By Investment Strategy Group
October 5, 2012
With about a month to go before Election Day, we have entered the final stretch of the campaign season, with early voting already underway in swing states such as Iowa. In a basic sense, the U.S. election is about defining the long-term direction of the country and finding a balance between political ideologies. But more immediately, it could have a significant impact on how a looming threat to near-term economic growthâ€”the â€śfiscal cliffâ€ťâ€”is resolved. Below, we discuss what the polls are currently saying and the implications for future policy.
Odds Favor the Status Quo
In recent weeks, President Barack Obama has widened his lead over challenger Mitt Romney in most polls. As of October 4, the Iowa Electronic Markets (a trading market operated by the University of Iowa) puts the Presidentâ€™s chance of winning at around 70%, up from a little over 50% in May. Obama appears to have benefitted from a postconvention bounce and rising consumer confidence, although Romneyâ€™s strong showing in the first presidential debate might narrow that lead in the coming days. Meanwhile, the House of Representatives appears increasingly likely to remain in Republican control, with the market pricing in an 80% chance that the GOP will hold steady or gain additional House seats. The Senateâ€™s election outcome appears to be a function of the presidential race; with Obamaâ€™s recent gains, Democrats appear to have the upper hand.
The table on the next page summarizes the probabilities of various election outcomes as implied by the market. There appears to be about a 60% possibility that President Obama will preside over a split or Republican Congress (highlighted in yellow) and a 24% probability of a President Romney working with a split Congress (blue). In short, despite the millions spent by both campaigns, the status quo is likely to prevail with political leaders finding themselves in similar strategic positions as before the election.
OBAMA VICTORY AND SPLIT CONGRESS LIKELY
Better Luck This Time?
Unfortunately, the highest probability scenario creates the most uncertainty in terms of predicting policy decisions going forward. In the past few years, the legislature has often been paralyzed by partisanship at the expense of practical policymaking. Itâ€™s hard to know whether the upcoming elections will remedy the situation and somehow prompt timely effective action on the fiscal cliffâ€”especially given that some action is required before the start of the year when the new Congress convenes.
Given the short timeframe, investors are rightly nervous that a solution will not be achieved, particularly in light of last yearâ€™s harmful debt ceiling debate, which prompted a downgrade of U.S. Treasuries and caused global markets to tumble. However, many investors expect that a short-term extension on certain areas of controversy (i.e., the expiration of Bush-era tax cuts and a mix of spending reductions) is likely, which could soften the immediate impact on economic growth. In such a scenario, we believe the stock market is likely to react well in the short term but could become increasingly volatile as these issues are revisited in 2013. We caution investors against being too optimistic as we believe many elements of the fiscal cliff, such as payroll tax cuts, will probably be allowed to expire quietly regardless of the election outcome, creating a drag on GDP in 2013.
Other effects of an Obama victory are more predictable. We anticipate that higher income taxpayers would see their taxes rise during his second term. And the Affordable Care Act (ACA) and the Dodd-Frank financial regulations would likely remain in place, potentially with some adjustments. In contrast, a Romney victory would be supportive of lower tax rates, larger spending cuts, attempts at entitlement reform and a repeal or major overhaul of the ACA.
It Ainâ€™t Over...
Despite increased odds of an Obama victory and a split Congress, a lot could change between now and the November 6 election. The polls are heavily influenced by confidence in the economy, which in turn is affected by the stock market (see display).
The recent rise in equity prices has partly been the result of looser monetary policy from the European Central Bank and Federal Reserve, but its impact may weaken, especially if employment data soften more than expected. Moreover, the remaining presidential debates could have an impact and there is always a chance of a last minute blunder or controversy that could sway results.
Notwithstanding the constant election headlines to come and the immediate implications for the fiscal cliff, the main economic effects of an election tend to be long term in nature. In the near term, we think investors should not be too distracted by political rhetoric and instead continue to focus on fundamentals affecting the economy.
OBAMA'S PROSPECTS LARGELY TRACK MARKET RESULTS
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