Despite some degree of posturing by both
the triumphant Democrats and defeated Republicans,
we do not expect any major changes in US economic
policies after the November 7 mid-term elections.
Instead, we anticipate a change in
emphasis. Along these lines, economic policy will
remain broadly supportive of growth and
employment, though the Democratic-led House of
Representatives and Senate are likely to push for
tighter regulation of the food industry, lean on
the pharmaceutical
industry to reduce costs,
reassess spending on defense companies, and more
aggressively promote alternative energy at the
cost of the large oil companies that have been
close to the administration of President George W
Bush.
With an eye to the next election in
2008, the Democrats need to present themselves as
thoughtful moderates, seeking to clean up the
former Republican den of corruption and privilege.
For the Republicans, the White House needs to
provide the image of compromise and statesmanship
and a willingness to move ahead from the defeat.
This provides for a confluence of
interests, which bodes well for markets - at least
in the short term. Both political parties are
aware of the cooling economic environment, and
moderate policies are more likely to help buffer
any downturn in the months ahead as opposed to any
radical departures. All the same, the political
class is going to see its ability to maneuver
shrink as the housing market continues to cool and
the long buildup of household and consumer debt
increasingly limits policy directions.
This could translate into a
bumpier-than-expected economic ride in 2007, just
as Nancy Pelosi becomes the first female Speaker
of the House.
The Democratic leadership
under Pelosi has a big task ahead. Her party
gained 28 House seats and six in the Senate,
giving the Democrats control over both houses of
Congress for the first time since 1994. Long in
the political wilderness, the party brings with it
a lot of expectations.
Yet facing the
Democrats is a cooling economy (we expect 2.4%
real growth in gross domestic product in 2007), a
seemingly endless conflict in Iraq, and a
Republican president who still carries veto power
through 2008. The danger is that the legislative
process gridlocks, the economy slides into a
recession, Iraq unravels into warring zones,
another terrorist attack occurs on US soil, and
the Democrats get blamed for everything by a
fickle electorate.
New and old
Democrats Pelosi's challenge is to
maintain the unity of a party that has moved
Congress to the left, but at the same time many of
the same party's new members have moved it to the
right. The new Democrats include some social
conservatives and economic moderates who favor a
more prudent fiscal situation and are more likely
to want to maintain most of the Bush tax cuts.
In a sense, they are very different from
the old social-liberal Democrats of Pelosi's
stripe and more apt to see government as an answer
to problems. While Pelosi has been very careful in
appearing as a calm voice ready for compromise,
she is well aware that she holds sway over a
potentially very fractious group.
While
Iraq remains a core issue for the Democrats, their
economic agenda looks somewhat uninspiring. In the
short term we expect the Democrats to push for
increasing the federal minimum wage, enacting the
homeland-security recommendations of the
bipartisan 9-11 Commission, promoting stem-cell
research, and reducing university costs. They will
also have to deal with Bush proposals on
immigration, energy and free trade, some of which
are achievable.
More controversial are
efforts to give the government the power to
negotiate with pharmaceutical companies to lower
prices in the Medicare prescription-drug program,
rolling back what they argue are
Republican-supported incentives to shift jobs
overseas, and rescind some US$11.6 billion in
subsidies for big oil companies and using those
funds to promote alternative energy.
There
is also talk of holding hearings on the oil
companies' involvement in Iraq (read Halliburton)
and the exact nature of closed-door discussions
that were held between Vice President Dick Cheney
and the oil companies over energy policy.
At the same time, Democrats have indicated
that they are taking a go-slow approach to
regulating hedge funds and may consider changes
sought by Wall Street to the Sarbanes-Oxley
corporate-accounting law. As Congressman Barney
Frank, in line to become chairman of the House
Financial Services Committee, stated before the
elections: "Hedge-fund regulation won't be one of
the first things we get to." Pressure could be
leveled against credit-card companies, as this has
been mentioned as a point of concern in the past.
The Iraq issue Outside of the
economy, Iraq is the single most important issue.
Indeed, opinion polling data indicate that this
was the leading issue for voters last week and one
of the main reasons for the Republican election
loss. To put it mildly, the reconstruction of Iraq
has not gone as expected and large numbers of US
troops are still fighting there. The effort to
push off more responsibility to Iraqi authorities
has been slow and complicated by Shi'ite-Sunni and
Arab-Kurdish tensions and by the involvement of
Iran and al-Qaeda.
With public discontent
evident and now a Democratic-controlled Congress,
the Bush administration is in the process of
changing direction. This was reflected by the
departure of Donald Rumsfeld as defense secretary
and his replacement by former director of central
intelligence Robert Gates, a confidant of former
president George H W Bush. The new Pentagon head
is also one of the 10 members of the Iraq Study
Group, a bipartisan panel trying to devise a
blueprint for stabilizing the Middle Eastern
country.
Kenneth Mayer, professor of
political science at the University of Wisconsin,
said this of the electoral outcome: "When power
shifts like this, there is a lot of instability on
the losing side and lots of ambitious people on
the winning side." This is certainly the case of
Washington in the days after the vote: Pelosi is
in, Rumsfeld is out, and a number of powerful
committee posts are to be contested.
In
the short term this translates into the potential
for more uncertainty. Whoever wins chairmanship of
the committees will signal to the market policy
direction. We expect a strong showing by moderates
but concede that energy and pharmaceuticals could
face tougher times ahead.
And the
markets respond Thus far, the stock and
bond markets have handled the transition
relatively well (though pharmaceutical and
defense-industry stocks have been hit). After the
Democrats' victory, the bond market saw a very
mild widening of spreads, in particular in the
higher beta names. However, as it appeared that
the Democrats are not likely to launch any radical
departures in policy, spreads stabilized.
It may well be that the Democratic victory
was a short-lived tempest in a teacup and that the
co-sharing of power between a Republican White
House and Democratic Congress could result in the
same positive mix that marked the
politico-economic landscape after the 1994
mid-term elections (but at that time with a
Democratic president and Republican Congress).
If nothing else, Washington faces an
economic environment with less room for
complacency. The year 2007 could be a more
difficult one than many people expect. The auto
and paper sectors are already in recession. The
housing market is also in a recession and likely
to soften further. This has a knock-on effect in
construction, appliance makers, forest companies
linked to housing, real-estate brokers, and
mortgage finance.
Unlike past economic
downturns, the housing recession could sink some
of the smaller banks that are overly concentrated
in mortgage markets where the air has already left
the speculative bubble. The challenge ahead will
be how the US consumer balances moderate spending
habits and savings rebuilding. It should be noted
that the consumer faces a difficult time ahead -
the personal-saving rate is now in negative
territory for the first time since 1933 and debt
burdens at all-time highs.
If Washington
is busy with corporate witch-hunts and partisan
infighting while the economy sputters in a more
pronounced fashion, there will be a political
price to pay - most likely by the Democrats, who
currently have the momentum. In many regards,
Pelosi and her cohorts must be thinking about the
adage "be careful what you wish for".
The
next two years are likely to be a very testing
time for the Democrats.
Scott B
MacDonald is senior managing director at
Aladdin Capital and a senior consultant at KWR
International.
