The final US Senatorial seat, in Virginia, has just been confirmed as falling to the Democrats. This leaves the Senate tied at 49 seats to both the Republicans and the Democrats with 2 independents, both of whom have traditionally sided with the Democrats on key votes. That control of Congress has shifted from the Republicans to the Democrats is very significant in terms of future policy and injects a degree of uncertainty into the outlook for a number of the United States’ biggest companies, an uncertainty which, judging by recent US equity index action is not being factored in to valuations.
The point we regard as key is the fact that almost all the equity market’s rally since July can be ascribed to the expansion of US price earnings ratios not, significantly, down to an improvement in corporate earnings which are, in fact, slowing on a quarter on quarter basis. Investors’ desire to pay up for less earnings certainty at a point when US economic activity seems likely to experience a period of sub-trend growth and during which Fed policy seems likely to remain on hold for a hard to determine length of time, seems incongruous.
Democratic gains, not just in both houses of Congress but also in State governor elections and boosted by a big turnout, may well encourage Nancy Pelosi (the likely new Speaker of the House) to pursue the Democratic agenda with some vigour. The question now pertains to how the Republican Party might respond. The President’s knee-jerk action, to sacrifice Defence Secretary Donald Rumsfeld as the fall-guy for the Iraq war, does perhaps indicate a willingness to recognise the public’s concerns and represents the possible precursor to a more general shift back towards the centre, centre-left, ground. Such a move, if confirmed, would represent a major threat to the status quo with which investors have become accustomed over the past six years.
The central issue now becomes the nature of the relationship between a Republican President and a Democratic Congress. Equity market reaction to the news suggests that investors anticipate a period of gridlock in which a President not for turning uses his veto pen to preclude Democratic inspired legislation from reaching the statute book or, vice versa, Congress votes down any Republican-inspired legislation or, again, filibustering precludes any legislation from being voted through by either side. But far from being a good thing, two years of lame duck presidency and stalemate is actually a very bad thing, particularly when major issues pertaining to Iraq and Homeland Security need addressing as a matter of urgency. The Republicans may hope to gain some advantage by involving Democrats in the decision making process. Continued policy failure with regard to the appropriate way to handle the quagmire that Iraq has become could rebound on the Democrats just as easily as it did on the Republicans (and investors should remember that the Democratic gains were achieved largely as a function of public protest over the handling of Iraq, the aftermath of hurricane Katrina and Republican Party scandal, NOT because the Democratic Party had a particularly cogent policy alternative).
We argue that gridlock is not a good thing and that what should really work for investors is the two parties’ ability to work together effectively. In previous situations where the President and Congress were of differing affiliation compromise worked because Ronald Regan was prepared to “cross the aisle” in 1986 and Bill Clinton did likewise in 1996. It is clearly still very early days to be making judgement calls but investors might be prepared to speculate that a result such as this should encourage Mr Bush to adopt a more centrist position in future and that really does have quite significant implications for the markets.
The reaction from the bond market
The strongest market reaction in the initial aftermath of the vote came not from the currency markets, where the economy’s performance and Fed rate policy dominates sentiment, but from the bond market. Bonds rallied on the strength of the Democrats’ apparent desire to get to grips with the country’s fiscal deficit. In particular, they seek to slam the door on Republican attempts to keep dividend, capital gains and high income tax cuts alive. Bonds benefit too, from a less certain outlook for international trade. President Bush currently enjoys the ability to sign free trade deals at will, but only until next summer. Given Democrats have traditionally been less favourably disposed to free trade and more prepared to embrace protectionism it is not clear as to whether this authority will be extended?
A less equitable life for equities?
Right at the very top of the agenda for the altered Executive will be how to fashion an appropriate policy towards Iraq and a continuation of the “War on Terror”. Peering through the labyrinthine Democratic discussion on Iraq it just about appears as if the Party’s stance is to encourage Iraq to take greater control of its own destiny promising, as it does, the likely redeployment of US troops over time. The war in Iraq has already cost $300bn since 9/11 and resulted in a 70% increase in defence spending. Any decision to scale down US involvement in Iraq would, therefore, lead to a likely reduction in defence spending over time and thus negative for defence companies. By contrast the Democrats have shown a relative preference for homeland security thus those companies involved in the manufacture of screening, scanning and border control security could benefit.
Sectors that could be affected:
1. Big Oil
Another high profile casualty could be “Big Oil”. The Democrats have stated their intention to end subsidies to US oil giants, many of which did very well throughout the Republican dominated era. The Party goes further, rhetoric suggesting that the dependence on overseas oil should be reduced and that greater emphasis be placed on environmental issues. Whether this goes as far as embracing Sir Nicholas Stern’s recent report into the economics of climate change, a Report very much designed to encourage US buy-in, remains to be seen? Note, too, the Democrats’ desire to keep the Arctic Wildlife Refuge intact and an enthusiasm for biofuels. This could help alternative energy producers.
2. Pharmaceuticals
Perhaps the sector which has suffered the most in the period immediately prior to and post the midterm results has been Pharmaceuticals. Investors should note that Nancy Pelosi has herself pushed for legislation allowing the government to negotiate directly with drug companies with regard to the purchasing of medicines relating to Medicare. Such negotiation is currently disallowed and the Pharma sector believes such interference to be equivalent to price capping. Furthermore, the Democrats favour an end to subsidies to big pharma groups and wish to enable the government to offer its own drug universe in competition to the products offered by the private sector. This policy is seen as favouring generic manufacturers, but biotechs might also benefit from the Democrats’ overwhelming desire to support stem cell research. This could be a real test of any relationship between the President and Congress given the former’s high profile opposition to the project and his single use of the veto thus far.
Elsewhere we might draw investors’ attention to possible weakness in the retail and leisure sector. The Democrats have shown a desire to increase the minimum wage from $5.15 which, in inflation adjusted terms, is as low as it has ever been and relatively strong support for unionisation. Higher wages for employees, coupled with a desire to over rule tax cuts for high earners could have a negative impact on consumer facing sectors. Again, however, the scale of Democratic control in Congress is insufficient to overcome the President’s veto should he chose to use it.
Conclusion: investors should be wary for now
On balance we suspect that the long-term fall-out from the partially seismic upheaval in US politics last Tuesday could be more significant than recent equity market performance might have investors believe. The strength of US share prices since the summer, while corporate earnings news has been deteriorating quarter on quarter, might suggest that investors have consigned the concept of risk to the distant past. The potential impact of the US elections indicates that to ignore the risk of possible change leaves one at its mercy when change actually takes place. Given the incipient economic slowdown and the possibility that US base rates might be held for a few more months than had earlier been anticipated, we continue to recommend that investors be wary about chasing indices higher and stick to high quality.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley