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ElectionWatch2012
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Perspectives on a critical political season from UBS Wealth Management Research
Taxes
De� cit
Entitlements
Volume 3 Implications
Markets
Economy
PAGE
02 Election outcomes
05 Election issues
08 Economic implications
11 Market implications
18 Conclusion
ElectionWatch 2012 Publication details
Publisher UBS Financial Services Inc.1285 Avenue of the Americas, 13th Floor New York, NY 10019
This report has been prepared by UBS Financial Services Inc. (“UBS FS”). Please see important disclaimer and disclosures at the end of the document.
This report was published on 11 September 2012.
Editor in ChiefKatherine Klingensmith
Authors (in alphabetical order)Thomas BernerJerry BrimeyerNicole DeckerSally DesslochMichael DionRobert FaulknerStephen FreedmanJoe KenolKatherine KlingensmithGeorge LambertsonDavid Le� owitzBarry McAlindenThomas McLoughlinKathleen McNamaraKurt ReimanMike RyanRobert SamuelsAndrew SutphinDean UngarJon WoloshinJeremy Zirin
Research AssistantsDan KennyMaryam Khan
EditorMarcy Tolko�
Desktop Publishing George StilabowerCognizant Group – Basavaraj Gudihal,Srinivas Addugula and Virender NegiLisa Klausing
Project ManagementPaul LeemingGreg Rosman
In this pivotal year for the political landscape in the US and abroad, Wealth Management Research is pleased to introduce Election Watch 2012, a series of reports designed to guide investors through the critical issues and develop-ments of this election season. In four � agship reports, we will individually address the issues, global elections, implications, and the outcome. As always, we welcome your feedback.
Dear reader,
With both parties hunkering down for the election, it is easy to believe that the policy paths being charted by the candi-dates represent stark choices that would lead to radically dif-ferent outcomes. But the reality is quite a bit more subtle. Keep in mind that whether Republican or Democrat, the fu-ture occupant of the White House and leaders of the 113th Congress will need to deal with the same high de� cits, en-trenched entitlements and slow-growth environment. In short, either an Obama or Romney administration will � nd itself limited in its policy options.
That’s not to suggest that the election won’t have any im-pact on economic growth and � nancial markets. As our panel made clear in our September 5, 2012 report entitled, Exchange: Election 2012, the lack of clarity on issues rang-ing from � scal and tax reform to regulatory enforcement will likely weigh on growth. This uncertainty has only reinforced the overall skittishness of markets. How elected of� cials choose to address these issues, and over what timeline, will therefore have repercussions.
In this third volume of our Election Watch 2012 series, we sort through the likely outcome of the election, the potential impact on the economy and the implications for investors. While the policy paths may not diverge as radically as some suggest, there are still important distinctions that could cre-ate selective investment opportunities and risks. It is also im-portant – particularly with an election so dif� cult to call – to consider investments that are likely to perform well regard-less of the victor.
Letter to readers Summary
Mike Ryan, CFAChief Investment StrategistHead, Wealth Management Research – Americas
With the elections less than two months away, the outcome is still very much in question. However, based upon current polls and the electoral calculus, it would appear that President Obama will win a closely contested reelection, the Republicans will retain a comfortable majority in the House and the Democrats will hang on to the Senate by the very narrowest of margins.
The policy issues• While the candidates present vastly di� erent ideologies about
the role and size of government, many of the policy outcomes ironically would be quite similar.
• We think some sort of “grand bargain” that would cut de� -cits by $4 trillion over the next 10 years is likely, regardless of who wins in November. Taxes would be part of such a deal, but under Republican leadership, broad-based tax code re-form would be more likely.
• Policy di� erences are much sharper regarding speci� c ele-ments of tax and � scal reform as well as � nancial sector and healthcare policies.
Economic and market implications• Both Romney and Obama would have to address a slow-
growth economy and the ongoing pain of austerity mea-sures. However, we think that a Republican administration could produce fewer and clearer regulations and more spending and tax reform, which could enhance growth pros-pects in the long run.
• A Romney presidency could also bring greater uncertainty in the near term amid a more substantive realignment of the political balance, which could in turn lead to slower growth in 2013.
• A moderately better intermediate-term growth outlook, fewer regulatory threats and higher chances of long-term tax reform therefore paint a slightly more positive equity outlook under Romney.
• Republican leadership would likely eliminate or so� en certain elements of reform for the Healthcare and Financial sectors.
• While some may wish to speculate about “winners and los-ers” based on the outcome of the election, we choose to focus on equity sectors, such as Technology and Consumer Staples, whose fortunes are less “outcome-dependent.”
• Interest rates are unlikely to be dramatically a� ected by the elections, though somewhat higher long-term growth could imply a sharper rise in bond yields. A credible commitment to de� cit reduction targets of $4 trillion is probably suf� cient to avoid another downgrade to the US government’s credit rating.
• Municipal bonds could be impacted by a potential increase in marginal tax rates as well as wholesale reform that subjects in-terest on state and local bonds to federal taxation. While the former would likely enhance the value of municipal bonds in general, the latter would create a two-tiered municipal market with a premium placed on “grandfathered” bonds.
2
With the conventions now behind us and November 6 rapidly approaching, the 2012 election race has continued to tighten. The UBS US Of� ce of Public Policy’s current base case scenario is that President Barack Obama will serve a second term in the White House, Republicans will retain control of the House with a comfortable majority and the Senate will remain Democratic by the narrowest of margins.
Given how the electoral calculus works on a state-by-state basis, it would appear that the White House and Senate would both end up under control of the same party (both Republican or Democrat) following the November election (see Fig. 1).
A less likely scenario at this point would be for a split government where the Democrats retain control of the White House while Republicans take the House and the Senate. But no matter the outcome of the election, we see virtually no chance that Republicans would lose the House or that either party would gain a 60-seat � libuster-proof majority in the Senate. This suggests that we are much more likely to see a divided government following the November elections, rather than one in which a single party controls all the branches of power.
History paints a mixed picture for the presidentEvidence suggests that economic trends and public ap-proval ratings can be helpful in predicting an incumbent president’s likelihood of being elected to a second term. In the � rst of our Election Watch series, “The issues,” we concluded that economic momentum in the year of an election can have a critical impact upon the electoral out-come. This same point was stressed by a group of econo-mists, strategists and public policy analysts in the most recent edition of our Exchange publication. They argued that, while other issues such as foreign policy and domes-tic social issues are important, it is the economy that ulti-mately plays the biggest role in determining the outcome of a presidential election.
