Time for Mitt to take the gloves off

The US Presidential election is between two candidates, one of whom believes that it is not worth worrying about the 47% of voters who do not earn enough to pay income tax, and the other who tells small businessmen that it was the government that enabled their business to be successful. Such a clear ideological difference should mean that the result matters greatly to Wall Street and financial markets.

Yet, 2012 has seen little impact on markets from US politics – the headlines this year have been about the Eurozone debt crisis, the Federal Reserve’s policy and the Chinese economy. The election should be close given the poor performance of the US economy (though not its stock market) under Obama, but the lack of strong Republican candidates has left them with the rather uncharismatic Romney as their best choice. His gaffes in recent weeks leave him currently trailing Obama in most of the key swing states as the contest enters the final straight.

There are three election debates to come, which could turn things around, but it seems unlikely that the experienced and eloquent Obama would lose out so badly to the more formal Romney in head-to-head debate.  A Romney win from here would be a big surprise but would in all likelihood also come with Republican majorities in both Congress and the Senate This is typically a combination that Wall Street would cheer. However an Obama win would be combined with a continued Republican majority in Congress and the only question for markets would be what happens to the Senate. Currently the Democrats have a 51-47 majority with 2 Independents – with 33 Senate seats being contested in November. Of those 7 (6 of which are currently held by Democrats) are believed to be races that are too close to call.

This all matters because of the “fiscal cliff”. This is (i) a number of previously agreed tax cut measures which expire on December 31, and (ii) the penalty clause US politicians set for themselves if they were unable to agree on long term measures to reduce the budget deficit, which make roughly equal cuts in defence and welfare spending. The idea of the penalty clause was that each side would be forced to make compromises on a longer term deal in an attempt to avoid large cuts in the area that most concerned them (defence for the Republicans and welfare for the Democrats) – sadly it didn’t work. The combination of all these measures would be to tighten fiscal policy by about 4% of GDP in 2013 and would send the US economy into recession.

No one seriously believes that such a massive tightening of policy would be allowed to happen, but to avoid it , the “lame-duck” sessions that occur from the election until Christmas with the old membership of both Congress and Senate, will have to agree to some compromises. It is perhaps understandable that, before the elections, neither side were prepared to make any compromises, but the hostility shown by many in the Republican Party towards Obama since he became President has taken the working relationship in Washington between the two parties to a very low ebb. It is not clear that this would change if Obama were to be re-elected and still faced a hostile Republican party in the two Houses. It is possible that an angry and upset Republican Party would not make any compromises and let the US economy fall into recession.

Markets are currently pricing in an Obama victory, and then some sort of compromise over the fiscal cliff that doesn’t drive the US economy into recession. A Republican victory would lead to a rally on Wall Street, but a bad-tempered defeat for them where emotions ran high would be a very negative development for America and the world.

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