Orlando's Outlook: Status-quo election raises fiscal-cliff and debt-ceiling angst
Bottom Line The American people had their say on Tuesday, and the pre-election forecast from Intrade was spot on—it was a status-quo election. President Obama returns to the White House for a second term, while the Congress remains split. Democrats will continue to control the Senate, while Republicans remain in control of the House of Representatives. But investors had their say on Wednesday and Thursday, and stocks have plunged by nearly 4% over the past two days—marking the fifth-worst post-election performance in the past 112 years—while benchmark 10-year Treasury yields have plummeted from 1.75% to 1.58% in a massive flight-to-safety rally. Why is the investment community so upset with the results of this election? Because with the fiscal cliff and debt ceiling looming by year end, investors vividly remember the policy horrors of 2011—the failed “Grand Bargain” between President Obama and House Speaker John Boehner, the last-second debt-ceiling drama, the U.S. credit downgrades by the rating agencies, and the inept Congressional Super Committee. Now, as a result of Tuesday’s election, we’ve sent the same people back to Washington to have the exact same discussion. So can we reasonably expect different results this time, and avert a recession? While the optimist in us remains hopeful, we also realize that hope is not an investment strategy.
Presidential election results:
- President Obama enjoyed a narrow popular-vote victory over Gov. Romney (50% versus 48%), but he strategically parlayed that into an electoral-college landslide (332 versus 206, which includes Florida), with wins in virtually all of the dozen critical swing states.
- President Obama performed better among women, minorities (blacks, Hispanics and Asians), younger people and urbanites, while Gov. Romney performed better among men, whites, older people, independents, and suburban/rural dwellers.
- Exit polls suggest that President Obama was viewed as a much more likable candidate than Gov. Romney, with better positions on social issues such as gay marriage, abortion and contraception, health care, and immigration. Gov. Romney was viewed as the stronger candidate on core economic issues like job creation, economic growth, and the deficit.
Congressional pendulum swings to the left:
- Democrats solidified their hold on the Senate, picking up two seats, which widens their majority advantage to 55 versus 45, with Democratic Vice President Joe Biden returning to break any ties.
- Despite the 2010 census redistricting that benefited the Republicans, it appears that the Democrats still managed to pick up an estimated five to seven seats, which narrows the Republican majority in the House of Representatives to 235 versus 200. But the Republicans should still be able to orchestrate an effective check-and-balance legislative function with this smaller majority.
Hurricane Sandy was a wild card The October surprise in this election was a natural disaster that ranks as the second-worst storm ever behind Katrina, which we believe had a significant impact on the election:
- The Sandy aftermath gave President Obama the opportunity to act presidential in organizing federal relief efforts, and he performed well, in our view.
- The storm—and the self-imposed break from campaigning that week—appeared to thwart Gov. Romney’s then-rising momentum with voters.
- Positive comments from Gov. Chris Christie (R-NJ) and Mayor Michael Bloomberg (I-New York City) supported President Obama’s storm-related performance and environmental views.
On to the lame duck So with Congress and the president returning to Washington next week to launch their year-end lame-duck session, the next big question is whether this status-quo election result can successfully achieve what Washington has utterly failed to do over the past two years—craft an intelligent, bipartisan compromise in a timely fashion, to avert the looming fiscal-cliff and debt-ceiling deadlines and keep the U.S. economy out of recession.
- Debt ceiling Federal debt will hit its current ceiling of about $16.4 trillion over the next two or three months, depending on the timing of Treasury Department actions, and the three rating agencies (S&P, Moody’s and Fitch) are poised to downgrade the U.S. credit rating again, as they did with disastrous consequences for investors in August 2011.
- Expiring Bush tax cuts Changing President Obama’s definition of “rich” from $200,000 per person or $250,000 per family, to perhaps $500,000 or $1 million, as some members of Congress are now suggesting, could be the semantic change that defuses this problem.
- Automatic sequester No one likes the automatic federal budget cuts in defense and non-defense discretionary spending that the failed Super Committee agreed to last year, but President Obama and Congress need to reach another comprehensive agreement to substitute those savage cuts.
- Alternative Minimum Tax (AMT) Congress needs to apply its typical year-end patch—or institute comprehensive tax reform; otherwise, the middle class gets swept up into this tax, due to the absence of income indexing.
- Social Security payroll tax holiday The 2% cut is set to revert back to the normal 6.2% rate on employees, with little appetite at present to save it.
