We’ll have more next week on the elections and their potential impact on the markets, but for now we’ll pass along some thoughts from the strategy team at RBS — thankfully free of the silliness that often accompanies analyses of this kind.
First a quick primer:
What’s at stake? All 435 seats in the House of Representatives and one-third of the 100 Senate seats are up for election on November 2. The Republicans need a net gain of 39 seats to gain a majority in House. Polls suggest they may take as many as 54 seats. The Senate, on the other hand, is likely to remain in the hands of the Democrats, although their majority will be cut from 59 to as low as 51. The President is not up for reelection until 2012.
And the expected impact on a few issues:
Market impact: Continued gridlock places the burden of providing further support to the economy mainly on monetary policy. Unless the economy accelerates more rapidly, ZIRP could persist for a long time and the case for extended QE2 is strengthened. Gridlock means that it will be more difficult to take extraordinary measures to recapitalize the financial system, should they be needed. This fattens the downside tail of the economy’s distribution of outcomes.
Regulatory uncertainty: Nor do we expect the economy to get a big shot in the arm from a reduction in either electoral or regulatory uncertainty. The rules and regulations that will make operational the legislation of the past two years are now being written by various government agencies. This is largely independent of the election outcome. Regulatory uncertainty won’t be reduced until the process is closer to completion.
The budget. We have already incorporated the baseline outcome for the election, as well as expectations for a less hostile fiscal environment generally, into our forecasts, so that such a development would not lead us to meaningfully alter our 2011 GDP forecast or FY 2011/2012 budget projections.
Our current budget forecasts call for a $1.25 trillion deficit in FY 2011 and a $1.1 trillion deficit in FY 2012, assuming all of the Bush tax cuts are extended. Our estimates would not change materially if the tax cuts on upper income earners were allowed to expire. In a world of $1 trillion+ projected deficits, even a $150 billion increase in revenues would represent a rounding error. Similarly, with respect to growth, our forecast for a slight pick-up in real GDP growth from roughly 2.5% Q4/Q4 in 2010 to around 3% in 2011 assumes no income tax increases. If the top income tax rate went up next year, we would shave our 2011 GDP estimates modestly, perhaps by one-quarter of a percentage point.
A cautionary message to those who think the similarities between this year’s elections and those of 1994 might be a good omen:
In 1994, the economy was expanding at an above-trend rate (e.g. that year, real GDP rose 3.1% on a Q4/Q4 basis and payroll gains averaged 170,000 per month). The Republicans gained control of both houses of Congress while the Democrats controlled the Presidency. Gridlock may have kept down “regulatory drag” and stopped higher interest rates on Treasuries from crowding out private borrowers. For instance, President Clinton’s attempt at health care reform, which failed before the 1994 elections, was never resurrected. And, the Federal budget deficit was controlled in the years following 1994, eventually going into surplus.
Now, however, growth is now well below potential and the economy faces a large negative output gap. The data points in Figure 1 below highlight more of the differences between then and now.
Finally, RBS have put together a chart showing the positions of each party, plus the Obama administration, on various issues related to the GSEs and housing reform. Click to open the pdf:
The next step in the process is Treasury’s road map for reform that must be submitted to Congress by the end of January 2011, as required by the Dodd-Frank law. The first aspect of this will be to define the desired role of government in housing finance followed by a framework for the future, including a plan for the legacy entities. We expect any new model to address the faults in the current structure while maintaining the benefits of the existing model. The combination of a Democrat led Senate and Administration is likely to result in proposals for a well- defined, explicit role for the government in housing finance. Senate Republicans will not accept that role for government which, again, means an unlikely bi-partisan compromise is the only answer.
Whole note in the usual place.
Related link:
Prepare for a blockbuster mega week – FT Alphaville