With less than three months to go, the outcome of the November election remains highly uncertain. SocGen notes that, as always, economic performance over the coming months will be a key determinant of who wins and who loses. If the elections were held today, the most likely outcome would be a Republican win in both Congressional races and a Democratic win in the race for the White House. This means that any new significant legislation will almost certainly have to be a product of compromise. In this sense, we may very well be looking at a status quo in terms of bipartisanship and gridlock which have dominated Washington politics over the past few years. This would be bad news at a time when the country faces a number of serious challenges with significant long-term implications. From the economy to long-term fiscal health, and from the debt-ceiling to Housing, Healthcare, and energy policy differences, the following provides a succinct review.
Societe Generale: American Themes - US Elections
There is a strong need for leadership in Washington. The economy is performing poorly and monetary policy options have been nearly exhausted. Unfortunately, the ongoing split promises more of the same from Washington: politics instead of leadership.
A close race for president, coupled with uncertain congressional power. A split in the Congress can inhibit the agenda no matter who wins the presidential race. Unless the president’s party makes gains in Congress, it will be difficult to agree on any changes. The healthcare overhaul was achieved with a Democratic congress during President Obama’s first year in office. Reversing course requires not just a Republican president but a cooperative Senate. Sadly, gridlock is likely to prevail.
In Washington, there is widespread support for fiscal stimulus, at least for immediate support within the context of long-term discipline. Specifically, there is support to reduce the anticipated fiscal drag of higher tax rates and spending cuts that are set for 1 January 2013.
Election-year politics prevent current action. Congress may take action immediately after the election to reduce onerous tax rate increases or may wait until the new government takes office in January before acting. This uncertainty comes at a cost to markets and indeed to the economy in the short-term.
Key main assumptions and potential for surprises:
- President Obama expected to win re-election but faces a Republican Congress.
- Challenger Governor Romney victory would be a surprise. Narrow Republican control of Senate would be an obstacle.
- Choice of vice presidential candidate, Congressman Paul Ryan, hints at a more aggressive entitlement spending overhaul. The differences between President Obama and Ryan are fundamentally ideological and represent a serious choice for voters. Yet, it should not be forgotten that it is Governor Romney who is running for president, and the agenda of the presidential candidate is what will be focused on, no doubt. Moreover, Romney is the underdog.
- Quantitative approaches for determining whether a Republican or Democratic president are better for the equity market are somewhat flawed by a low sample size. Only 13 presidents have held office since the late 1920s when many current equity indices start with continuous data. Democrats have faired better according to the S&P500. The timing of bubbles, inflation and wars are key drivers, rather than coincidental party affiliation. Simple party alliance is not a driver for fundamental analysis.
Election scenarios – latest odds
Much could still change between now and the 6 November election. However, based on the latest indications from online prediction markets, the Republican Party is seen as the likely winner of both Congressional races.
Democrats are still seen as the favorite in the race for the White House, with President Obama winning re-election. In any case, it is unlikely that one party will control all three institutions. Moreover, any one party in the Senate is unlikely to hold the 60 seats (out of 100) needed to avoid filibusters. Therefore, in the absence of the majority needed for any post-election scenario, significant new legislation will require bipartisanship and compromise. In this context, the risk of gridlock remains high.
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With less than three months to go, the outcome of the November election remains highly uncertain. As always, economic performance over the coming months will be a key determinant of who wins and who loses. If the elections were held today, the most likely outcome would be a Republican win in both Congressional races and a Democratic win in the race for the White House (see Charts 1a-c above ). This would give Republicans an improved standing relative to the current configuration (in which they only control the House), but it would nonetheless leave power divided. The latest indications from online prediction markets suggest only a 40% probability that any one party will end up controlling both houses of Congress and the White House, leaving a 60% probability of a split scenario (see Chart 2 below).
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It is also very unlikely that any party will win a filibuster-proof super-majority. This means that any new significant legislation will almost certainly have to be a product of compromise. In this sense, we may very well be looking at a status quo in terms of bipartisanship and gridlock which have dominated Washington politics over the past few years. This would be bad news at a time when the country faces a number of serious challenges with significant long-term implications.
US election issues – what’s at stake
There is a lot at stake as we look to 2013. Immediately after the new Congress and/or administration take over, they will have to deal with the fiscal cliff as well as the long-term fiscal challenges, healthcare and financial regulation, and lastly, with energy policy, which is also crucial for long-term economic sustainability. We discuss these issues in greater detail in the following sections.
1. Economy
The first and perhaps the most important decision to be made by the incoming Congress and/or administration will be resolving the fiscal cliff in a way that does not undermine the still fragile economic recovery. If all of the planned spending cuts and tax increases go into effect as scheduled, the economy will experience a reverse stimulus of $600bn next year, or about 3.5% of GDP. A shock of this magnitude would almost certainly lead to a contraction in activity in the first half of 2013, which in turn could push unemployment toward 9.5-10%. The alternative, which is to extend all expiring tax provisions and do away with planned spending cuts, is unfortunately not viable. Maintaining the status quo on fiscal policy would result in a continuation of large deficits which would push the debt/GDP ratio above 90% by the end of the decade. Without addressing entitlements, the ratio would start rising even more rapidly after 2020, largely due to the effects of the aging population.