Election outcomesA close contest, likely shaded more blue than red
Katie Klingensmith; Mike Ryan, CFA
Our own analysis tends to bear this out, and suggests that two economic factors in particular were most closely tied to a successful bid for a second term: manufacturing mo-mentum and job creation. The level of manufacturing ac-tivity as measured by the ISM Manufacturing Index and
House seats projected and current
178145
2117
23 23 28
Source: RealClearPolitics, as of 27 August 2012 (projected); Office of the Clerk of the U.S. House of Representatives, as of 27 August 2012 (current)
Likely DemocratDemocrat Toss upLeans Democrat
Likely RepublicanLeans Republican Republican
191
3
241
Current
Fig. 1: Congressional seats by party af� liation
Senate seats projected and current
4237
55 7 3 1
*Democratic count includes Joe Lieberman and Bernie Sanders, two Independents who caucuswith the DemocratsSource: RealClearPolitics, as of 27 August 2012 (projected); Office of the Clerk of the U.S. House of Representatives, as of 27 August 2012 (current)
Likely DemocratDemocrat* Toss upLeans Democrat
Likely RepublicanLeans Republican Republican
53 47
Current
Election Watch 2012 3
health of labor markets re� ected in nonfarm payroll growth in the year of the election appear to have impact-ed the margin of victory or defeat of previous incumbents (see Fig. 2). The health of the economy over the next few months will therefore play a crucial role in determining the next president.
The job approval ratings of sitting presidents have also been a fairly reliable indicator of an incumbent’s reelection success. What we found in our analysis was that the pub-lic approval ratings during the � rst three months of an election year were most helpful in determining a presi-dent’s reelection prospects: Keep in mind that no presi-dent with an approval rating below 50% during this period has ever been reelected. Obama’s approval during this period was just 48%. So, with an unemployment rate above 8%, an ISM index hovering just below the 50 mark and an approval rating now just above 50%, the presi-dent’s prospects for being reelected seem mixed at best.
Keep in mind, however, that although the economic data would appear to work against the president, there are mitigating factors that might make simple historical com-parisons less relevant. While the economic data remains weak, President Obama took of� ce amid the deepest eco-nomic recession since the Great Depression. So although the unemployment rate remains well above the 7%
threshold that some view as the critical level for reelec-tion, the jobless rate has fallen from a high of 10% back in October 2009. It should be noted that President Ronald Reagan was reelected despite an unemployment rate above 7.5%.
Standard approval ratings may also turn out to be less reli-able than in the past given instant access to information, the increased polarization of the two parties and an ever- larger portion of the voting public that identi� es itself as independent. Given how the electoral map shakes out, this election will likely be decided by the swing voters in just 10 states (Colorado, Florida, Iowa, Michigan, Nevada, New Hampshire, Ohio, Pennsylvania, Virginia and Wisconsin). President Obama currently leads Governor Romney in six of those states, is tied in three of them and trails in only one. So while economic data and approval polls would seem to favor the challenger, they may not fully re� ect the critical factors that will ultimately deter-mine the outcome of this election. It is therefore our view that President Obama will be reelected President – albeit by a narrow margin.
“While economic data and approval polls would seem to favor the challenger, they may not fully re� ect the critical factors that will ultimately determine the outcome of this election.”
Fig. 2: Job creation important for President Obama
Note: Red dot indicates predicted outcome based on 2012 annualized change through August.Source: Bureau of the Census, St. Louis Federal Reserve, UBS WMR as of 7 September 2012.
Incumbent party’s margin of victory/defeat, % of popular vote
1948
1952
1956
1960
1964
1968
1972
19761980
1984
1988
1992
1996
2000
2004
2008
–15
–10
–5
0
5
10
15
20
25
–2 –1 0 1 2 3 4 5
Change in nonfarm payrolls, in % (Jan-Sep of election year, annualized)
4
Election snapshot
29% 15% 15% 15% 26%The US Electorate
172 49 126 57 134The Electoral CollegeCurrent 2012 projection270 votes needed to win
Democratic Leaning Democratic Independent / undecided Leaning Republican Republican
VT3
NH4
MA 11
CT7
NJ14
RI4
DE3
MD 10
DC3
HI4
AK3
AZ11
NM5
TX38
OK7
CO9
NV6
IA 6
MO 10
IN11
WI10
OH 18
VA 13NC 15
PA 20
FL 29
NY 29
ME 4
GA 16
SC 9AL
9MS6
LA 8
AR6
TN 11
KY 8
WV 5
KS6
MN 10
IL20
MI16
NE5
SD 3
ND3
MT3
WY3
UT6
ID4
WA12
OR7
CA 55
The Nation
Follow the money
Source: Data from the New York Times, as of 31 July 2012
The Nation State-by-state breakdown of 2012 Electoral College projection
Source: Data from RealClearPolitics, as of 11 September 2012
Source: Gallup poll, 12 August 2012
Source: Data from RealClearPolitics, as of 11 September 2012
Democratic
Leaning Democratic
Toss up
Leaning Republican
Republican
221 Obama 126 Toss Up Romney 191
President Barack Obama Approval on Issues (Gallup poll, 12 August 2012)Do you approve or disapprove of the way Barack Obama is handling _____?
DisapproveNot sure
Approve
58%
Terrorism Education Immigration
35% 49%43%38%
54%
37%
Creating jobs The economy The federal budget deficit
58%
36%
60%
30%
64%
270 Electoral votes needed to win
RepublicanIndependent / undecidedDemocrat
587.7502.8
131.2
524.2
395.1
197.1
Note: Figures are in millions of US dollars. Totals include money raised and spent through July by the presidential candidates, the national parties, and the primary “super PACs” supporting the candidates (“Priorities USA” for Obama, “Restore Our Future” for Romney).
Raised Spent Cash on hand
Obama
Romney
Election Watch 2012 5
The Democratic and Republican parties are advancing de-cidedly di� erent visions for the future role of the govern-ment; however, we think that many of the policies would actually only be di� erent at the margin under either an Obama or Romney administration. Keep in mind that even with a Republican sweep, the large minority of Democrats in the Senate would make bipartisan support necessary for any major policy changes. Although opinions vary, our own discussions with economists and policy analysts sug-gest a bipartisan � scal deal that includes reductions in def-icit spending and some changes to the tax code is likely under either candidate. A Romney administration is more apt to achieve fundamental tax reform and potentially some long-term reforms to entitlement programs, such as Medicare. However, energy policies would likely be similar under either candidate, with both looking to promote nat-ural gas production. Recent healthcare and � nancial regu-lations would admittedly be vulnerable under a Repub-lican sweep, but probably not as much as the campaigns would have voters believe.
The � scal cli� and the debt ceilingThe most immediate challenges facing the president and Congress a� er the election will be addressing the � scal cli� and raising the debt ceiling. January 2013 will see four major � scal initiatives expire and soon therea� er yet another potential showdown on the debt ceiling (see Fig. 1). If Congress fails to renew or replace these measures, taxes will rise and US government spending will contract sharply (see our June 26, 2012 publication, No US � scal cli� , but beware the pothole). Our view remains that a crisis likely will be avoided. However, if Republicans do take both the White House and the Senate, sitting Republicans may simply refuse to make a deal during the “lame duck” session. While we expect the Bush tax cuts to be temporarily extended, automatic spending cuts to be avoided and the debt ceiling to be raised under either electoral scenario, the payroll tax holiday will likely expire and emergency unemployment bene� ts will likely be phased out.
