Economic News & Analysis—August 20, 2012

An investor’s guide to the presidential election

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

The November election matters to investors. With the entire House of Representatives, one-third of the Senate, and many state and local seats in question, the presidential race is just one of many to watch. All together, the new makeup of two of the branches of national government will likely have a profound impact on tax policy, the federal budget, and regulatory interpretation and enforcement. In addition, with three justices at or approaching retirement age, the next president will likely determine the political complexion of the Supreme Court for many years to come.

One outcome I’m anticipating is that the House will retain a Republican majority. Taking this as a given, I believe there are three election outcomes for which investors need to prepare.

Split Senate: Why it matters who’s in the White House

When there’s a tie in the Senate, the vice president casts the tie-breaking vote, effectively tipping the balance of power to his party. Under President Obama, a split Senate would effectively be controlled by the Democrats. It would be functionally similar to a scenario in which President Obama is re-elected along with a Democrat-controlled Senate. Under Mitt Romney, a split Senate would effectively be controlled by the Republicans and would be functionally similar to a scenario in which there’s a Republican-controlled Congress (both the House and the Senate).

Republican-controlled Congress: Significant changes in store

In a Republican-controlled Congress, the party would play an important role in bringing legislation to a vote. This would lead to the Republicans retaining control of the legislative agenda for the next session of Congress and could result in significant proposals related to defunding the Affordable Care Act and the Dodd-Frank Act. Additionally, there could be significant changes to the tax code and the growth of federal government spending, though defense spending would likely continue to grow (benefiting defense industry stocks). Entitlement programs (Social Security, Medicare, and Medicaid) would likely have long-term reductions in their growth rates by means-testing benefits and increasing the eligibility age for benefits. These changes, however, would not likely affect any person who is 55 or older.

If Mitt Romney is elected president, he will likely sign these proposals into law, especially because it is highly likely that his candidate for vice president will spearhead the proposed changes. President Obama would likely veto changes that eliminate funding for the Affordable Care Act, but he may be more accommodating on the other issues. He demonstrated willingness to compromise at the last minute on many programs favored by Republicans after Republicans took control of the House with the 2010 mid-term election.

Implications of a Republican-controlled Congress to investors

  • Tax reform could be a significant boost to the economy. Not only could tax reform be beneficial to the overall economy, improving earnings of U.S. businesses, it could also prod investors to be willing to attach a higher price-to-earnings multiple to those earnings providing a nice boost to the stock market.
  • Tax reform could possibly hurt the housing market and housing-related stocks. One popular proposal is to eliminate or change the mortgage interest deduction in the tax code. The mortgage interest deduction is a significant subsidy to the housing industry. Eliminating it, or even capping it, could hurt housing-related stocks.
  • The change in the regulatory environment could benefit the energy sector and the financials sector. The energy sector could benefit from the further opening of federal lands and water to oil-and-gas exploration. The financials sector could also benefit if parts of Dodd-Frank are repealed. There is significant skepticism on both sides of the political spectrum as to whether banks should be allowed into risky investment activity, so the upside to financials may be limited.
  • The health care sector would undergo significant changes. After the Supreme Court ruled that the individual mandate was constitutional as a tax, managed care and insurance stocks did well while, by comparison, the rest of the sector declined. This pattern could reverse itself if the Republicans repeal or defund the Affordable Care Act.

Democrat-controlled Senate: A continuation of the status quo

A Democrat-controlled Senate is likely only if President Obama is also re-elected. This outcome would, effectively, be a continuation of the existing state of affairs in Washington, D.C., and would mean at least two more years of the past two years: gridlock and buying time until the next mid-term election.

Implications of a Democrat-controlled Senate to investors

  • The danger that tax policies don’t get extended. A split Congress could result in a significant hit to stocks across the board, as higher tax rates across the income spectrum would lower short-term growth. The long-term effects of higher taxes may not be as negative as on short-term growth, so the stock market adjustment could be temporary.
  • Higher tax revenues could keep currently low interest rates low. However, the low rates of today have likely more to do with the problems in Europe than in the U.S. Thus, the election might not have much of an effect on interest rates, regardless of how it turns out.
  • The risk that the economy could go off what Federal Reserve Chairman Ben Bernanke has called “the fiscal cliff.” I’m willing to invest against that risk. Congress men and women have a strong re-election instinct, and orchestrating a mild recession in the U.S. is not a way to endear oneself to the electorate. That’s why I’d put the odds significantly in favor of a continued extension of existing policies until comprehensive tax reform can be negotiated and passed.

The bottom line for investors

The upcoming election could significantly affect the markets. The most likely sectors that would benefit from a Republican sweep of the House, the Senate, and the White House are health care, financials, and energy, and defense-related stocks would also likely get a boost.

It’s unlikely that Democrats can wrestle control away from the Republicans in the House, but if Democrats retain control of the Senate, they could simply keep the status quo in place. That would likely mean continued high market volatility, as substantive reforms are pushed further into the future. Tax and spending reform almost necessarily needs to happen, but it likely wouldn’t until after the 2014 mid-term election, at the earliest. A divided government can lead to positive change, but only if you’re already on the right track. However, if we are left with a divided government, investors, I think, can still look forward to longer-term reforms and can continue to invest for growth. It just might take longer for those investments to pay off.

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