- Extended unemployment benefits With the labor market gradually improving, Congress is likely to allow the extraordinary 79 weeks of benefits to revert back to a normal benefit schedule.
- Estate tax The current low rate spikes and the exemption plunges at year end, unless Congress negotiates more reasonable levels.
- Medicare doc fix Congress shifted a $21 billion payment cut from doctors to hospitals this year, but that also expires at year end. If that cut is reversed, look for many doctors to stop taking Medicare patients at a time when 35 million more Medicare patients come into the system due to the full implementation of Obamacare.
What about the economy? At the same time, Congress also has the daunting task of desperately needing to reform corporate and personal taxes and entitlements, grow the economy more strongly, boost job creation, generate more revenues for the federal government, cut spending, balance the budget, and shrink the federal deficit.
- Subtrend economic growth After bottoming at a negative 3.1% in calendar 2009, U.S. Gross Domestic Product (GDP) growth in 2010 and 2011 was 2.4% and 1.8%, respectively, and we’re now forecasting GDP growth of 2.1% for 2012 and 1.2% in 2013. Given the depth of the Great Recession, the economy, in our view, should have already rebounded to a level well above trend-line growth of 3.0%—perhaps to 4.0% or more—as the deeper the recession, the higher the economic bounce. So we need more pro-growth policies from President Obama and Congress.
- Employment is rebounding too slowly President Obama won reelection with the highest rate of unemployment since FDR in 1936. Even though unemployment rate for October 2012 is 7.9%, unemployment had been stuck above 8.0% for 43 consecutive months since February 2009 through August 2012, marking the longest such stretch of joblessness since the government starting collecting data on this metric in 1947. To be sure, unemployment did fall from a peak of 10.0% in October 2009, but that’s only because of a 2.1% drop in the labor force participation rate over this period—which is now sitting just above a 31-year cycle low of 63.5%—due to a surge in discouraged workers. The labor impairment (U6) rate—also known as the “total” rate of unemployment because it more broadly includes discouraged workers and the underemployed—is at 14.6%.
- Deficit and debt need to come down Due to a surge in government transfer payments, we’ve run $1 trillion federal budget deficits in each of the last four years, and our total federal debt now approximates $16 trillion, with a debt-to-GDP ratio of about 100%. We’re certainly not Greece at almost 160%, but we’re well above a comfortable 50-75% ratio.
- Entitlements unsustainable As baby boomers age and start to retire, that creates an increasingly larger draw on Social Security, Medicare and Medicaid, an incremental strain that the federal budget was not designed to handle. As a result, entitlements remain on a demographically unsustainable trajectory, and Congress needs to take corrective policy action, such as gradually raising the retirement age and means-testing benefits for the wealthy, to ensure that the social safety net will be there for the people who truly need it.
Mandate for fiscal prudence and social responsibility Both voters and investors have spoken, in our view, and their message is loud and clear: We want bipartisanship in Washington, and we want a fiscally prudent budget approach that’s achieved in a socially responsible manner.
- Note to Republicans This was an eminently winnable election for you, given President Obama’s weak economic track record. But instead of grabbing the brass presidential ring, you snatched defeat from the jaws of victory. Why? Because of your antediluvian social positions on contraception and abortion, immigration, health care and gay marriage. You need to rip a page from the Democrats’ playbook on inclusion. Study it. Adopt it.
- Note to Democrats Congratulations on your victory, but don’t let it go to your head; there’s a lot of hard work still to do. As President Obama shifts his focus from “reelection” to “legacy,” we know that he’s eying that fifth bust up on Mount Rushmore. Here’s how to get it. Reach across the aisle to the Republicans, and incorporate their economic suggestions into your second-term fiscal policy. Their ideas on personal and corporate tax and entitlement reform, economic growth, job creation, deficit reduction and balancing the federal budget are worthy of strong consideration. The American people told us that in the exit polls, and the financial markets told us that on Wednesday and Thursday. President Obama won this election because he was a more likeable candidate than Gov. Romney and because he had better social policies, despite the fact that Gov. Romney had better pro-growth economic ideas. Learn from them. Embrace them.
The American people and the financial markets will be watching closely, to see if Washington has learned its lesson from last year’s debacle. Can our elected officials successfully stage a do-over? Can they make progress the second time around on this admittedly aggressive, but critically important, agenda, during the early stages of President Obama’s second term?
Good luck to you, President Obama and Congress, Democrats and Republicans, and God bless the United States of America.