A grand bargain?Following an increasingly familiar high-stakes game in-volving threats of sequestration and/or a government de-fault, reductions in de� cit spending could materialize under Democratic or Republican leadership. President Obama’s second term could well resemble President Clinton’s, with a shi� toward the center. We think a deal under Obama could result in up to $4 trillion in de� cit re-duction over the next 10 years, comprising a spending cuts/revenue increases ratio of potentially 3 to 1. This would likely include de� cit reduction measures that would replace the discretionary spending caps and the across-the-board spending cuts currently on the books (i.e., sequestration). While Democrats have insisted and will continue to insist upon increases in tax revenue, ex-penditure reductions are still likely to be the bulk of any major � scal deal.
Under a Republican sweep, the size of the package would be roughly similar, but spending cuts could exceed reve-nue increases by a ratio of 4 to 1. Such reforms would likely be inspired by Representative Ryan’s proposals, in-cluding some long-term changes to large social safety net programs. The reforms would be limited, in part, because
Election issuesThe legislative agendas under Democrats or Republicans
Katie Klingensmith; David Le� owitz, CFA
Fig. 1: US debt poised to hit limit soon
Source: Bloomberg, UBS WMR, as of 5 September 2012
US statutory debt limit and public debt level, in trillions of US dollars
16
14
12
10
8
6
18
Debt limitDebt levels
2006 2007 2008 2009 2010 2011 2012
6
“Virtually everyone in Washington wants to see some sort of change to personal taxes, especially given that the Bush tax cuts are set to expire in 2013.”
of the Republicans’ narrow majority in the Senate as well as the political challenge of cutting such popular pro-grams. A Republican Congress would likely be forced to use the reconciliation process to achieve such spending cuts, since this process would require only a majority vote in the Senate and thus avoid the threat of � libuster. Reconciliation can generally be used for legislation that has an impact on government spending or revenues with some limits.
Personal tax reform comes into focusVirtually everyone in Washington wants to see some sort of change to personal taxes, especially given that the Bush tax cuts are set to expire in 2013. A Democratic White House is unlikely to pursue major reforms, but rather would work to extend the Bush tax cuts for all but the highest earners. This would likely a� ect households earn-ing over $1 million dollars annually, but the threshold could be set even lower, depending on revenue needs and projected spending cuts (see Fig. 2).
Tax reform likely would be an early focus under Republican leadership, although implementation would prove dif� cult. Romney would likely seek to reduce per-sonal income tax by 20% for all brackets relative to the pre-Bush levels; however, identifying the deductions re-quired to o� set the loss in revenue would be challenging. The UBS US Of� ce of Public Policy has a high conviction that the � nal outcome would be at least as progressive as the current tax code, since most deductions are currently disproportionately enjoyed by the wealthy. However,
major tax reform is politically challenging and takes care-ful study and analysis given the potential impact on cer-tain critical sectors of the US economy as well as the almost certain opposition by entrenched special interests. It is only likely to be achieved if Congress initiates a seri-ous process to remedy these challenges in a comprehen-sive manner, since a last-minute deal and/or piecemeal approach cannot address the complexity of the tax code.
Deductions: very few sacred cowsAll deductions are vulnerable under either party’s leader-ship, especially in the event of comprehensive tax code re-form. Among the most likely changes are both the elimination of second-home mortgage interest deductions as well as the reduction in the size of a primary mortgage from which interest can be deducted. Municipal bond tax exemption is another likely target. However, it is still un-likely to be completely eliminated and interest on existing bonds would be grandfathered in under the existing tax rules, in our view. The most sacrosanct and therefore the least vulnerable deductions are the de� ned contributions to quali� ed retirement plans.
Only modest changes to capital gains and dividendsUnder either political alignment, but especially under Republican leadership, capital gains and dividends are un-likely to be taxed as ordinary income. However, the rate could rise from the current 15% to as high as 25% in a second Obama administration – once the additional 3.8% tax on unearned income for high earners mandated by the A� ordable Care Act (ACA) is included. Romney, on
Fig. 2: Marginal income tax rates at historic lows
Source: Internal Revenue Service, UBS WMR, as of 30 August 2012
Top marginal federal income tax rate, in %
80
60
40
20
0
100
1943 1953 1963 1973193319231913 1983 1993 2003 2013
Wils
on
Hard
ing
Cool
idge
Hoov
er
Carte
r
Reag
an
GW
Bush
Clin
ton
Bush
Oba
ma
Roos
evel
t
Trum
an
Eise
nhow
er
Kenn
edy
John
son
Nix
on
Source: Organization for Economic Co-operation and Development (OECD) Tax Database, UBS WMR, as of 1 April 2012
IrelandPolandTurkey
SwitzerlandIsrael
South KoreaUK
CanadaItaly
AustraliaMexico
SpainGermany
FranceJapan
US
3020100 40
Fig. 3: US corporations face higher statutory rates than peers
Total corporate tax rate, including provincial and central government, in %
Election Watch 2012 7
the other hand, would seek to maintain both dividend and capital gains rates at the current 15% level.
Corporate tax reform likely in either scenarioCorporate tax reform appears to be a goal, of both parties – albeit a challenging one. US statutory rates are high rel-ative to the rest of the world (see Fig. 3). However, US corporations don’t pay higher e� ective rates, nor have these e� ective rates gone up over time, as many take ad-vantage of loopholes and companies have increasingly taken advantage of lower tax rates outside the US. Reform is challenging precisely because so many � rms have been structured around these loopholes. Corporate taxes are likely to be reduced under either party’s leader-ship, with a goal of a 25% rate, although something clos-er to 30% is probably more feasible. Democrats would look for some revenue enhancement and would be more willing to close many loopholes. On the other hand, Republicans would seek a revenue-neutral proposal. Pass-through entities such as S corporations, MLPs and REITs with more than $50 million in revenue could be at some risk of facing corporate income tax, especially under an Obama administration. A one-time reduction in the tax rate on the repatriation of overseas corporate cash is likely – but only as part of a broader tax deal.
Healthcare reform in jeopardy While it should come as no surprise that the ACA would remain largely untouched under a second Obama admin-istration, we believe signi� cant components of the law could be modi� ed by a Romney administration and Republican Congress. Republicans would try to use the congressional reconciliation process to repeal the individu-al mandate and block the expansion of Medicaid. Additionally, a Romney administration may be much more inclined to grant waivers exempting states from establish-ing insurance exchanges. Given the breadth and complex-ity of the law, it is unlikely that it would be entirely repealed and there may be substantial uncertainty for some time. In addition, Medicare reimbursement cuts would be likely under any budget de� cit reduction initia-tive. However, comprehensive entitlement reform is more challenging, in light of the need to reach 60 votes in the Senate.