The ideal outcome is one that addresses long-term fiscal challenges, while recognizing the near-term fragility of the economy. This could be accomplished via a plan which phases in gradual tax increases and spending cuts over the next 10 years. The risk is that a post-election gridlock may lead to a more rapid fiscal consolidation, with adverse implications for the US economy. Given the high odds of a split government, as highlighted above, this is not a non-negligible risk. The most likely scenario is that some portion of the planned fiscal contraction will be delayed. But it is very unlikely that all of it will be legislated away. For example, payroll tax cuts look unlikely to be extended, which by itself could shave about 0.7% from next year’s growth. In our central forecast for the US economy, we have discounted a fiscal drag of about 1.3% in 2013.
Our central economic forecast does not rely on any specific assumption about the outcome of the November election. Indeed, we can envisage our economic scenario under a number of post-election configurations. First, it must be noted that both presidential candidates recognize the need for fiscal reform, and at the same time, neither wants to do consolidation in a way that would significantly undermine the US economy. And, although there are significant distributional differences between their prospective fiscal plans, both will most likely have to work with the opposing party in order to pass any significant legislation. This, then, leads us to two key conclusions. First, the early phases of post-election negotiations may prove highly disruptive, with a non-negligible risk of a gridlock scenario resulting in greater fiscal restraint than is desirable. Second, after all the dust settles, the ultimate fiscal deal could well end up resembling the Simpson-Bowles blueprint which itself was a product of compromise and bipartisanship.
2. Long-term fiscal health
In the tables below, we offer a summary of where the two candidates stand on key issues with respect to fiscal finances and the economy. We also include the Simpson-Bowles recommendations which we consider to be a benchmark for a balanced and pragmatic approach to fiscal reform.
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There are significant differences in how the two candidates plan to achieve fiscal balance. President Obama’s plan relies on a combination of revenue increases (to 19.7% of GDP by 2020) and spending cuts (to 22.5% of GDP by 2020), with spending cuts spread across both defense and non-defense budgets. In contrast, Governor Romney’s plan aims to cut taxes further, increase defense spending relative to the baseline and offset the budgetary impact by very large cuts to discretionary spending (see Table 1 for details). Under his plan, federal spending would eventually be capped at 20% of GDP. These ambitious cuts would bring spending below the long-term average despite the aging population and the projected growth in mandatory spending. As a benchmark, the Simpson-Bowles proposal aimed to stabilize federal spending at 22% while bringing revenues to 20.5% by 2020.
Tax Policies Under Competing Proposals
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Discretionary Spending Policies Under Competing Proposals
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Mandatory Spending Policies Under Competing Proposals
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3. Debt ceiling
The debt limit will soon rear its ugly head, but only after the 6 November elections. Fortunately US Treasury debt limits do not overlap the immediate election calendar. In August 2011, politics intertwined with debt ceilings and Congress appeared near the brink of a technical default. The rising risk of dysfunction and the impact it would have had on debt was partly the reason for Standard & Poor’s downgrade of the US’ long-term debt.
The US Statutory Debt Limit is $16.394 trillion. At the end of July 2012, the Treasury had just under $500bn of borrowing authority. Further, Treasury estimates its borrowing need in the second half of 2012 at nearly $600bn – calling it close. Treasury already indicated it could hit debt limit at the end of the year. Importantly, hitting the debt limit and the need for Congress to approve an increase will not occur until after the elections. The US Treasury is very likely to temporarily suspend certain debt transactions and could delay hitting the debt limit until Spring 2013. At that point a new Congress can consider legislation that is free of an immediate election. Congress can tie in the debt limit to legislation to reduce the “Fiscal cliff.”
4. Dodd–Frank Regulation
Reversing elements of the Dodd-Frank financial regulation has been a talking point among many Republican candidates. Yet concrete plans are thin. Romney calls for replacing Dodd-Frank with a streamlined, modern regulatory framework. Streamlining may be hard to differentiate from normal evolutions that would occur in the aftermath of such a major overhaul in financial regulations.
Regulation of financial institutions following the crisis is a force influencing global markets, regulators and economies. Voter sentiment against financial institutions is too strong at the moment. The best scenario may be no more than to dial down the anti-“fat cat” rhetoric. The Republican party may have differing views. The essence of the Tea Party is a grassroots, main-street effort to change the business-as-usual practices of both Washington and New York. Dodd-Frank legislation is already two years underway. Many important provisions, regulatory bodies and market exchanges have yet to be implemented. Nonetheless, considerable progress has been achieved in defining these functions, rules, markets, etc. Re-steering at the margins rather than any major repeal would be a more likely scenario with a Romney presidency. Even the current government, that passed Dodd-Frank legislation, would find needs to modify elements at the margins during a second term. Chances for a major reform is low.
