OPINION: Obama vs Romney: will it hurt your clients?

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How will the result of Obama vs Romney affect the US stock market? Should you be concerned? Tom Stevenson, Investment Director at Fidelity Worldwide Investment, explains all.

The US election is becoming one of the next key considerations for equity investors.

Ironically, the state of the American economy and stock market could influence the election outcome. In the past, the lower the level of inflation and the higher the level of economic growth, the greater the incumbent’s share of the votes has been.

There is a common perception that the Republican Party is more pro-business, deregulatory and tends to support lower taxes and takes a more limited role in governance. The Democratic Party, on the other hand, is seen as more willing to regulate business, support higher taxes and play a more active role in government. The implication is that a Republican outcome should be better for stock markets.

However, the evidence does not bear this out. Over the past twelve elections spanning 48 years, the S&P 500 has delivered a higher average annual return under the Democrats.

At present, spread betting markets have offered relatively accurate predictions for the outcome of recent elections. The market odds for Barack Obama being re-elected continually fluctuate and these odds are very well correlated with the performance and level of the S&P 500. The latest (Intrade) odds of 57% (as at 4 September) suggest Obama will win. Any material fall in the US stock market would hurt Obama’s chances.

Some academics have theorised a link between business cycles and election cycles. Since the 1960s, the US economy has experienced seven business cycles with an average length of 75 months, or a little over six years. Unfortunately, this theory is not borne out in reality. Similarly, history shows that unemployment is a relatively poor predictor of election results.

Whichever party wins the US election, they will have some hard economic work ahead of them.

Future challenges – the fiscal cliff

Tackling what has been labelled the fiscal cliff in a way that does not do further damage to an already weak US economy is the biggest challenge faced by the next administration.

They will have a choice; they could let sequestration kick in, which will indiscriminately see tax increases and spending cuts across the board. The Congressional Budget Office has estimated that this would see the US economy shrink by 4% in 2013, which makes this an unpopular option. At the other extreme, cancelling the automatic tax increases and spending cuts would stoke the US budget deficit and perhaps lead to a further sovereign rating downgrade.

The Republicans want to cut spending significantly and avoid raising taxes, while the Democrats want more limited spending cuts combined with tax increases.

An ideal outcome would be to phase in tax increases and spending cuts over time, and target cutbacks in areas where the economy is least sensitive, to minimise economic damage. While both parties want to avoid the ‘fiscal cliff’, finding an agreeable compromise on the issue will be difficult.

If Congress fails to find a solution to the fiscal cliff, spending cuts and tax hikes will be enacted indiscriminately across the board under sequestration.  And this could be extremely damaging if it adversely affects the most productive areas of the economy.

This becomes a higher risk if a clear election outcome is not achieved.

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