Cheap natural gas, not politicians, driving energy Campaign rhetoric suggests a bigger di� erence in policy than is actually likely to materialize in the Energy sector.
Under either Obama or Romney, natural gas extraction through hydraulic fracturing (fracking) is likely to expand and the Keystone Pipeline is likely to be approved. Obama could push for regulations that encourage alternatives to carbon-intensive fossil fuels, promoting green and renew-able energy, but would likely only achieve policies with small price tags. Alternatively, Republicans could reduce or simplify some environmental regulations and facilitate on- and o� shore drilling. Wind power subsidies could contin-ue despite the election outcome given that GOP-leaning states are major wind power producers. Coal usage could face incremental pressure under an Obama reelection, but a Romney EPA will likely not roll back the coal regulations that have been put in place over the last four years. We see the nuclear industry as being largely una� ected by the election.
Financial regulation could lightenIf Obama returns to the White House, Dodd-Frank likely will be fully implemented. But even under a Romney ad-ministration, Dodd-Frank would also remain largely intact – although certain measures could be revised in the all-important rule-making process. If Romney wins, regula-tions that have not been � nalized before the election may be subject to a more industry-friendly interpretation. Of note, the Volcker rule, which limits proprietary trading at large banks, will not likely be � nalized before the election and a Romney administration could pursue a more indus-try-friendly interpretion of this rule. The Basel capital ac-cords which regulate bank capital levels could potentially also be applied more leniently.
8
While the political messaging on the campaign trail sug-gests fundamentally di� erent economic policies, we ex-pect the di� erences between a second Obama administration and a Republican sweep are likely to be much more subtle. The four areas that we focus on are 1) the size of the de� cit reduction package; 2) the composi-tion of that package; 3) the level of policy uncertainty; and 4) the degree of regulation. Both candidates would have to contend with the same high de� cits, entrenched entitlements and overall slow-growth environment. We expect that a de� cit reduction plan emerging from either political scenario would come at substantial cost to GDP growth – either now or in the future. But foregoing de� cit reduction risks an even bigger crisis down the road. However, we conclude that a Romney victory may lead to slightly lower growth in 2013 but higher growth in the years therea� er, relative to an Obama victory.
De� cit reduction similar size under either partyWe envision de� cit savings of up to $4 trillion over the next 10 years under either party’s leadership. This assumes an ad-ditional $3 trillion in de� cit reduction beyond the nearly $1
trillion of savings in the form of spending caps agreed upon during the debt ceiling negotiations of 2011, but in lieu of sequestration, triggered by the Budget Control Act, or BCA. While $4 trillion may sound like a large number, the de� cit projections would still not bring the US budget into balance anytime in the foreseeable future (see Fig. 1). However, this level of savings would at least begin to stabilize debt-to-GDP levels over the next decade.
The Congressional Budget Of� ce (CBO) shows that under a continuation of current policy, de� cits would improve from an estimated 7.7% of GDP in 2012 to about 5% by 2018, and then begin to deteriorate again therea� er. Savings of $4 trillion,1 spread evenly across 10 years, would lower the de� cit to about 3.5% by 2018, with a subsequent deterioration therea� er. These cuts would therefore signi� cantly improve debt sustainability relative to current policy, largely stabilizing the debt-to-GDP ratio close to current levels over the next decade (see Fig. 2). However, without signi� cant reform, the rising cost of Medicare will drive an increase in debt-to-GDP levels be-ginning in the latter part of the decade. While Republican
Economic implicationsLarge � scal drag regardless of election outcome
Thomas Berner, CFA; Stephen Freedman, PhD, CFA
Note: The "grand bargain" is approxrimately 4 trillion US dollars in deficit savings. The CBO projection is from its extended alternative scenario, which is based on current policy and includes the savings from the discretionary spending caps from the Budget Contral Act of 2011.Source: CBO, UBS WMR, as of 29 August 2012
Grand bargainCBO current policy baseline
85
80
75
70
95
90
2012 2014 2016 2018 2020 2022
Fig. 2: Debt-to-GDP would stabilize with a grand bargain
Federal debt held by the public under different scenarios, in % of GDP
Note: The "grand bargain" is approxrimately 4 trillion US dollars in deficit savings. The CBO projection is from its extended alternative scenario, which is based on current policy and includes the savings from the discretionary spending caps from the Budget Control Act of 2011.Source: CBO, UBS WMR, as of 29 August 2012
Grand bargainCBO current policy baseline
–2
–3
–4
–8
–7
–6
–5
0
–1
2012 2014 2016 2018 2020 2022
Fig. 1: Grand bargain doesn’t drastically change projections
Federal budget projections under different scenarios, in % of GDP
Election Watch 2012 9
leadership may be more likely to implement some entitle-ment reforms, deeper cuts would subsequently be neces-sary to bring the programs into balance. Importantly, this level of de� cit reduction would likely be enough to avert another US credit rating downgrade in the near term, while a smaller package of de� cit cuts, or one that only promises to make cuts in the future, could prompt further credit rating downgrades.
Small di� erence in composition of de� cit reduction Based on their respective political preferences, we expect that the composition of a � scal package would di� er moderately under Democratic or Republican leadership. In the status quo scenario, we expect the ratio of spending cuts to revenue increases to amount to 3 to 1, compared to a 4 to 1 ratio under a Republican victory. These distinc-tions are likely too small to imply a materially di� erent economic growth outlook. The International Monetary Fund (IMF) estimates that spending cuts have a larger drag on the economy than revenue hikes. Assuming for sim-plicity and illustration purposes that � scal restraint starts in 2012 and is spread evenly over 10 years, we estimate that a 3 to 1 spending-to-revenue ratio would reduce real GDP by 2.1%, and 1.5% in the � rst and second year, respec-tively. Under a 4 to 1 ratio, these � gures would be insigni-� cantly higher at -2.3% and -1.6% (see Fig. 3). In practice, political realities and the business cycle would probably make these cuts more back-end loaded but the relative impact under both scenarios should be similar.
The key takeaways are that:
1. The � scal restraint necessary to stabilize public debt ra-tios implies a signi� cant drag on the economy in the coming years unless the de� cit cuts are weighted to-ward the end of the decade.
2. A greater focus on spending cuts will have a stronger adverse impact on growth, but not signi� cantly so.
Policy uncertaintyEconomic policy uncertainty has been abnormally high since the � nancial crisis � rst broke. Polarization and grid-lock in Congress have added to the sense of uneasiness among businesses and consumers that has discouraged hiring, investing and spending. In our recent Exchange publication focused on the upcoming election, industry experts discussed how this heightened uncertainty about everything from the tax code to the ability of the US to pay its debt has been detrimental to con� dence and a drag on growth. This can be illustrated with the US Economic Policy Uncertainty Index2 (see Fig. 4), which has remained elevated since 2008.
