Hot topic Mid-Term Elections and Market Implications
With 11 days to go ahead of the mid-term elections, in which 1/3rd of the Senate seats and the full House are up for election, the polls are suggesting it could be a very interesting election night. In this week's Hot Topic we discuss the possible impact of the different election scenarios on the overall financial markets, and specifically on key US industries.
Below is a listing in order of likelihood of the different outcomes of the mid-term Congressional elections, according to most political pundits.
* Democrats capture a slim majority in the House (pick up 20-25 seats; 15 needed for majority control), but not the Senate (pick up four -five seats; six needed).
* Democrats capture a slim majority in both the House and Senate.
* Democratic rout – take decisive control of the House (more than 30 seats captured) and capture a majority in the Senate.
* Republicans maintain control of the House and Senate.
However, before we get into specifics on the industry implications, it is important to note that just a slim Democratic majority win in the House (which most political pundits list as the most likely outcome) limits how far to the left policies will swing. Even before a legislative bill reaches the President's desk it has to be approved by both the House and Senate. If the Democrats do not secure the Senate, then that is the first hurdle they need to jump. And even if they do win a majority in the Senate, no one predicts the Democrats will garner the needed 60 votes to overcome a filibuster. A filibuster is a tactic used to defeat proposed bills or motions by employing prolonged debate, possibly indefinitely. So, the Republicans, as the Democrats have had at their disposal, could use this to prevent bills even reaching the Senate floor for vote.
Moreover, President Bush could easily use his veto pen more freely. To override a Presidential veto, a two-thirds vote is needed in each the House and Senate, a highly unlikely scenario unless it is an issue that Republican as well as Democratic members disagree over with the Administration. That all said, even a narrow majority victory by the Democrats will change what legislation is passed and impact the financial markets. It would be a signal for Republicans, including the Administration that they need to move a bit to the left or center on many issues. This is particularly true for the President if he wants to be remembered for significant legislative reforms or changes in his second term.
Thus, if Democrats capture a slim majority in the House, but not the Senate, we would have a split government. Overall looking at the performance of the equity and bond markets over the past 50 years split government has been both bullish for the equity and bond markets (see Table 2). The result could reflect investor sentiment that divided government leads to legislative gridlock, which means status quo in Washington. Investors seem to be expressing a view that less government intervention is best for the economy and markets.
However, let's examine and identify the winners and losers by industry if the Democrats win control of the House, keeping in mind if they win the Senate as well and/or if we see a Democratic rout on Election Day the impacts are even more heightened. If the Republicans surprisingly retain control of the House and Senate, then the winners in the alongside table become losers and vice versa.
Traditional Defense vs. Defense Technology and Homeland Security
No doubt the Iraqi war and the war on terror are the top issues for the upcoming elections. Therefore it is not surprising that the first issue addressed as part of Democratic agenda is foreign military and homeland security policies. The Democrats argue for the Iraqis to take on more responsibility for their country and to begin a phased redeployment of U.S. forces from Iraq. The Iraqi war has cost more than $300 billion and has driven a 72% jump in defense outlays since 9/11. Therefore, scaling back efforts in Iraq would lead to a significant pull back in defense outlays and would be negative for traditional or conventional defense companies. This comports with our Aerospace and Defense Analyst Ron Epstein's work published in "A New Model for Defense Spending" (Aerospace & Defense, 15 September 2006), in which he found that overall defense spending is dictated by political control (Republicans spend more on defense than Democrats) and in turn defense spending powers defense stock valuations.
However, the Democrats advocate spending more resources on state-of- the-art military equipment and want to direct more money towards protecting the homeland. Therefore, companies that provide hi-tech defense technology and homeland security equipment used for screening containers, securing our borders, etc. should benefit positively. For more on defense technology plays see Rich Bernstein's latest report (Thematic Investing, 25 October 2006).
Big Oil vs. Alternative Energy and Electric Utilities
A Democratic win could be very negative for the oil industry since Democrats want to first end tax subsidies directed to Big Oil companies and enact punitive laws to prevent so-called price gouging. Moreover, they aim to "curtail" America on our foreign oil dependence and at the same time create a cleaner environment. This would include defeating calls to open up the Arctic National Wildlife Refuge and extending tax incentives to energy-efficient technologies and domestic alternative fuels such as bio-fuels. So, the alternative energy sector would receive a big boost. The prospect of tougher environmental laws would have a negative impact on electric utilities and the coal industry.
