US Election 2012: What’s at stake for global markets?

The 2012 US election promises to be a white-knuckle affair for the two candidates and the nation, and the impact on global markets could be significant.

A few weeks ago, we might have penned a pre-election outlook that merely pondered what a second Obama term would look like as the polls were tilted so heavily in his favour. But the race tightened in a heartbeat after Romney’s aggressive performance and Obama’s beleaguered one at the first presidential debate in early October.

With the election result on a knife’s edge, the opportunities and risks for investors from either outcome demand consideration.

Gridlock still an obstacle

If there is anything that the last four years has shown us, it is that partisanship and gridlock remain serious obstacles to either President Obama or President Romney achieving any significant new policy goals, particularly on the economic front. By all appearances, the House of Representatives will have a solid Republican majority while the Senate will remain narrowly in Democratic hands. So the gridlock will continue for at least two more years until the 2014 mid-term elections, regardless of who wins.

Still, there are a few important differences between the two candidates that may exert significant influence on global markets, particularly later next year when it comes time to make the decision on whether Fed Chairman Bernanke will get another four-year term.  There are three major areas that will be affected by the occupier of the Oval Office in the months and up to a year ahead: the Fiscal Cliff, the overall US Economic Outlook, and the Federal Reserve.  

Today we'll look at the first two: I'll discuss the Fed in a separate piece. 

The Fiscal Cliff
The very first order of business for the market is in understanding the degree to which an Obama or a Romney presidency would alter the course of the “fiscal cliff” – the series of automatic reductions in spending and hikes in taxes (as tax cuts expire) that will go into effect on January 1, 2013 if no new deal is struck between Congress and Obama. (The new Congress first meets on January 3, while the next US Presidential term begins on January 20.) The basic assumption is that some softening of the cliff is inevitable with a new “deal”. Looking back, it is almost inconceivable that Obama and Congress didn’t look far enough ahead to anticipate the awful timing of this fiscal cliff, as a new deal will have to be hammered out by a lame duck Congress and possibly even a lame duck president, whose motivation is questionable.

The basic assumption regardless of the election winner is that the Obama payroll tax cuts will not be renewed, which will immediately take spending power at the margin out of consumers’ pockets. Another key issue on the taxation front is the Bush-era income tax cuts, which will expire unless extended.

If Obama wins, we can expect a nasty Congressional fight over the expiry of the Bush-era cuts and whether they should be renewed for all, or only those who earn less than USD 250,000 per year. The game of chicken will be intense regardless, but the fiscal cliff might be marginally worse if Obama wins a second term. Some Republicans may be obstreperous in the event of a narrow Obama win and want to score points ahead of the 2014 mid-term elections. Obama might also try to play a more forceful hand in his second term in the interest of his legacy and because he won’t be up for re-election.

If Romney wins, there is a risk of Obama having no motivation to cut a deal with Congress.  Or would he instead prefer to cut a generous deal? Or a deal that effectively delays most of the decision making for another year in order to avoid a tarnished legacy? The fiscal cliff may be less severe in the event of a Romney victory.

The Economy
The usual consensus is that a Republican presidency is better for an economy than a Democratic presidency, simply because of the “pro-business” stance of the Republican party, but that’s not always true.

Obama presidency: Another four years of the same policy, possibly with higher taxes and no real reductions in spending. Would the world begin to lose faith in the US treasury bonds or the dollar, as the nation fails to shore up its deficits and Bernanke is allowed to print ever more money? Obama is likely to suffer from the same Congressional gridlock as before and may be unable to enact any new legislation beyond whatever deal is lashed together to soften the fiscal cliff. This leaves the economy and markets to the wiles of Fed policy. Bernanke would probably get four more years, as the Fed enables the government’s overspending in the first place.

Romney presidency: The market will anticipate that Romney policies will be more business-friendly, particularly longer-term, as the costs of Obamacare may be eventually rolled back and because of easier tax policy. But it is extremely difficult to determine what a Romney presidency could actually achieve, as campaign promises and eventual policy decisions are often two entirely different animals. It appears that Romney harbours all of the usual Republican fantasies that taxes can be cut without affecting revenue (look at the failed Reagan and Bush II record on that account), all while talking tough on the deficit without actually doing anything about it. Let me be clear: the risk to confidence in US debt and the US dollar is as great as under Romney as it would be under Obama. Meanwhile, if Romney actually does follow through on his spending cut promises, the bottom line of the US economy will suffer, as even the IMF recently admitted that studies have shown that the fiscal multiplier (which shows the effect of government spending on the economy) is between 0.9 to 1.7, rather than the previously assumed 0.5. 

In a separate article, The 2012 US election: What it means for the Federal Reserve, I discuss what the election means for the in terms of "QE Infinity" and the re-appointment of Ben Bernanke.