Bonds should vote for Obama, equities for Romney
November 4, 2012 3:11 pm
by Gavyn Davies
The two candidates in the American Presidential election are ideologically as far apart as any I can remember since Ronald Reagan and Jimmy Carter in 1980. In fact, it is hard to imagine the US political system throwing up a greater divide, unless the Republicans were to choose a Tea Party candidate. This gap is producing exceptionally strong personal sentiments from voters on both sides of the fence as the election approaches.
Yet the financial markets seem to be completely unfazed by the decision which the American electorate will make on Tuesday. Asset prices are acting as if they do not care very much who wins. Does this attitude make sense, and will it survive the election?
The prices which emerge from financial markets often diverge markedly from the personal political attitudes of the investors who control the assets. That is certainly the case this time. Paul Krugman neatly summarises the issues at stake in his latest column:
No wonder personal preferences on Wall Street are in favour of candidate Romney!
Yet the behaviour of asset prices is not pointing in the same direction. If anything, the US equity market has tended to rise in periods where the probability of an Obama win has been rising, and vice versa. Although the relationship shown in the first graph looks impressive, it is in fact not statistically significant, and in any event the correlation may be spurious: President Obama’s standings and the equity market may both be affected by a common third factor, such as the behaviour of the economy. Nevertheless, it does seem clear that there has been no tendency for the equity market to rise when the probability of a Romney win has gone up.
There could be several reasons for this. Since Mitt Romney has never really broken into territory where he looked like the favourite to win (at least in the polls, and the betting markets), investors may simply have ignored this possibility altogether. After all, markets are not very good at pricing unlikely events until they actually happen. Alternatively, the policy areas in which the candidates differ most clearly may not be areas which investors consider very relevant for near term economic performance and therefore asset prices. The distribution of income, and the level of marginal tax rates, are cases in point.
A third possibility is that the markets are aware that, whoever wins the White House, the overall balance of power in Washington is likely to remain gridlocked.
Even if Mitt Romney wins the Presidency with a late swing in his direction, it now seems doubtful whether his coat tails will prove strong enough to allow the Republicans to take the Senate. And if Barack Obama wins the Presidency, the likelihood of the Democrats winning a majority in the House seems very small. According to the betting markets, one form of gridlock or another is 80 per cent likely after Tuesday’s showdowns.
Despite all this, there are two clear reasons why the markets should wake up and pay attention on Tuesday. First, the next President will decide the identity of the Chairman of the Federal Reserve when Ben Bernanke’s second term ends on 31 January, 2014.
Under a President Obama, the new Fed Chairman (whether Bernanke himself, Janet Yellen or Bill Dudley) will certainly continue to prefer the accommodative monetary policies which have been in place since 2008. Under a President Romney, the new Chairman (whether John Taylor, Greg Mankiw or Glen Hubbard) will probably be less inclined to quantitative easing, and will place less weight on unemployment, and more on inflation risks, when setting interest rates.
Using John Taylor’s own policy rule, it is plausible that a Romney Fed Chairman would want US short rates to be at least 1-1.5 per cent higher than the present Fed leadership might prefer. Although the Chairman cannot shift policy to that extent on his own, the prospect of higher short rates would be reflected in the bond market, the dollar and the gold price if Romney wins.
The second reason is, of course, the fiscal cliff and the longer term prospects for a “grand bargain” on the fiscal deficit. On the immediate matter of the fiscal cliff, it is likely that a President Romney would find this easier to navigate than a re-elected Obama. Even if Romney has to face a Democratic Senate, that would probably not prove to be an immovable obstacle to an incoming President with a fresh electoral mandate.
Obama, by contrast, has already discovered that the House Republicans are extremely intransigent on the question of higher taxes, and that position will not change after the election. A deal would eventually get struck, but not easily, and not without spending cuts next year. Fiscal policy in 2013 looks likely to be easier under a tax-cutting President Romney.
The longer term outlook for the budget deficit and public debt is hard to call. Candidate Romney has emphasised the need to bring down deficits and debt during his term, but has not specified exactly how he would do this. His tax plans are intended to be revenue neutral, involving reductions in marginal tax rates offset by smaller deductions and allowances.
On spending, he is committed to greater outlays on defence, so there would have to be very large cuts in entitlement and medical outlays if the budget deficit is to be brought down. These seem implausible.
More likely, a President Romney’s budget outcomes would be reminiscent of President Reagan’s, three decades ago. Reagan reduced marginal rates of corporate and personal tax, arguing (incorrectly, as it turned out) that total revenue would nevertheless expand as GDP growth recovered. He also increased defence spending, so deficits and debt increased. Helped by lower interest rates and a recovering economy after 1982, equities loved every minute of it. The Fed will not be as friendly as it was under Paul Volcker after 1982, but equities should still benefit if Mitt Romney upsets the electoral odds this week.