It is our view that a Republican sweep would allow for a greater political mandate that would ultimately reduce policy uncertainty. However, the � rst year of a Republican administration may actually see a spike in uncertainty, as the GOP is likely to attempt to overturn or revise previous legislation and embark on its own reform agenda. A� er
Note: The indexes are standardized and have a mean of zero and a standard deviation of one.Source: EconomicPolicyUncertainty.com, UBS WMR, as of 29 August 2012.
6-month moving averageUS policy uncertainty index
2
1
–2
–1
0
5
4
3
1985 1990 1995 2000 2005 2010
Fig. 4: Policy uncertainty remains elevated post-Lehman
US economic policy uncertainty index, standardized
“Polarization and gridlock in Congress have added to the sense of uneasiness among businesses and consumers that has discouraged hiring, investing and spending.”
Note: Ratios computed assuming that fiscal restraint starts in 2012 and is spread evenly over 10 years. Source: IMF Fiscal Monitor April 2012, UBS WMR as of 7 September 2012.
–1
–2
–3
0
1st year
–2.1
–1.5
–2.3
–1.6
2nd year
Fig. 3: GDP suffers under austerity regardless of party
First and second year impact of Grand Bargain on real GDP growth
3 to 1 ratio (Democrats)4 to 1 ratio (Republicans)
10
this period of more heightened uncertainty, we expect the policy environment would become less volatile and uncer-tain than it has been in the past few years.
Considering only this di� erence in uncertainty and relying on our estimates of the impact of uncertainty on GDP growth,3 we believe economic growth under a Romney administration would be 0.3% lower in 2013 but then 0.6% faster in 2014 vs. the Obama reelection scenario. These di� erences – while not extreme – do suggest that the election results will have some impact on both current and longer-term growth prospects.
Regulatory burdenThe last aspect that is likely to distinguish between politi-cal scenarios is the amount of government regulation. We assume that under a Romney administration a lighter ap-proach to regulation would ultimately prevail. We esti-mate that in 2014, the level of regulation might revert halfway to pre-crisis level. This may amount to a 0.2% boost to GDP growth in that year.4
Election Watch 2012 11
market valuations are lower, which we believe is the pri-mary factor that explains the moderate outperformance (see Fig. 1). With less than two months remaining before the election, numerous historical “facts” (most lacking statistical relevance) will be bandied about regarding the relationship between elections and the stock market. The most well documented thesis is that stocks perform best in the second half of presidential terms as incumbent ad-ministrations promote pro-growth policies in order to im-prove their chances of remaining in power. Keep in mind that while “on average” stocks have historically per-formed better in the two-year period that includes the presidential election, the sample size that goes back 84 years is still relatively small (21 data points per year of election cycle), and the premise has not been validated by the past two presidential cycles (See Fig. 2).
While this type of analysis makes for fun cocktail party conversation, it tends to grossly oversimplify the investing landscape. We believe a better approach is to determine the outlook for corporate earnings and market valuations, i.e., core equity market fundamentals. As we describe above, the economic outlook under either election
Market implicationsElections don‘t radically alter market outlook
Jerry Brimeyer; Nicole Decker; Sally Dessloch; Michael Dion, CFA; Robert Faulkner; Joe Kenol; George Lambertson; David Le� owitz, CFA; Barry McAlinden, CFA; Tom McLoughlin; Kathleen McNamara, CFA; Robert Samuels; Andrew Sutphin; Dean Ungar, CFA; Jon Woloshin, CFA; Jeremy Zirin, CFA
Note: Historical analysis begins in 1928.Source: FactSet, Office of the Clerk of the U.S. House of Representatives, Robert Shiller, UBS WMR, as of 6 September 2012
4
2
0 14xRepublican PresidentsDemocratic Presidents
8
6
10
17x
16x
15x
18x
19x
P/E begin of term (right)Avg annual return (le)Avg annual EPS growth (le)
Price-to-earnings ratio
Fig. 1: Low valuation behind outperformance under Democrats
Average annual S&P 500 return and EPS growth, in %
Source: Bloomberg, Ibbotson, UBS WMR as of 10 September 2012
Fig. 2: Stock market election cycle has not worked recently
S&P 500 returns by year of presidential term
-40%
-30%
-20%
-10%
0%
10%
20%
30%
Year 1 Year 2 Year 3 Year 4
All terms since 1929Bush (second term, 2005-2008)Obama (2009-2012 YTD)
The market rami� cations of policy decisions made over the next several years will be widespread and, in some cases, very important. However, we do not think that whoever controls the White House will radically alter the course of � nancial markets in general. Asset allocation im-plications at the broad asset class level will therefore likely be limited. However, equities are poised to perform some-what better under a Republican administration, while bonds may come under greater pressure – especially a� er the � rst year. If there is indeed a major � scal deal, US Treasuries will retain their current ratings. Municipal bonds run a not insigni� cant risk of losing their tax-exempt sta-tus, regardless of who is in power. Implications for munici-pal bond holdings will depend on how broad the application of such a change would be, and whether ex-isting bonds would retain their tax-free status.
Equity markets
Fundamentals matter more than party controlAverage annual US equity market returns have been high-er under Democratic presidents since 1928. But we also found that Democrats tend to take of� ce when stock
12
outcome is fairly similar and therefore earnings growth rates should not di� er greatly under Romney or Obama. But there could be di� erences in equity market valuation multiples as we describe below.
Obama victory – limited impactAn Obama victory would more or less be a continuation of the status quo and therefore not likely alter our cur-rent stance on US equities, which we believe are close to fair value. Over the last four years, P/E multiples have av-eraged about 13x forward estimates, lower than the long-term average of 14.5x. We believe this valuation discount is a re� ection of uncertainty about the long-term sustainability of US government debt dynamics, greater-than-normal threat of regulatory changes, con-sumer deleveraging, demographics and other factors that constrain economic growth and increase uncertain-ty. In an Obama second term, most of the factors that are weighing on equity market valuations will continue to linger. However, there could be some progress on budget sustainability although long-term entitlement re-form is challenging. Romney victory – a modestly higher P/EA Romney victory could be mildly supportive for US equity markets. Policy uncertainty could increase in the near term; however, once the � scal cli� is behind us and Republicans have le� their mark on tax, � nancial and healthcare reforms, uncertainty should decline. Looking ahead a bit further, we believe a Romney administration may be able to achieve some long-term and marginal en-titlement reform, likely more than under a second Obama term. However, a Romney administration would still have to address many of the same secular challenges, such as consumer deleveraging, demographics and the pain of � s-cal austerity. But given our view that a Romney administra-tion will be able to achieve some long-term � xes to personal and corporate income taxes and greater regula-tory clarity, even with a rocky transition and potentially some growth slowdown in 2013, we believe equity mar-ket valuation multiples have a greater potential to improve in this scenario.
Separating rhetoric from realityWhile economic policy may not be that di� erent under an Obama vs. a Romney administration, there are still a num-ber of areas where speci� c policies would vary. The policy agendas presented in the campaign may indeed be
curtailed by a near evenly divided Senate, but whichever party controls the White House will be able to pursue and implement at least some changes.
