Election 2012: What Now?

This is a repost from Jeremy Webman, Chief Economist of Oppenheimer Funds.


The election results were exactly what the markets had been predicting for weeks.  There will be no change in the balance of power in Washington, D.C.  President Obama was re-elected, the Republicans maintained control of the House of Representatives and the Democrats maintained control of the Senate.

We now turn our attention from the campaign season to the realities of governing.  There are several huge fiscal-related issues that now need to be resolved, and investors are watching closely.  The much awaited lame-duck session of Congress is now upon us and what needs to be accomplished is clear.  Step 1 will be to blunt the most severe components of the Fiscal Cliff. Step 2 will be to raise the debt ceiling. Step 3, (the most important, in our opinion) a “Grand Bargain” to arrest the growth in the nation’s deficits and debt, will have to wait until the next Congress is sworn in and the President inaugurated.

None of this will be easy. The rhetoric will be heated, and we can expect bouts of market turmoil as leaks and posturing threaten the most constructive outcomes. The most likely outcome, however, is a short-term compromise before year’s end to buy time for a more deliberative process on a “Grand Bargain” in 2013.

Fiscal Cliff

The Bush-era tax cuts are set to expire at the beginning of the year, while the $1.5 trillion cut in across-the-board spending over the next decade, known in Washington as the sequestration, is set to begin shortly thereafter.  President Obama will claim a mandate thanks to his re-election, but the Republican members of the House of Representatives most likely will claim the same thing.  The rhetoric—from all sides—will be very heated in November.  We could possibly go well past Thanksgiving without any resolution. Characteristically, Congress and the administration will likely posture loudly until the last minute, but we believe that something will actually get done.  No one will likely want the blame for causing severe damage to the economy by letting the nation go over an avoidable fiscal cliff.

Plus, there are real reasons to compromise.  Conservative members of Congress will want to avoid huge tax increases, and big cuts to defense.  Obama and Senate Democrats will want to prevent higher tax increases for the middle class, including the Alternative Minimum Tax (AMT) hitting 30 million more Americans than it did in 2011.1 Obama also does not want a recession in the first months of second term and will try to tie the debt ceiling increase to a tax cut extension.

What Investors Can Expect

  • Some taxes likely will go up. In order to get the debt ceiling raised and to fix the AMT patch and a Medicare fix, we expect President Obama to agree to a short-term extension of the Bush tax cuts for all of those but the “wealthiest” Americans.  Obama currently maintains that the marginal tax rate will increase on households earning more than $250,000 per year but that number could potentially be negotiated to as high as $1 million.  At the same time, the tax rate on dividends will also likely increase, but we do not believe it will go as high as the highest marginal tax rate.  A more likely scenario has the dividend tax rate back above 20% but moving in lockstep with the capital gains tax rate.  The payroll tax holiday, which went into effect in 2011, will end. And the taxes called for in the Affordable Care Act (aka Obamacare) will go into effect.
  • The sequestration likely gets delayed. A comprehensive fiscal plan will likely be left to the incoming 113th Congress.
  • The total cost of avoiding the fiscal cliff will likely be a 1.0-1.5% drag on the U.S. economy.That’s a case of simple math. An end to the payroll tax holiday would increases taxes on workers by roughly $110 billion.1 The taxes associated with the Affordable Care Act add another $20 billion.1 Those alone represent nearly 1% of U.S. Gross Domestic Product. A tax increase on the wealthiest Americans could create another 0.5% drag.  A fiscal drag of this size would weaken the economy but thanks to a recent pick up in momentum would likely not be large enough to tip the economy into recession in 2013.