Yet the financial markets seem to be completely unfazed by the decision which the American electorate will make on Tuesday. Asset prices are acting as if they do not care very much who wins. Does this attitude make sense, and will it survive the election?
The prices which emerge from financial markets often diverge markedly from the personal political attitudes of the investors who control the assets. That is certainly the case this time. Paul Krugman neatly summarises the issues at stake in his latest column:
If President Obama is re-elected, health care coverage will expand dramatically, taxes on the wealthy will go up and Wall Street will face tougher regulation. If Mitt Romney wins instead, health coverage will shrink substantially, taxes on the wealthy will fall to levels not seen in 80 years and financial regulation will be rolled back.
No wonder personal preferences on Wall Street are in favour of candidate Romney!
Yet the behaviour of asset prices is not pointing in the same direction. If anything, the US equity market has tended to rise in periods where the probability of an Obama win has been rising, and vice versa. Although the relationship shown in the first graph looks impressive, it is in fact not statistically significant, and in any event the correlation may be spurious: President Obama’s standings and the equity market may both be affected by a common third factor, such as the behaviour of the economy. Nevertheless, it does seem clear that there has been no tendency for the equity market to rise when the probability of a Romney win has gone up.
There could be several reasons for this. Since Mitt Romney has never really broken into territory where he looked like the favourite to win (at least in the polls, and the betting markets), investors may simply have ignored this possibility altogether. After all, markets are not very good at pricing unlikely events until they actually happen. Alternatively, the policy areas in which the candidates differ most clearly may not be areas which investors consider very relevant for near term economic performance and therefore asset prices. The distribution of income, and the level of marginal tax rates, are cases in point.
A third possibility is that the markets are aware that, whoever wins the White House, the overall balance of power in Washington is likely to remain gridlocked.
Even if Mitt Romney wins the Presidency with a late swing in his direction, it now seems doubtful whether his coat tails will prove strong enough to allow the Republicans to take the Senate. And if Barack Obama wins the Presidency, the likelihood of the Democrats winning a majority in the House seems very small. According to the betting markets, one form of gridlock or another is 80 per cent likely after Tuesday’s showdowns.
Despite all this, there are two clear reasons why the markets should wake up and pay attention on Tuesday. First, the next President will decide the identity of the Chairman of the Federal Reserve when Ben Bernanke’s second term ends on 31 January, 2014.
Under a President Obama, the new Fed Chairman (whether Bernanke himself, Janet Yellen or Bill Dudley) will certainly continue to prefer the accommodative monetary policies which have been in place since 2008. Under a President Romney, the new Chairman (whether John Taylor, Greg Mankiw or Glen Hubbard) will probably be less inclined to quantitative easing, and will place less weight on unemployment, and more on inflation risks, when setting interest rates.
Using John Taylor’s own policy rule, it is plausible that a Romney Fed Chairman would want US short rates to be at least 1-1.5 per cent higher than the present Fed leadership might prefer. Although the Chairman cannot shift policy to that extent on his own, the prospect of higher short rates would be reflected in the bond market, the dollar and the gold price if Romney wins.
The second reason is, of course, the fiscal cliff and the longer term prospects for a “grand bargain” on the fiscal deficit. On the immediate matter of the fiscal cliff, it is likely that a President Romney would find this easier to navigate than a re-elected Obama. Even if Romney has to face a Democratic Senate, that would probably not prove to be an immovable obstacle to an incoming President with a fresh electoral mandate.
Obama, by contrast, has already discovered that the House Republicans are extremely intransigent on the question of higher taxes, and that position will not change after the election. A deal would eventually get struck, but not easily, and not without spending cuts next year. Fiscal policy in 2013 looks likely to be easier under a tax-cutting President Romney.
The longer term outlook for the budget deficit and public debt is hard to call. Candidate Romney has emphasised the need to bring down deficits and debt during his term, but has not specified exactly how he would do this. His tax plans are intended to be revenue neutral, involving reductions in marginal tax rates offset by smaller deductions and allowances.
On spending, he is committed to greater outlays on defence, so there would have to be very large cuts in entitlement and medical outlays if the budget deficit is to be brought down. These seem implausible.
More likely, a President Romney’s budget outcomes would be reminiscent of President Reagan’s, three decades ago. Reagan reduced marginal rates of corporate and personal tax, arguing (incorrectly, as it turned out) that total revenue would nevertheless expand as GDP growth recovered. He also increased defence spending, so deficits and debt increased. Helped by lower interest rates and a recovering economy after 1982, equities loved every minute of it. The Fed will not be as friendly as it was under Paul Volcker after 1982, but equities should still benefit if Mitt Romney upsets the electoral odds this week.
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