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Kurt Reiman looks at the outlook for the US elections in November 2012 and argues how the results could impact both the economy and financial markets. The 2012 US presidential and congressional elections come at a time of heightened voter anxiety, particularly about economic uncertainties. The anemic US economy, the trajectory of the federal debt, and the nation’s influence and competitiveness on the world stage are among Americans’ top concerns as they head to the polls. US election outlook Since 1928, stocks have performed better when a Democrat has occupied the White House. Equity markets have risen 8.5% annually under a Democratic president and only 3.0% under a Republican. However, equity markets may be more influenced by initial valuation, rather than administrations. Democrats have benefited from favorable valuations at the beginning of their terms. When price-to-earnings multiples were lower than average at the beginning of a president’s term, gains over the next four years were almost 10 percentage points higher compared to periods when multiples were above average. Earnings growth rates do not seem to be affected by which party is in the White House. Stocks are more “fairly valued” heading into this year’s election, US corporate profit growth is slowing into the single digits, and the US economy is growing at a lackluster pace of around 2.0%. Therefore, the direction of financial markets may hinge on how the election results affect the elected officials’ ability to reach an agreement on key legislative measures related to fiscal policy. What does this mean for investors? Investors with higher risk-tolerance can look for opportunities in high-yield or non-investment-grade bonds. Asia’s growth has brought more of such issuers to the market as they seek to fund their expansion. The stronger of these credits tend to be those exposed to rising domestic consumption, such as retail, services, utilities and energy companies. There are also a number of Chinese property companies in this segment, but preference should be given to the state-owned or leading national developers rated ‘BB-’ or above. Because many high-yield Asian issuers are novice borrowers and carry corporate-governance risk, investors need to be selective and diversified, potentially using bond-funds to gain exposure. Local currency bonds are also interesting, especially the Singapore dollar and offshore renminbi or ‘Dim Sum’ bonds. The Singapore dollar has potential to appreciate because it is used as a policy tool to counter domestic inflation, while the offshore renminbi could be a long-term store of value. Recent expectations for the renminbi to appreciate to a lesser extent have also pushed up yields of Dim Sum bonds, providing a more reasonable entry point to these assets. Dim Sum bonds are suitable for investors with a medium-term horizon, and much of the potential gains that should come from the renminbi’s appreciation against the US dollar in the near term should be modest. With such a range of bond options, Asian investors have a wealth of opportunities to balance their portfolios and achieve decent returns. What does this mean for investors? There is a perception that gridlock is good for markets because it means that Congress is unlikely to change the “rules of the game” and create uncertainty. However, we found no difference in stock market performance when one party controls both the executive and legislative branches versus when the parties share power. With many tax policies set to expire at the end of 2012, mandated spending cuts due to kick in at the beginning of 2013, an impending need to raise the debt ceiling yet again and an unsustainable long-term fiscal outlook, the economy and financial markets can ill-afford a protracted phase of partisan bickering and policy dysfunction. Moreover, markets and credit rating agencies are unlikely to welcome temporary “fixes” to the tax code and further indecision over how to cut spending. If elected officials in the US are unable to reach a reasonable compromise on legislation to extend expiring tax cuts and spending measures, the economy would likely fall back into recession. Based on Congressional Budget Office estimates and our own analysis, if each of the budget measures is permitted to expire — and were the additional cuts mandated as part of the debt-ceiling agreement to be strictly enforced – the total fiscal drag would total 3.5%-5.0% of projected GDP for 2013, depending on the magnitude of the negative growth impact. With the US expected to grow at just a 2.0%-3.0% pace next year, the economy can ill afford such a dramatic and near arbitrary tightening of fiscal policy. Therefore, while some fiscal drag is likely in 2012, we foresee the prospects for a sharp contraction in public sector spending and broad-based increase in taxes are extremely limited. While fiscal consolidation is necessary to preserve the long-term growth prospects of the US, it must be done thoughtfully and not in an abrupt or haphazard manner. Until the nation’s finances are put on a more sustainable long-term footing, we believe investors will shy away from taking excessive risk, thus crimping growth and valuation expansion potential. Are Republican presidents better news for bond investors? In contrast to equity markets, of the 21 presidential elections between 1928 and 2008, bond returns have been higher under Republican presidents. However, we think this is coincidental. The main drivers of bond returns are changes in interest rates, which are largely determined by shifts in monetary policy. The Federal Reserve — not the US President or Congress — implements monetary policy. There is a high correlation between the Fed funds rate and the 10-year Treasury note yield. Both peaked in 1981 and trended lower for the next 40 years, producing double-digit returns during every presidential term since the 1980 election. This larger economic trend has little to do with the policies of either party. Returns under Republican presidents may be higher simply because yields declined more steeply when they were in office. UBS’s conclusion is that the direction of Fed policy was a far more important factor in determining bond returns than the party affiliation of the president. Looking ahead: New return drivers Treasuries have long been considered ‘risk-free’ assets. However, as the eurozone debt crisis demonstrates, a country’s sovereign debt can decline in credit quality when its financial strength erodes due to sustained fiscal imbalances. Given substantial recent and projected US budget deficits, there is a real possibility that the credit quality of Treasury securities could suffer over the next several years. To the extent that a president shapes the national conversation about taxes and spending, the policies pursued by Congress and the President could become more important drivers of bond returns than they have been in the past. |