Pharmaceutical Makers vs. Generic Drug Companies
A shift towards Democrats in the upcoming election also yields a large negative impact on pharmaceutical drug makers, but benefits generic drug makers. Democrats are highly critical of big drug makers and want the government to have the right to negotiate prices on prescription drugs for seniors under the Medicare program. In addition, Democrats would end subsidies given to big pharma and HMOs. Moreover, Democrats, unlike Republicans, favor allowing the government to offer its own drug coverage in competition with those sold by private companies.
Democrats, unlike Republicans, aim to promote stem cell research, which would benefit the biotech industry. However, progress on this agenda item will likely have to wait until after the 2008 presidential election, given President Bush's strong opposition – in fact, his first and only veto thus far was to stop a bill that aimed to lift funding restrictions on human embryonic stem cell research.
GSES, Student Loan Providers and Commercial Banks
Democrats have long been backers of the GSES – Fannie Mae and Freddie Mac since they argue it helps make homeownership more available to all Americans. Republicans in contrast have been extremely critical of Fannie and Freddie and have launched hearings and have been in favor of reigning in the growth of their mortgage portfolios. On the other hand, Democrats in an attempt to make college education more affordable for all would push to lower student loan interest rates. This would be negative for providers of student loans such as Sallie Mae. Democrats could also pursue tighter lending standards for commercial banks, which would be negative for their bottom line.
Retailers
A swing in power towards the Democrats could be a negative for retailers. Democrats want to increase the nation's minimum wage, which is currently $5.15 and in real terms is the lowest ever, and also are supporters of labor unions. Higher wages for workers would result in a higher cost structure for retailers. Democrats favor rolling back some of the Bush tax cuts, particularly those aimed at high-income earner while at the same time eliminate the alternative minimum tax (AMT). However, rolling back the Bush tax cuts will be difficult without a veto- proof majority in the Congress.
Manufacturing
Manufacturing companies could also fare worse with a Democratic win since the Democrats are more protectionist than Republicans. They will try to stem the tide of jobs moving overseas and in doing so could hurt the competitiveness of the manufacturing sector that relies the most on job outsourcing. Additionally, their pro-labor union bias also could work against manufacturers.
Life Insurance Companies and Other Insurers, and Tobacco
The Democrats have long been critical of President Bush's tax cuts and would argue strongly against elimination of the estate tax, which Republicans would still like to pass. A permanent repeal as the Republicans want would be negative for life insurance companies since much of their sales are estate-tax related. Conversely, a Democratic agenda would be positive for life insurance companies. However, the Democratic platform would not be favorable for other insurance companies, since they would likely stop some the new limits placed on the tort system and could increase insurance-industry regulation. For a similar reason, Democrats would be negative for Tobacco companies.
Bond Market Impact
Shifting to the bond market, a Democratic victory in the House (or if they win both House and Senate) would be bond bullish as we think Democrats would be more fiscally prudent than Republicans. Spending during the Bush Presidency has posted an average annual growth rate of 6.6% (and 7.4% since 9/11), led by a surge in defense spending. Democrats as mentioned above might quickly move our troops out of Iraq, thus reducing defense expenditures. As noted above, Democrats hope to roll back some of the Bush tax cuts, especially those aimed at the top income earners. Such action is not likely since the Democrats are not all expected to capture a veto-proof majority. However, a Democratic win would ensure defeat of Republican motions to eliminate the estate tax.
Foreign Exchange — Dollar Impact
According to our Foreign Exchange analyst Jason Daw, it is rarely the case that political events have a large immediate impact on currencies, especially in developed countries. Over the medium term, the fiscal/monetary policy mix is only one issue for currencies; numerous other domestic and international issues are also at play, making it difficult to isolate the impact of politics.
That said, in the case of a Democratic victory there are two ways to view the impact on the USD. Tighter fiscal policy resulting in lower spending, lower growth and subsequently monetary policy not being as tight as otherwise could be marginally negative for the USD. On the other hand, a weaker US growth backdrop could be favorable to the current account deficit and somewhat positive for the USD. Given the prevailing backdrop of the US 'twin deficits', any measures seen as being beneficial to external imbalances should win out. However, we stress that these effects are marginal and need to be considered in the context of the Federal Reserve remaining on the sidelines while central banks outside the US proceed with their tightening cycles.
Kathleen Bostjancic, Economist, MLPF&S