Saturday, October 30, 2010

Focus - US: Mid-term election primer

It looks like a landslide victory for the Republican Party


Where the 435 members of the House face election every two years, the hundred senators (two from each state, independent of size) serve for six years, with overlapping terms. At the moment all major polls suggest that the Democrats will lose their majority in the House – hereby losing their current 40 seat lead. In the Senate 37 seats are up for election (19 currently held by Democrats, 18 held by Republicans). Here, the race is expected to be much tighter, with most major polling units predicting a very narrow win for the Democrats – landing on a 1-2 seat majority.

The party of the sitting President often ends up being the loser in the mid-term elections, particularly in a President’s first term. This will probably be further enhanced by many of the groups who supported Obama two years ago, such as African Americans and young voters, historically showing relatively lower turnout rates at mid-term elections than in presidential years.

The Democratic party is also expected to pay heavily for the consequences of the financial crisis, with unemployment at almost 10 percent, and government debt building at an alarming rate. This has made many Americans doubt that the Obama administration’s strategy of e.g. large stimulus packages has been the right one.

Particularly the so called Tea-party movement, which has grown increasingly powerful within the Republican party, continues to advocate the opposite – campaigning for a smaller government and further tax cuts.

All in all, a so-called divided government, with different parties controlling Congress and the presidency, has become a likely outcome of Tuesday’s election. This situation is, however, nothing new to American politics. For 38 out of the last 60 years the President and the majority of the House have been from different parties, and particularly during the 1980s and 1990s this was the norm. However, it can prove an unfriendly environment, and effectively shut down the legislative process, as seen when president Bill Clinton was faced with a Republican-controlled Congress in the mid 90s. If the US, come Tuesday, ends up having a split Congress under a Democratic president, it will be the first time this has happened since World War II.

It is not easy to say anything certain about the implications of a split Congress for the coming two year’s political decisions. However, on balance we think that it will mean a more difficult environment for implementing strict regulation of the financial sector, less inclination to raise corporate taxes and it will probably be more difficult to agree on a new round of major fiscal stimulus. That said, we do expect the new Congress to agree on extending the 2001 and 2003 Bush tax cuts, which would otherwise expire in January
2011. According to CBO’s estimates and our own calculations, if the Bush tax cuts are allowed to expire this would result in a drag on GDP growth of 0.6-1.5pp in 2011.

Market implications of elections: Is history a guide?
With a divided government a likely outcome of the mid-term elections, a natural question to ask is whether this may have implications for investor risk appetite. A divided government may complicate political matters, and the composition of Congress may affect investor expectations about both fiscal policy and possible regulation measures. But what are the implications for the markets? We studied post-WWII data of the composition of Congress after each election throughout the years from 1945-2010 and held them against the performance of the S&P 500 index from the date of inauguration (Jan-20 in odd years) to the next Congress.
Interestingly, periods with the White House controlled by a Democrat and Congress controlled by the Republicans – a situation that is likely to be in place from 20 January 2011 - have seen the best average equity market performance. One important caveat is, however, that this result is heavily influenced by the fact that the period 1995-99, during which President Clinton faced a Republican-controlled Congress, coincided with the technology equity market boom.

When looking solely at the party controlling Congress, equities have performed better during periods of Republican control than in periods of Democratic Congress majority. This could indicate that from the point of view of investors, a Republican-controlled Congress is generally seen as less likely to put through legislation that is hostile to business, both in terms of tax policies, but also in terms of regulation issues. In the
current situation , with financial sector regulation issues likely to remain high on the agenda in 2011-12, a Republican-controlled Congress could be seen as less likely to enact further measures to tighten regulation.

We do emphasize, however, that these results should be taken with a “grain of salt”, as financial markets are driven by a wide range of factors, with politics only one factor. Nevertheless, the results do highlight the fact that a divided government does not necessarily lead to weaker performance in risky assets.
http://www.danskebank.com/

Full report : Focus - US: Mid-term election primer

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