Dividend and capital gains taxesUnder an Obama reelection scenario, we expect only a modest increase in dividend tax rates to 20-25%. A Romney victory could result in no change to current divi-dend tax rates (15% for quali� ed dividend income). Historically high valuations of the highest-yielding sectors of the market (Telecom and Utilities) would be vulnerable if dividend income tax rates were to rise. However, an in-crease in dividend tax rates under an Obama White House will likely be accompanied by an increase in ordinary in-come rates for the highest earners as well, which means that dividend yields may not lose their tax advantage rela-tive to � xed income investments. Capital gains tax rates are scheduled to rise to 20% next year (from 15%), a level that is likely under an Obama victory. As a result, there could be some year-end pro� t taking in stocks that have performed well. A Romney administration would likely be able to achieve an extension of the 15% capital gains tax rate, mitigating this risk.
Corporate tax reform: lots of moving piecesAny corporate tax reform will likely have to be at least rev-enue-neutral, which means that a lower tax burden for some industries has to be o� set by higher taxes for oth-ers, creating winners and losers (see Fig. 3). One big ticket item that lawmakers would likely include as part of a larg-er tax reform, especially under a Romney win, is a
“The economic outlook under either election outcome is fairly similar and therefore earnings growth rates should not di� er greatly under Romney or Obama. But there could be di� erences in equity market valuation multiples.”
Source: Office of Management and Budget, UBS WMR, as of 6 September 2012
Fig. 3: Corporate tax burden in line with historical average
Corporate tax receipts as a share of GDP, in %
3
2
1
9
4
8
7
6
5
1940 1950 1960 1970 1980 1990 2000 2010
Election Watch 2012 13
one-time reduced tax rate on the repatriation of overseas income. While this would be modestly positive for Technology, Industrials, Pharmaceuticals and select Consumer Staples companies, there will be intense scruti-ny around how companies deploy this cash, and manage-ment teams will have to be careful about distributing too much of this to shareholders. In addition, the quid pro quo for this one-time tax holiday will likely be restrictions on transferring intellectual property to overseas subsidiar-ies in locations with lower tax rates, which may be a mod-est negative for many Technology and Pharmaceutical companies.
Finding opportunities regardless of the election outcomeNot surprisingly, industries would likely face more change under a Romney administration rather than a second Obama term, as a new president tries to roll back some of the reforms put in place over the last four years and im-plement his own policy agenda. Therefore, in the run-up to the election, investors in Healthcare and, to some ex-tent, Financials, will once again contend with some policy uncertainty. As the election is still a very close call, we rec-ommend investors focus on sectors that are well-posi-tioned regardless of the election outcome. Within cyclicals we highlight the Technology sector (low valuations, prod-uct cycle visibility, and strong balance sheets). Consumer Staples (dividend growth, emerging market consumer ex-posure) is our preferred defensive (see Fig. 4). In Fig. 6, we summarize the potential impact on all sectors of an Obama or Romney victory.
FinancialsMost of the changes we expect under a Romney adminis-tration, as laid out in “Election issues” section, would have only a modest impact on Financial sector earnings, but there could be notable valuation expansion, especially for the large banks and brokers which are trading at his-torically very low valuations (see Fig. 5), based on an im-provement in the regulatory environment. These companies represent nearly 40% of the sector. Insurance companies (25% of the sector) would be largely una� ect-ed, but there could be a “halo e� ect” that also boosts valuations for this industry. With the status quo largely maintained under an Obama victory, the sector would likely be una� ected if Obama wins reelection.
Healthcare Contrary to consensus thinking, we believe a Romney vic-tory would be slightly negative for the sector. The product companies (pharmaceuticals, biotech and medical devic-es), which comprise 80% of the market cap of the sector, would su� er from fewer Americans with medical insur-ance coverage and possibly lower government reimburse-ments (see Fig. 7). This would be somewhat o� set by a higher valuation multiple due to less government regula-tion and a tax holiday on the repatriation of overseas cash. Furthermore, there is a small chance of Medicare eli-gibility changes that would reduce bene� ts in the long term. On the � ip side, a Romney victory would be positive for the managed care industry, which represents about 10% of the sector. These companies would likely bene� t from incentives for individuals to move to
Source: UBS WMR, as of 6 September 2012
n– –– – – – + ++ +++
Consumer StaplesCons Discretionary
Industrials
FinancialsEnergy
Technology
Health CareMaterials
UtilitiesTelecom
Underweight Overweight
Fig. 4: Current WMR sector allocation
Tactical deviations from benchmark
Source: Thomson Datastream, UBS WMR, as of 1 September 2012
0.5
0.4
1.1
0.6
1.0
0.9
0.8
0.7
Fig. 5: Increased regulation has weighed on Financials valuation
Relative price-to-book ratio of Financials vs. the market
1980 1985 1990 1995 20052000 2010
14
Impact Obama victory Romney victory
Financials Medium/ High
• Small risk that quasi pass-through entities, such as REITs, will incur corporate tax, depressing earnings and valuations
• Reduced risk of regulation/threats of legal action, more industry-friendly interpretation of � nancial reg-ulations and potential scale back of rules to limit pro-prietary trading could li� the current low valuations of large banks and brokers
Utilities Medium • Some risk of lower industry valuations due to higher dividend tax rates
• Wind power generators bene� t from extension of subsidies beyond 2012
• Coal-� red generators face further potential restrictions
• Potential bene� t from extension of low dividend income tax rates
• Threat of additional regulation removed for coal-� red generators
Healthcare Medium • Pharma bene� ts from repatriation tax holiday but tax reform may limit ability to book pro� ts in non-US, low tax jurisdictions going forward
• Overall slightly negative for the sector• Healthcare product companies such as pharma, bio-
tech, medical equipment hurt by lower volumes (less insurance coverage) and government reimbursement cuts
• Managed care companies bene� t from less regulation and move toward privatization of Medicare/Medicaid although possible government reimbursement cuts could hurt
• Pharma bene� ts from repatriation tax holiday but tax reform may limit ability to book pro� ts in non-US, low tax jurisdictions going forward
Energy Low • Small risk that quasi pass-through entities, such as MLPs will incur corporate income tax, depressing earnings and valuation
• Streamlining of drilling permits could bene� t E&P and oil � eld services companies
• Coal mining companies bene� t from lower threat of additional regulation on coal usage
Consumer Discretionary
Low • Homebuilders could bene� t from possibly more aid to underwater homeowners
• Cable companies could bene� t if allowed to prioritize internet traf� c (scale back internet or net neutrality) at the expense of content owners
Consumer Staples
Low • Modest possible bene� t from repatriation tax holiday
• Modest possible bene� t from repatriation tax holiday
Industrials Low • Defense contractors hurt by continued defense spending reductions
• Modest possible bene� t from repatriation tax holiday
• Somewhat smaller defense spending reductions• Rails could bene� t from less pressure on coal and
threat of regulation• Modest possible bene� t from repatriation tax holiday
Materials Low • No signi� cant changes likely • Possible reduction to ethanol mandates could lead to reduced corn and fertilizer demand
Technology Low • Could bene� t from repatriation tax holiday but tax reform may limit ability to book pro� ts in non-US, low tax jurisdictions going forward
• Cuts in government spending could hamper Tech demand
• Could bene� t from repatriation tax holiday but tax reform may limit ability to book pro� ts in non-US, low tax jurisdictions going forward
Telecom Low • Some risk of lower industry valuations due to higher dividend tax rates
• Could bene� t from government green light on wire-less industry consolidation
• Pricing may improve if allowed to prioritize internet traf� c (scale back net neutrality)
• Potential bene� t from extension of low dividend income tax rates
Source: UBS WMR, as of 11 Septebmer 2012
Fig. 6: Sector implications of potential election outcomes
Election Watch 2012 15 Election Watch 2012 15
privately managed Medicare and Medicaid plans. Repeal of the individual mandate would translate into less growth for the commercial insurers, but we believe the market is skeptical of the pro� tability of this incremental business anyway. An Obama reelection would not have much im-pact on the sector as the status quo is maintained.
