Weekly Market Commentary - Get to Work, Mr. Senator

Last week, the Federal Reserve (Fed) put the ball back in Congress’ court as it relates to the economy and the upcoming fiscal cliff. The so-called “lame duck” session that takes place between the November 6 elections and January 1 holds some promise for getting a deal done.

While the road travelled depends upon the elections’ outcome, it may be the journey—not the destination—on the way to the deal to mitigate the fiscal cliff that has the most potential to upset the markets and contribute to volatility in the coming months.

 

 

“Get to Work, Mr. Senator”

“Get to work, Mr. Chairman,” said Senator Chuck Schumer, wagging his finger at Federal Reserve (Fed) Chairman Ben Bernanke two months ago. Last week, Bernanke delivered and pointed back as if to say: “Get to work, Mr. Senator.”

Last week’s announcement of another program of bond-buying by the Fed, known as quantitative easing (QE), delivered a boost to the markets, sending stocks sharply higher on Thursday as the Fed’s statement was released. With this action, the Fed put the ball back in Congress’ court. The Fed’s QE program may help mitigate some of the risks to the economy, but if we go over the fiscal cliff it is like getting a flu shot before storming the beach at Normandy.

Congress must address the more than $500 billion in tax increases and spending cuts equivalent to 3.5% of Gross Domestic Product (GDP) due to go into effect on January 1, often referred to as the fiscal cliff. The United States has never seen an economic drag of anywhere near that magnitude that did not quickly result in a recession and big drop for stocks.

Despite Bernanke’s shifting of the economic burden back to Congress, there is almost no chance that the tax and spending issues get resolved before the elections. However, the so-called “lame duck” session that takes place between the November 6 elections and January 1 holds some promise for getting a deal done.

Status Quo (Obama wins, Dem Senate, GOP House) -

Polls, including our “Wall Street” Election Poll, increasingly point to this as a high probability outcome of the elections. (Please see our recent The “Wall Street” Election Poll publication [09/13/12] for a description of our poll and methodology.) Although there would be no change in control, holding the White House and the Senate during adverse economic conditions could be considered a victory for the Democrats, and to top it off, the GOP’s majority in the House likely shrinks. A deal to mitigate the fiscal cliff would probably be reached in the lame duck session under this scenario, but it would likely be closer to the Democrat’s terms given their election victory and primarily consist of higher tax rates.

Congress Unlocked (Obama wins, GOP Congress)

Although the battle for the Senate is looking closer than before, this is the scenario we believed was most likely all year. Congress goes from being gridlocked to unlocked as the GOP takes the Senate, but by a very slim margin, and retains control of the House. Obama wins a narrow victory in the White House, but Republicans pick up the Senate and hold the House. A deal in the lame duck session is likely in this scenario where the Bush tax cuts get extended.

GOP Sweep (Romney wins, GOP takes Senate and holds House)

A big win for Republicans. Under this scenario, Republicans will be unlikely to compromise with Senate Democrats on only extending some of the Bush tax cuts in a lame duck session. In addition, it is unlikely that President Obama would sign an extension of the Bush tax cuts as his last official act. With no deal in the lame duck session, the Bush tax cuts would expire at the end of the year. Republicans would try to renew them after President Romney takes office on January 20, but they will need 60 votes in the Senate to do it quickly, requiring the support of more than a handful of Democrats. As a result, Republicans may not be able to pass an extension of the Bush tax cuts for several months until they first pass a budget resolution that would allow them to pass a tax bill through reconciliation requiring only 51 votes in the Senate.

White House Flip (Romney wins, Dem Senate, GOP House)

If Romney wins the White House, it is likely the GOP would ride his coattails in the Senate, but possible that they only pick up one or two seats, leaving the Democrats in control. Under this scenario, Romney wins a narrow victory, and the Senate remains closely divided in favor of the Democrats. A deal in the lame duck session to temporarily extend the Bush tax cuts is possible, but not probable.

 

Democrat Sweep (Obama wins, Dems hold the Senate and take the House

This would be a huge win scenario for Democrats, given the large majority held by the GOP in the House. In the lame duck session, House Republicans may compromise on extending the Bush tax cuts only for those who make less than $250,000, or they refuse to compromise and go down fighting. In the scenario, the top dividend rate would likely go to 43% weighing on dividend-paying stocks, and bonds could be hurt by the potential for a downgrade to U.S. debt (the rating agency Moody’s Investor Service warned of this last week) due to the unwillingness of Democrats to cut entitlement programs, given that they would likely owe their win in the House to a backlash to the Ryan budget plan. There are three other possible election outcomes, but there is almost no chance of the Democrats taking the House if Romney wins or of the Democrats taking the House while the GOP wins the Senate if Obama wins. It would be difficult at best to say what the lame duck session would yield in these odd scenarios.

Therefore, there is a meaningful risk for the markets that Congress fails to craft a deal in the lame duck session and the U.S. goes over the fiscal cliff into recession. However, it is worth keeping in mind that Washington has a lot of experience in kicking the can down the road to avoid short-term pain and will likely find an eventual compromise. Instead, the real risk to the markets is what Congress may do in the lame duck session (or early next year) on the way to the compromise. We only have to look at the negotiations around the debt ceiling increase in August of 2011 to see how bad the process of negotiations can be for the markets. Back then we ultimately got the increase in the debt ceiling, but not without a 13% stock market decline in a week and the loss of the United States’ AAA credit rating by Standard & Poor’s rating agency.

The economic impact of the many scheduled tax increases and spending cuts is likely to prompt action, as will the fact that we will again hit the debt ceiling in early 2013 and require legislative action to approve an increase. Also, further pushing things along, the rating agencies have warned that they will be watching U.S. actions to return to a path of fiscal sustainability. And, finally, the president and a newly elected Congress will have maximum political capital to make it all happen in early 2013.

While the road travelled depends upon the elections’ outcome, it may be the journey—not the destination—on the way to the deal to mitigate the fiscal cliff that has the most potential to upset the markets and contribute to volatility in the coming months. We ultimately believe a deal will be forthcoming, but only after the elections can we expect Washington to get to work. IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Standard & Poor’s Credit Rating: A credit rating is Standard & Poor's opinion on the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation. Over the years credit ratings have achieved wide investor acceptance as convenient tools for differentiating credit quality.

An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. This research material has been prepared by LPL Financial.

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