The Die is Cast, but Uncertainty Remains

Another election cycle is over, though with over US$6 billion spent on the various campaigns across the country, the political landscape looks practically the same today as it did yesterday. This, I fear, may be the outcome the U.S. economy could most ill afford at this time. While President Obama’s reelection delivers clarity on a few issues important to the economy, the partisan status quo that remains in Congress likely raises the risk of recession.

First, the clarity. With Romney out of the equation, President Obama’s signature health care reform is probably cemented in place. You can debate the economic impacts of the legislation, but at least businesses and individuals will know that it’s here to stay and can begin forming up plans to adjust to the new health care regime. Next, Fed chairman Ben Bernanke still has a job…if he wants it. Governor Romney had pledged to remove Bernanke from his post when his second term expires in 2014. This probably ensures that Bernanke’s easy-money policies will continue, even if he declines a third term.

More important though is where uncertainty still reigns. With barely even time to celebrate, Obama must face a divided House and Senate to negotiate a way to avoid the fiscal cliff. This combination of tax increases and spending cuts will begin to bite at year’s end if a solution can’t be found. Republicans remain opposed to any form of tax increase, while Democrats are equally opposed to any cuts to entitlement programs. Then, very soon in the new year (with some manipulation from the Treasury), the United States will likely reach its debt ceiling again. The last time this impasse was reached, Standard & Poor’s downgraded their rating on the United States from AAA to AA+. While this didn’t negatively affect U.S. sovereign borrowing rates, if Republicans try to use the debt ceiling debate in a protracted fiscal-cliff battle, Fitch and Moody’s could be moved to lower their ratings on the U.S. as well. That potential downgrade, while not likely to impact the demand for U.S. Treasurys, could affect the ratings for other assets closely tied to Treasurys, like Fannie and Freddie debt.

Finally, we know where Obama and the Democrats stand on taxes, but it remains uncertain what will actually be enacted. The Obama administration has its own ideas for tax reform touching on personal income, corporate tax, AMT, etc. A tent pole of Obama’s reelection campaign was increasing the top tax rate on the nation’s highest earners. With Republican inflexibility on the issue of tax hikes, I don’t see a strong likelihood of the current proposal of increases on individuals making over US$250,000 per year getting much traction. Perhaps an increase on those making over US$1 million would be a workable compromise for both parties.

If Washington takes us careening over the fiscal cliff, it’s likely that the United States will suffer a mild recession in 2013. The prospect of continuing deadlock, following this election result, increases the probability of this negative outcome from perhaps 10% to more than 30% in my view. It is this increased downside risk on the economy, rather than a verdict on the presidential election, that seems to explain today’s market setback.

The risks of a delayed policy response and partisan acrimony are high, but the costs of letting the country plummet from the fiscal cliff are even higher. Just today, House Speaker Boehner at least signaled that he’s willing to negotiate. Maybe the grand speeches of Tuesday night will somehow translate into action.

I’m putting together some more thoughts about the investment implications of these ideas, and I’ll post a link to that when I’ve formalized.