Energy and powerDespite the rhetoric, the divide between the two candi-dates on energy policy is actually quite narrow. Rather than policy, the sector is being reshaped by cheap natural gas, which we expect to continue under either candidate. On the margin, a Romney victory could boost sector valu-ations due to the perception that a new administration would be more supportive of the industry and could pave the way for slightly faster domestic drilling over time. Coal miners would probably also get a boost as the threat of further regulation diminishes. An Obama victory would not likely have a major impact on the sector, although coal mining shares could come under some pressure over fears of further restrictions on coal usage, and wind power gen-erators could bene� t from expansion of renewable power mandates.
MLPs and REITs will face more scrutinyWhile not our base case, we believe there is some risk that MLP and REIT income (and other quasi pass-through enti-ties) could become subject to corporate income tax as the government looks to raise revenue while reducing corpo-rate tax rates. As a result, these securities could come under substantial selling pressure. This scenario has up to
a 20% probability under an Obama victory with slightly lower odds under a Romney win. Once again, this is not our baseline view. However, given its potential signi� cant impact on investors, we will be monitoring this issue very closely.
Fixed income
Treasuries: not election-dependent in the near termElection results, while important over the long run, are less likely to drive yields in one direction or another. We expect economic fundamentals in the US and developments in Europe to determine the general direction of Treasury yields in the near- to medium-term. The � scal cli� poses the most signi� cant risk to this forecast as a failure to ne-gotiate a political compromise may yet trigger another economic recession. The second main event risk is the ex-tension of the debt ceiling, which could lead to technical default if the statutory borrowing limit is not increased.(see Fig. 1 on pg. 5). However, we expect a satisfactory de� cit reduction package and an increase in the debt ceil-ing regardless of the outcome of the election. Any signs of economic normalization could lead to an eventual tightening of Federal Reserve policy, consistent with our expectation for marginally higher yields over a 6- to 12-month horizon. To the extent GDP growth may be lower under Romney in 2013 but higher in 2014, a Romney vic-tory may keep downward pressure on yields at � rst but then lead to a somewhat sharper rise therea� er.
“Longer term, the size of the federal budget de� cit and elevated levels of debt to GDP should exert a powerful in� uence on yields – particularly as the cost of funding increases when growth picks up, as we expect.”
Source: FactSet, UBS WMR, as of 6 September 2012
0
30
20
10
60
50
40
70
80
Pharma, Biotech,Devices, Equipment
Managed CareOther services Distributors
Fig. 7: 80% of sector negatively impacted by ACA repeal
Share of Healthcare sector, as % of market cap
Source: Bloomberg, Ibbotson, UBS WMR as of 10 September 2012
15
10
5
0
20
1972 1978 1984 1990196619601954 1996 2002 2008
Fed funds rate10-year Treasury noteRepublican
Democrat
Fig. 8: Monetary policy is a key driver of bond yields
10-year Treasury note yield and fed funds target rate, in %
16
Note: GO stands for general obligations.Source: Municipal Market Data, Bloomberg, UBS WMR as of 4 September 2012
A-rated corporate IndustrialsTreasury A-rated Muni GO
3
0
1
2
4
5 10 15 20 25 30
Fig. 10: Market assigning little value to tax-exemption
Treasury, municipal, and corporate yield curves, in %
Longer term, however, the size of the federal budget de� -cit and elevated levels of debt-to-GDP should exert a pow-erful in� uence on yields – particularly as the cost of funding increases when growth picks up, as we expect. In the absence of credible longer-term � scal reform, an addi-tional credit risk premium has the potential to be built into Treasury yields, in light of the risk of future credit rating downgrades. This could contribute to Treasury yield levels that are considerably higher than current levels in the years ahead. However, a lack of viable safe haven alterna-tives would still serve to limit the magnitude of any repric-ing on credit concerns alone. And if a credible � scal plan is indeed put into place, it would also prevent any such sizable uptick in yields.
Rating agencies taking a wait and see approachS&P’s much publicized US sovereign credit rating down-grade in August 2011 initially triggered substantial con-sternation among market participants. Since then, Moody’s, S&P and Fitch have maintained a negative out-look on their Aaa/AA+/AAA ratings, respectively. A nega-tive outlook represents the possible ratings path over the intermediate term, whereas a credit watch or review re-� ects prospects in the near term. We expect the agencies would � rst move from a negative outlook to a negative credit watch before changing the rating. While it is dif� -cult to precisely identify when any of the rating agencies will act, all three have intimated that they would be in a position to alter their outlooks in mid-2013 to early 2014. As it relates to � scal reform, the rating agencies are taking
a wait-and-see approach over a horizon that spans the presidential election and subsequent lame duck session of Congress (see Fig. 9). All three agencies agree that some form of de� cit reduction package in excess of last year’s Budget Control Act (BCA) is likely and have largely built this into their base case � scal outlooks. We believe that a $4 trillion de� cit reduction package is likely to placate the rating agencies for now, but still result in warnings about the long-term outlook and the commitment to control de� cits. Political brinkmanship could yet threaten current credit ratings in the near term, especially as it relates to a potential showdown in raising the debt ceiling in early 2013. Over the longer term, US sovereign ratings could be at risk if debt/GDP ratios are not deemed to be within ac-ceptable limits, which would likely necessitate more signif-icant entitlement reforms.
GSE reform not likely Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have been in government conservator-ship since September 2008 and have received $188 billion in cash from the US Treasury in order to keep the compa-nies a� oat. Since that time, no piece of reform legislation has made progress in Congress. The most signi� cant changes were recently announced in August and seek to expedite the wind-down of the GSEs. This includes an ac-celerated permanent liquidation of their retained mort-gage portfolios, submission of an annual plan to reduce taxpayer exposure to mortgage credit risk and turning over any future earnings to the Treasury.
