflation) and high employment. Our current Federal Reserve Chief, Ben Bernanke, has signaled that he will stand down in 2014, but since the re-election of the President, it is likely the accommodative policies will continue. In addition, there is consensus his replacement will most likely be current Federal Open Market Committee member, Janet Yellen. Mrs. Yellen has already indicated comfort with the existing zero interest rate policy, so long as inflation remains below 3%, and unemployment remains above 7%. In other words, the “dovish” monetary policy — accepting higher inflation in an attempt to maximize employment, is a probable policy target for the near to medium term.
Given the re-election of President Obama, legislative milestones which would have been threatened under Romney’s administration now appear stable. As the Republican candidate, Mitt Romney vowed to undo the Affordable Care Act (i.e. “Obamacare”), but the law itself will likely stand unchanged for the near future, despite state driven challenges to implementation.
On a related note, challenges to the Wall Street Reform and Consumer Protection Act (i.e. “Dodd-Frank”) may be only marginal. This broad reaching legislation was drafted without specific detail, so full implementation and analysis of its effects will take time. For example, the law authorizes the SEC to impose “fiduciary duty” standards by broker-dealers to their customers, but the precise language surrounding this instruction has not yet been drafted. Nevertheless, the law itself should persevere without the threat of repeal.
There are elements to US policy which, following the Presidential debates and other expressions, were not subject to material change no matter who became President or which political party dominated Congress. For example, many pundits noted key positions on international policy, such as free trade agreements and guidelines for armed intervention at global hotspots like Syria and Iran, were largely similar between President Obama and Governor Romney.
“Both sides could interpret the election results as an affirmation of their respective mandates, despite the fact they are in polar opposition to one another.”
Partisans often frame a political choice as a binary selection between extreme positions, but, in reality, the candidates’ preferences may have only a marginal effect on the likely outcome. For argument’s sake, an extreme simplification of each candidates’ energy policies might be stated thusly: Romney’s vision promoted the expansion of fossil fuels like oil, coal and natural gas whereas Obama’s vision was either hostile towards fossil fuels or, at best, an “all-of-the-above” approach which placed equal importance to renewable energy sources such as solar, wind, bio-fuels, and so on. Despite the President’s re-election, the expansion of domestic fossil fuel energy, as a result of technology improvements like hydraulic fracturing (“fracking”) and directional drilling, is still the most likely outcome. Douglas Coté, US Chief Market Strategist at ING, explains, “America will be energy independent by the end of the decade, but it could happen sooner with more accommodative government policies toward offshore drilling, fracking for natural gas and coal.”
The political benefits of domestic fossil fuel energy may simply be too great to ignore, despite the environmental lobby within the President’s political base. Coté continues by stating, “Trade could be dramatically increased, raising economic growth. Since this expansion is creating an incredible amount of jobs, it is highly unlikely that Federal policy will stop the progress.”
As usual, the recent election was subject to many predictions regarding the political outcome. This year, the most accurate election forecasts came from data aggregators (like Sam Wang of Princeton, Nate Silver of the New York Times, Real Clear Markets estimates, etc.). These aggregators did not generate any polling data; rather, they aggregated the results of other research to generate accurate forecasts. Since a change of the “base case” scenario of US policy is, in essence, a prediction of collective behavior, achieving a consensus between market strategists is an attractive attribute when establishing a new base case. There are no guarantees, but given independent consensus from market strategists, investors can be reasonably confident that the policy directions outlined above are probable outcomes.
The Bad News
The Dow Jones Industrial Average lost more than 300 points after Election Day, as investors were reminded of upcoming Fiscal Cliff negotiations. The Fiscal Cliff represents the expiration of the Bush tax cuts plus required spending cuts scheduled for January 1, 2013. Both actions stifle economic activity, but may ultimately be necessary to achieve long term fiscal solvency (i.e. not spending more than we take in). It is a delicate balancing act: deficit spending is keeping GDP above recession levels, but at a cost to future generations’ ability to borrow, high interest rates, and long term solvency. Implementing the tax hikes and spending cuts as scheduled would have generated a 3% drop in economic activity — more than enough to push the US into a recession. Congress and the Administration must now try to narrow the difference between long term spending and revenue without damaging current growth prospects and the associated tax potential from that growth.
If the Fiscal Cliff was so important, then why did Congress wait until after the election to resolve it? It’s all about mandates. The election maintained the status quo: a Democratic White House and Senate, and a Republican House of Representatives with a majority of governorships. Both sides could interpret the election results as an affirmation of their respective mandates, despite the fact they are in polar opposition to one another. Investors cannot help but be reminded of the toxic brinksmanship surrounding the August 2011 debt ceiling crisis between Congress and the President. The crisis offered hints for a “Grand Bargain” to reform the tax system, boost revenues, and slash entitlement spending, knocking future debt levels down by trillions of dollars, but lack of compromise scuttled those plans. Instead, the crisis ended with modest cuts in spending, a downgrade to our debt rating, deterioration to our credibility and a sequestration compromise which led directly to the Fiscal Cliff.