5. Healthcare
The Republican party is more uniform on its healthcare positions, relative to financial regulations. Futile repeals of Obama’s healthcare law (Affordable Care Act) were passed in the Republican controlled House of Representatives, but progressed no further. Repealing what is now termed Obama-care would require a Republican President and Congress. A simple majority in the Senate might not be enough.
Healthcare would be the biggest game in play with a Republican president. Assuming also a Republican Congress in 2013, efforts to repeal the Affordable Care Act would gain momentum. The US Supreme Court only narrowly upheld key portions of the heathcare reforms. Taxation and choice are unifying elements to counter the government-led widespread health insurance coverage advocated.
By the next election, 2016, Obama-care, or Affordable-care will be far more deeply ingrained in the US economy. Modifications rather than a reversal would be more likely. This election is most likely the last chance on a major reversal of the 2009 legislation. Yet the voter interest is not there. Governor Romney has not succeeded in capitalizing on healthcare repeal as a significant campaign issue.
6. Energy policy - no fracking difference
Broadly speaking, the US has not historically had a strong energy policy, in terms of market impact – that is, in terms of the fundamentals and pricing of energy, especially petroleum and natural gas. This has been true since the twin oil crises of the 1970s and it remains true today.
For Obama and Romney, the common ground on energy far outweighs the differences. The bottom line is that growing US natural gas and oil roduction is good for the economy. It should directly boost GDP, it will narrow the trade deficit and it should be supportive for the dollar.
In conclusion, no matter who wins the election, we believe that energy policy will not be dramatically different, especially given the likelihood of some sort of divided government in Washington. The emphasis will be on encouraging growth in US oil and natural gas production. This pretty much means getting fracking regulations resolved, in coordination with states and industry, and then getting out of the way. We do not expect the election results to have any impact on oil and natural gas prices.
7. Housing—GSE reform
Although not included in the debt figures reported by the government, the US government has moved to more explicitly to support the soundness of obligations of Freddie Mac and Fannie Mae, starting in July 2008 via the Housing and Economic Recovery Act of 2008, and the 7 September 2008 Federal Housing Finance Agency (FHFA) conservatorship of both government sponsored enterprises (GSEs). The on- or off-balance sheet obligations of those two independent GSEs was just over $5tr at the time the conservatorship was put in place, consisting mainly of mortgage payment guarantees. The extent to which the government will be required to pay these obligations depends on a variety of economic and housing market factors. The federal government provided over $110bn to Fannie and Freddie by 2010.
8. President without re-election
President Obama is a known commodity, at least he is perceived that way. As a second-term President, Obama may take a different turn. Without pressures of re-election, President Obama could return to early promises to move beyond partisan politics and build the future by taking steps to control long-term fiscal trends. Tackling long-term deficit trends was too dangerous for the president seeking re-election. Simpson-Bowles offers a blue-print for bipartisan support. This is hopeful – but may be unrealistic. Pressures to take action on the deficit, however are building. The bi-partisan groups in Congress offer some reflection on this. Grassroot efforts are also building and the Tea Party owes its start to one extreme effort to control deficits.
For financial markets, a President intent on building a legacy on long-term deficit reduction would be a positive-risk scenario for financial markets in the medium term. It is doubtful, however, that any immediate market response will occur on deficit reduction.
Conclusion
Following the elections, Washington will focus on the fiscal cliff, that is the currently legislated tax increases and spending cuts that would materially slow the US economy at the start of 2013. Election-year gamesmanship prevents pre-emptive efforts to reduce this fiscal drag on the US economy. A lameduck Senate may not take immediate action on tax cuts, and rapid action may be required in January. This is more timing uncertainty, and path uncertainty, but not eventual outcome uncertainty. At least not for major elements to reduce the threat from a fiscal drag.
The most likely scenario of President Obama and a Republican Congress suggest status quo. Importantly, however, status-quo reduces uncertainty surrounding fiscal policies as well as recently passed legislation on healthcare and regulation. The upside surprise would be a second-term president that wants to build a legacy of long-term deficit control. The downside risk would be a failure to reach compromise on the fiscal cliff despite overwhelming similarities in the party positions.
Within the Congressional elections, the risk versus our scenario would be that the Democrats maintain control of the Senate. This would be more of the status quo. Lack of a super majority in the Senate and a Republican-controlled House of Representatives would still foster gridlock on major economic and financial market legislation. A split Congress would make it difficult for President Obama to reach on a compromise on legacy building.
In the presidential elections, the surprise would be a victory by Governor Romney. With a Republican Congress, there are greater chances to repeal or substantially modify the recent healthcare overhauls. Additionally, reducing fiscal drag in early 2013 would be less complicated. Lastly, with full Republican control, we would expect lower taxes in the medium term and greater efforts on cost control. Drastic changes under a Romney presidency would likely hinge on the degree of control by Republicans in the Senate. Control of the Senate is likely to be razor thin. In the end, the election alone is unlikely to produce major legislative changes. Responses to market, economic and demographic pressures are more likely the triggers for significant legislative action in the next few years.