A “Grand Bargain”

The big hope for many investors is a comprehensive fiscal plan that can put a dent in the $1.09 trillion annual budget deficit and slow the growth of the Federal government’s debt. Right now, Uncle Sam has $11.4 trillion in debt held by other entities. That’s 72% of GDP; the highest level since 1950.2

What Investors Can Expect

  • There likely will be a push to cut $4 trillion from the deficit over the next decade.  Elections have consequences.  Obama will push for a permanent tax increase on the wealthiest Americans. Cuts to defense and discretionary spending will be on the table, as well.
  • Social Security is most likely in the crosshairs. The nonpartisan Simpson-Bowles deficit commission (which offers one plan on how to resolve the deficit and pull us back from the fiscal precipice) recommended formula changes to reduce Social Security’s cost of living adjustments and a rise in the retirement age, currently 67. Whether or not our elected officials follow the path on Social Security set forth by Simpson-Bowles remains to be seen, but changes to entitlements will have to be a part of any grand bargain.  President Obama might be willing to accept those terms if he can keep Social Security solvent for another generation.
  • Structural changes to Medicare will be very difficult to come by.  Democrats probably will rely on the administrative oversight means set up in the Affordable Care Act.
  • There likely will be no major changes to either the Affordable Care Act or the Dodd-Frank Wall Street Reform and Consumer Protection Act.  We do expect some changes to the regulations written to implement Dodd-Frank, however.

The Federal Reserve

The term of Ben Bernanke, the current Fed Chair, expires in 2014. Under Bernanke, the Fed has maintained an extraordinarily accommodative policy stance and is currently buying billions of dollars of securities and keeping interest rates at, or near, record-low levels.

What Investors Can Expect

  • There likely will be a new Fed Chairman, but no big policy changes. Bernanke will return to academia when his term ends. President Obama will likely appoint Vice Chairman Janet Yellen to succeed him.  She will likely keep the Fed on a dovish, low-interest-rate path through 2015. The only change might occur in the event of inflation shocks. No central banker wants to leave a legacy of spiraling inflation.

U.S. Dollar

The U.S. dollar has generally weakened in value against other major currencies for the past several years, with the recent exception of the euro.

What Can Investors Expect

  • The dollar likely will continue to weaken against select currencies. Now that Obama has been re-elected (and assuming Yellen succeeds Bernanke), markets will perceive that the nation’s current accommodative monetary policy (low rates, asset purchases) will continue for the next several years.  The dollar will likely weaken against the currencies of the countries enjoying stronger economic growth but investors need to be selective.  Many central banks around the world are intervening in currency markets and deploying accommodative policy actions of their own.
  • Over time, the dollar’s fate is tied to the growth potential of the U.S. economy.  Agreeing to a Grand Bargain would be a dollar positive.

The Stock Market

On a price basis, the S&P 500 rose 77% from Obama’s Inauguration Day in 2009 until the day before Election Day 2012. What is the outlook now that he will be in office for another term?

What investors can expect

  • Obama doesn’t control the broad stock market, earnings do. Some market participants might view Obama’s re-election unfavorably and some favorably, but over time, how and where companies make money will determine how the stock market performs.  Investors should remain focused on companies’ ability to generate profits in the policy environment they face.
  • That said, specific stocks could benefit. For example, we think hospital companies could profit from the Affordable Care Act, providing 35 million more Americans access to health insurance.3Infrastructure firms could also benefit.
  • Watch for any weakness. Uncertainty over resolving the fiscal cliff and eventually reaching a longer term path to fiscal discipline could result in downside volatility, but we will be selective buyers on any weakness.  Stocks are as cheap relative to bonds as they have been in decades. Investors still are not paying up for growth.

Read more from the series Election Insights 2012 athttp://blog.oppenheimerfunds.com/tag/election2012/

  1. Congressional Budget Office (www.cbo.gov) “An Update to the Budget and Economic Outlook Fiscal Years 2012 to 2022” published on 08/22/12.
  2. Bureau of Economic Analysis (www.bea.gov) National economic accounts data as of 9/30/12.
  3. Congressional Budget Office (www.cbo.gov) “Estimates for the Insurance Coverage Provisions of the Affordable Care Act Updated for the Recent Supreme Court Decision” published on 07/31/12.