The Fiscal Cliff negotiations act as harbinger for future negotiations, so the stakes were high. Both sides spent much of December 2012 competing for leverage. The key negotiators, President Obama and House Speaker Boehner, initially appeared to be bridging the gap between spending cuts and tax reform which may have achieved compromise similar to the 2011 Grand Bargain. By mid December, House Speaker Boehner abandoned the measured pace of mutual concessions and instead initiated an uncertain plan to achieve negotiating leverage with passage of a Plan B option. The Plan B option was ostensibly more palatable to the conservative wing of his party because it limited tax increases to those with incomes above $1 million (far from the President’s floor of $250,000), but it still failed to achieve enough support to warrant a vote on the floor of Congress. The Speaker, having left the negotiating table and failing to pass his own bill, shifted the issue to the Senate in hope of a speedy resolution.
Although the deadline for the Fiscal Cliff was technically broken, Senator Majority Leader Harry Reid and Minority Leader Mitch McConnell were able to put together a deal with fairly overwhelming support from the Senate, passing with an 89 to 8 vote. By the end of New Year’s Day, the House voted 267 to 167 to accept the Senate’s compromise deal.
The deal stops tax increases for most Americans, although households making more than $450,000 will return to Clinton era rates and many deductions phase out for households making more than $250,000. Regarding spending, the bill can only be seen as a stop-gap measure since most spending cuts are deferred for two months. A more comprehensive deal was too ambitious to hope for given the divide and the proclivity of both sides to adopt strong-arm tactics, as seen during the 2011 debt ceiling crisis.
Ironically, the 2011 debt ceiling debate is the reason that some strategists like Andres Garcia, Global Market Strategist at JP Morgan, are more optimistic that a comprehensive plan can ultimately be resolved in stages. Negotiations can work from the existing foundations of the nearly completed deals between the House Republicans and President. Speaking in December, Garcia suggested that any large deal may roll out in stages stating, “I don’t think they’ll be able to do it in December, but they can make a short term deal so that people in January don’t see their paychecks decreased significantly with tax increases.”
Speaking in December, Libby Cantrill. Senior Vice President at PIMCO, agreed for the possibility of a multi-stage fix, stating, “the fiscal cliff will be resolved by the end of the year, likely in a two-step deal: a short-term, ‘mini’ deal, which prevents the economy from falling off the cliff, but represents some fiscal contraction in 2013, coupled with a framework for a bigger debt deal in 2013 with likely effects not realized until 2014 and beyond.”
However, Garcia cautioned the delay in resolution has already had a chilling effect on corporate investment plans and hiring plans and, thusly, growth and employment. Echoing his sentiment, the November 2012 Wall Street Journal reports, “Uncertainty around the U.S. elections and federal budget policies also appear among the factors driving the investment pullback since midyear… Companies fear that failure to resolve the fiscal cliff will tip the economy back into recession by sapping consumer spending, damaging investor confidence and eating into corporate profits.” Recent reports have confirmed that consumer confidence has been bruised by the enduring sense of crisis on Capitol Hill. Uncertainty in tax rates for the middle class also softened retail purchases during the all-important holiday shopping season which had only modest (0.7%) growth.
Opinions differ as to whether we reach a recession now that a deal has been struck. ING’s line of thought suggests the 2012 election’s marginal impact to Fiscal Cliff discussions may be the last straw to send us into recession, but the underlying weakness in fundamentals would be the true culprit; it may be too late to avoid a recession no matter what happened in Washington. The US political system, by design, is filled with checks and balances such that no single person asserts too much influence; the President’s ability to change the economy is overrated. Coté contends that odds for recession are high, because of low US growth rates and the administration’s insistence on increased marginal tax rates, an anathema to growth. Furthermore, weakness in corporate earnings growth, a sharp slowdown in key economies (e.g. China), and a recession in the Eurozone had already set the circumstances for recession, regardless of which Presidential candidate took office. Other asset managers, namely PIMCO, have long argued for a reduced set of long term expectations from capital markets — a “New-Normal” — since the financial crisis started 5 years ago. Cantrill foresees a “tenuous economy” going forward even with a deal on the fiscal cliff, but her projected loss of -1.5% of GDP in 2013 from a negotiated deal might be soft enough to avoid outright recession.
The relatively bullish base case espoused by Garcia and others at JP Morgan reflects their belief that investors, driven more by fear than greed, have focused too much on worst-case scenarios and discounted the catalysts for improvement, such as a housing market resurgence after years of government accommodation. Alternatively, there are fundamental improvements which may boost growth, such as expanding free trade and domestic energy production, which do not predominantly depend on Washington.
The Fiscal Cliff has been a great source of uncertainty because it was the first issue to require immediate attention, and it has had great symbolic value. The polarizing campaign and the recent history of intransigence suggest continued acrimony and heavy handed tactics from both sides. Future issues of spending and growth, including an imminent revisit to the debt-ceiling in early 2013, have been shaped by the Fiscal Cliff debate and aftermath.
Articles by our Contributors
Chief Market Strategist at ING Investment
Douglas Coté, CFA, is the ING Investment Management U.S. Chief Market Strategist. With daily, weekly and monthly market commentaries, as well as speaking engagements, training seminars and conference calls, Doug provides in-depth analysis and practical support to help advisors maintain effective long-term, goal-oriented investment strategies.
Global Market Strategist at JP Morgan
Andrés Garcia is a Strategist on the J.P. Morgan Funds Global Market Insights Strategy Team. Andrés’ background in institutional sales trading and research are the cornerstones of his strong market knowledge.
Senior Vice President at PIMCO
Libby Cantrill is a senior vice president based in New York and works in PIMCO’s Executive Office, focusing on public policy issues and working with public pension clients. She has eight years of investment experience and holds an MBA from Harvard Business School.