Fourth Quarter, 2006
Investment Outlook Update
November 14, 2006
Let the Games Begin!
Ever since the Republican “thumpin” which occurred last Tuesday (11/7), we’ve been giving a lot of thought to the implications of the Democrats’ victory and their control of Congress. We’ve reached three conclusions:
1) It was a bad year to be a Republican, especially if you were a crook or a perv.
2) There is far more headline risk to the economy and financial markets than there is real risk to the economic or investment outlook.
3) We spend far too much time angsting over politics.
The Democrats’ claim that the election was a tsunami-like wave ushering in a mandate for change of historic proportion. The Republicans’ claim that it was little more than a “six year itch,” where the party in the White House losses seats in the House and Senate in the Congressional Mid-term election. We believe that the election was a referendum, pure and simple, on an unpopular President and an even more unpopular war. Additionally, since the Republicans had largely lost their ideological way and having given the electorate absolutely no good reasons to rehire them, the public decided to “throw the bums out!”
Leadership, or lack thereof, also played a big role in this election. Bush is now even a lamer duck. Bill Frist retired and Denny Hastert won’t stand for Minority Leader. The Republicans would do themselves a favor by having leadership that might steer them back toward the small government, conservative principles that worked well in the past but it looks like too many of the old captains will be returned to the bridge. The Democrats, meanwhile, will be recycling old, and I mean old, liberal warhorses like John Dingell, Henry Waxman, and Ted Kennedy into Committee Chairmanships while keeping Nancy Pelosi and Harry Reid at the helm. Pelosi will try to be bipartisan but her support of Jack Murtha to be the Majority Leader bodes ill.
Fed up with bipartisanship and confrontational politics, the electorate threw out a lot of moderates but elected a lot of conservative Democrats. The middle seems to be very much alive politically. While the Democrats and Republicans are all currently holding hands and singing “Kumbaya”, we’ll see how long this bipartisanship lasts. A couple of questions needing answers:
· How much will the Democrats accomplish during their “first 100 hours” effort?
· Will Congressional oversight under the Democrats dissolve into “show trials” of get-even politics?
· Will Democrats follow the poor lead of Republicans by shutting them out of the committee process?
George Bush tried to make the economy a major issue in this election and lost, big time. While the Republicans seem baffled by why the current economy wasn’t a better issue for them, the Democrats were able to capitalize on the economic uncertainty caused by globalization and the current “winner take all” nature of this expansion. The Democrats will make an increase in the minimum wage the cornerstone of their first 100 hours legislative blitzkrieg. Additionally, it is likely that the Democrats will make economic equality a cornerstone of their 2008 presidential run.
Bush claimed that, if elected, the Democrats would raise taxes and by the Thursday night after the election Robert Rubin was calling on the Democrats to do just that – raise taxes or, as he put it, increase revenues. Before the election, Charlie Rangel (probable Chairman of House Ways and Means Committee) was calling for rollbacks on the Bush tax breaks for the rich. He subsequently cooled his rhetoric to help the Democrats’ election effort. In all likelihood, the first tax issue in front of the newly Democratic Congress will be a fix for the Alternative Minimum Tax (AMT), which falls on middle and upper income earners, often disproportionately in “blue” states. Also, the AMT is the closest thing we have to a flat tax which Republicans supposedly support but they don’t like the AMT either. Indeed, tax simplification of any type is probably DOA as tax breaks for everything from alternative energy to college tuition will be proposed. Every liberal special interest will be lined up for their tax break. You have to love the irony!
We will hear plenty about health care regulation, especially the government’s ability to negotiate lower drug prices, about windfall profits taxes, about “pay go” budgeting and about implementation of the 9/11 commission regulations; but with Bush likely to wield the veto pen liberally (heh, heh) and given the Democrats’ razor thin margins in the House and Senate, little con/de-structive (you be the judge) is likely to become law. What does worry us is the possibility of protectionist legislation. On this issue, it is possible to put together an unholy alliance of luddite liberals and xenophobic conservatives to pass truly counterproductive protectionist legislation ala Smoot Hawley in the early 1930s. The U.S. has a kind of Marshall Plan working with China. They ship us lots of cheap consumer products which helps them develop their economy, and we sell them lots of U.S. Treasuries which helps us pay for our budget and trade deficits. It’s a pretty good deal for almost all concerned but could be derailed by protectionist legislation.
Even though the U.S. economy is slowing, it’s unlikely to go off the tracks into a deflationary or inflationary ditch. Split government makes Ben Bernanke and the Fed even more important to the economic and investment outlook. Housing looks to be a bigger problem while energy less of a problem for the economy than seemed to be the case earlier. This might also mean that inflation could prove less worrisome than it seemed until just recently. We continue to be concerned with the inverted yield curve and the fact that the leading economic indicators are down over the past six months. But, the U.S. economy has become very good at making adjustments quickly and with corporate balance sheets strong and earnings high we are less worried than maybe we should be. Additionally, employment is expanding and incomes are growing so the consumer is unlikely to roll over and play dead. It is our guess that the Fed will overstay its tightening since the Bernanke Fed seems just as intent on trying to micromanage the economy as did the Greenspan Fed. Some bad ideas die very hard.
It has become almost an article of faith among investors that “gridlock is good” for stock prices. Certainly the late 1990s didn’t hurt this near universal belief. But a recent study by the University of Chicago’s Center for Security Prices analyzed the data from 1949 to 2004 and came to some surprising conclusions. Stock prices did almost 3 times better when there was political “harmony” than during periods of “gridlock” (and did even worse when “gridlock” was as it will be for the next two years.) Ironically and somewhat counter intuitively, bonds did better during periods of gridlock – not that we’re very excited about the outlook for bond returns.
Headline risk to health care sector (especially the pharmaceutical industry); to the oil, gas and coal industries; to student lenders; and, to defense contractors could be high and there could even be punitive legislation. Meanwhile, Freddie Mac and Fannie Mae as well as alternative energy (a potential bottomless trough of pork) and agriculture could be back in political favor. The last two years (but especially the third year) of the Presidential cycle are usually good for stocks, so let’s hope historic trends dominate!
Our final conclusion is that we spend far too much time angsting over the political aspects of investing but we also feel that the majority of investors pay too little attention to it. To some extent the Republicans may have been lucky to get this “thumpin”. It might allow them time to find their political bearings since they certainly lost track of what won for them earlier. Also, with the Democrats “controlling” the House and Senate (sort of), blame will be apportioned across party lines. So, now that the mid-term elections are over, we can turn our attention to the big one: The Presidential Election of 2008. Let the games begin!
John E. Montgomery