Fig. 9: US sovereign rating agency outlooks
Rating/Outlook Guidance
Moody’s Aaa/Negative “Without further de� cit reduction measures, the rating could be placed on review for downgrade sometime in the coming year…the outlook change will most likely not occur until sometime in 2013.”
S&P AA+/Negative “The negative outlook re� ects our opinion that U.S. sovereign credit risks, primarily political and � scal, could build to the point of leading us to lower our ‘AA+‘ long-term rating by 2014.”
Fitch AAA/Negative “Fitch does not expect to resolve the Negative Outlook until late 2013. Fitch will take into account any de� cit-reduction strategy that may emerge a� er Congressional and Presidential elections in addition to an updated assessment of the medium-term economic and � scal outlook.”
Source: Moody’s, S&P, Fitch, UBS WMR as of 6 September 2012
Election Watch 2012 17
While the prospects for GSE reform could be higher under a Republican sweep scenario, we don’t believe any sub-stantive reform will take place in 2013, as de� cit reduction and tax reform will dominate the political agenda. Neither Obama nor Romney has expounded a speci� c view for the GSEs. Moreover, the recent announcement that GSE prof-its will be returned to taxpayers helps to bide additional time by enhancing the perceived safety of GSE debentures and mortgage-backed securities. This was noted by Fitch’s statement: “Absent a near-term requirement for more Treasury capital contributions to Fannie and Freddie, we believe pressure in Congress for a major overhaul of the agencies’ operations will be reduced.”5
Municipal securities: tax exemption at risk?While legislative initiatives to reduce or eliminate munici-pal bond tax exemption surface in Congress every few years, the proposals o� en lacked widespread support. We now expect policymakers to target municipal tax exemp-tion a� er the presidential election as part of comprehen-sive tax reform. Both Democratic and Republican members of Congress have expressed interest in reducing the value of tax preferences and deductions as a means of increasing revenues – and municipal bonds are unlikely to escape closer scrutiny.
In our view, the municipal bond exemption is likely to be among the tax expenditures targeted by Congress for a variety of reasons (see Fig. 9). First, we believe the size of the implicit subsidy is signi� cant enough to warrant closer scrutiny. Tax exemption ranks 12 out of the top 16 federal tax expenditures over � ve years at roughly $178 billion, according to the sta� of Joint Committee on Taxation. Second, the public interest groups in Washington, such as the Government Finance Of� cers Association and the National League of Cities, exert less political in� uence than they once did. Third, according to the Internal Revenue Service (IRS), of the US households earning more than $200,000 that paid no taxes in 2009, more than 60% reported that tax-exempt interest was the primary reason. Finally, representatives in both parties have ex-pressed skepticism regarding its utility value. Elected of� -cials on the le� have noted that the � nancial bene� t skews toward the af� uent investor, while their opponents on the right may see the tax preference as one that pro-motes borrowing and local government indebtedness.
We expect a robust debate regarding municipal tax ex-emption in 2013 within the broader context of tax reform. The debates will create headwinds for the municipal bond market as investors attempt to sort out the impact of par-tisan negotiations on their investment portfolios. While it is still early in the process, and therefore too soon to be absolutely certain of the outcome, we do not expect the treatment of interest on outstanding bonds to be a� ect-ed. Retroactive taxation is never popular with members of Congress.
However, we do believe that Congress will impose some restrictions prospectively. The limitations can take any number of forms. For example, the sale of new tax-ex-empt bonds may be limited to just a few public purposes. Alternatively, tax-exempt interest on newly issued bonds may be taxed but at a lower marginal rate than earned in-come. A third option, the provision of direct federal subsi-dies toward the payment of debt service, was successfully tested by the Build America Bonds program. To the extent any of these options plays out, we would expect pre-exist-ing municipal bonds to outperform other � xed income asset classes on the basis of scarcity value alone.
The outcome could go one of two ways. Grandfathering outstanding bonds in conjunction with the imposition of new limitations should produce a rally as long as these bonds retain a relative tax advantage to other asset class-es. Retroactivity, which we believe is far less likely, is more of a mixed bag. Provided the tax imposed on municipal bonds is relatively low, the tax advantage of municipals is preserved but the bene� t is reduced. We do not recom-mend repositioning municipal bond portfolios now since there is little clarity as to the path either administration would likely take, but closer monitoring is warranted.
“In our view, the municipal bond exemption is likely to be among the tax expenditures targeted by Congress for a variety of reasons.”
18
ConclusionOn the campaign trail, President Obama and Governor Romney advocate
vastly di� erent visions for the future role of the federal government.
However, in practice, the two may not be able to exercise as much discretion
as they promise and neither individual is likely to be able to radically alter the
role and size of government. Both candidates would be faced with a slow-
growth economy and the pain of implementing � scal austerity, and both
would have to reckon with a closely divided Senate which would inhibit
them from implementing or repealing ambitious reforms.
In spite of the political and economic challenges facing the next president,
we expect more progress on � scal issues than over the past several years.
While this may be the result of a more collaborative political environment,
it’s more likely that the � scal cli� – especially the unpleasant indiscriminate-
ness of sequestration and the looming debt ceiling – will force such a deal.
We believe a bipartisan de� cit reduction package would look broadly similar
under either administration, likely placating the rating agencies for now. A
mildly more optimistic intermediate-term GDP growth expectation, coupled
with incrementally greater policy clarity under Romney, may be more friendly
for equity markets.
While the big policy outcomes may not be vastly di� erent under a Romney
or Obama White House, there are still many speci� c areas that could di� er,
with important implications for � nancial markets. However, some important
policy changes may transpire regardless of who wins in November. Elections
do matter and the two candidates would pursue very di� erent visions, but
the di� erence between what each of them could actually achieve in of� ce
may not be quite as dramatic as current rhetoric would suggest.
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Endnotes 1 USD 3 trillion in addition to the assumptions embedded in the CBO
scenario. 2 The index was created by Baker, Bloom and Davis (see www.policyun-
certainty.com). 3 We estimate that a sustained one standard deviation increase in the
US EPUI curtails US real GDP growth by 0.6% a� er four quarters, as businesses and households pare back on their spending if they feel less certain about the economic and policy outlook. We assume that a Republican-dominated administration would lower the US EPUI half-way back to pre-crisis levels in year 2014 (a one standard deviation de-cline), while increasing uncertainty by half that amount in year 2013 (half a standard deviation increase), whereas under an Obama admin-istration, uncertainty would be largely unchanged.
4 See WMR research focus, “The � nancial crisis and its a� ermath,” March 2009, for estimates of the impact of regulation on economic growth. We assume that the Fraser Institute Economic Freedom Index’s regulation subcomponent corrects halfway back to its pre-crisis level under a Republican sweep scenario, but stays constant under an Obama victory.
5 FitchRatings. “Improved GSE results may ease push for immediate re-form,” 13 August 2012.
ab
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