Republican Victory May Keep Bull Market Alive


Prospect of entending Bush-era tax cuts gives hope to some on Wall Street

(Bloomberg) — The midterm elections that ended Democrats' control of the U.S. House of Representatives are likely to sustain the bull market that began in March 2009 at the depths of the financial crisis. U.S. stocks will continue their ascent because victorious Republicans probably will block Democrats' plans to raise taxes and impose stricter regulations on businesses, according to money managers interviewed before the vote.

"The near-term issue of importance to investors is the Bush-era tax cuts," said Robert Doll, chief equity strategist at New York-based BlackRock Inc., the world's largest fund manager with $3.45 trillion in client assets. The new Republican majority in the House may force President Barack Obama to back off efforts to let tax cuts enacted under President George W. Bush expire and to raise rates on dividends and capital gains. That would boost optimism among investors and company executives, driving improvements in financial markets and the economy, according to Barclays Capital in New York.

"From a macroeconomic perspective, we can't recall a time when we viewed the election results to be as critical to business confidence and economic activity," Barclays analysts led by Barry Knapp wrote in an Oct. 22 report. Investors also will be encouraged that the financial, energy and health-care industries won't be saddled with tighter regulations that could hurt profits, according to Doll and Timothy Flannery of Copia Capital LLC.

Up 13%

The S&P 500 surged 13 percent in September and October, the biggest rally for the two months since 1998, as the U.S. Federal Reserve signaled it will buy debt securities to lower long-term interest rates and accelerate the recovery. The gains have come even with sales of new homes near record lows and the unemployment rate at 9.5 percent or higher for the longest stretch since records began in 1948.

The S&P 500 index has gained 76 percent since bottoming out on March 9, 2009. The Republican victory in the House is priced into the market, and further gains are likely to be curbed by headwinds such as high unemployment and a large overhang of debt, said Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., the Newport Beach, California-based fund manager with $1.24 trillion in client assets.

Compromise Seen

While the outgoing Congress plans to debate whether to extend Bush-era tax cuts, set to expire Dec. 31, the Republican victory will influence the outcome. Senator Amy Klobuchar, Democrat of Minnesota, told CBS's "Face the Nation" on Oct. 31 that Democrats may compromise by extending the tax cuts for a year or two, or limiting the expiration to households earning more than $1 million. The administration proposed to end the tax cuts, enacted in 2001 and 2003, for couples earning more than $250,000. Republicans said that any tax increase will stifle entrepreneurship and job creation. The Democrats are also pushing to increase the 15 percent tax rate on dividends and most capital gains.

"If they end up extending the tax cuts, we move the uncertainty from Jan. 1 of 2011 to Jan. 1 of 2012, and that will at least have some short-term benefit," said BlackRock's Doll. Leaving the capital-gains rate unchanged may spur companies with cash to raise their dividends rather than initiate stock buybacks, making dividend-paying stocks a good bet for investors, Doll said.

Short-Term Fix

Duncan W. Richardson, chief equity investment officer at Boston-based Eaton Vance Corp., said a continuation of the Bush tax cuts would only be a short-term positive. "As an investor you have to recognize that's only going to be a one-year fix," Richardson said. You have to be prepared for higher taxes regardless of how elections turn out."

The U.S.'s rising debt and looming deficits in federal programs like Social Security and Medicare make higher taxes inevitable, he said. "In a generational sense, taxes may be as low as they are going to get," said Richardson, whose company oversees $180.7 billion. It's unlikely Republicans will pursue a Democratic plan to raise taxes on investment profits, known as carried interest, at private-equity and hedge funds. Managers of the funds can treat carried income at the lower capital-gains rate of 15 percent rather than as ordinary income. A change in those tax laws could more than double the tax rate on carried interest.

'Endless List'

Stephen Schwarzman, the chairman of New York-based private- equity firm Blackstone Group LP, said in an Oct. 28 conference call with investors and analysts that buyout managers are in "a position of uncertainty" because of the elections and the future of tax policies. "There's an endless list of things of that type that are making investors more cautious," he said. A Republican House may also benefit investors in certain energy, health-care and financial companies, fund managers and executives said.

"Certainly you'd be less inclined to be invested long in most energy technology stocks, and I'd be incrementally more positive on natural gas," Flannery, co-founder of Copia Capital, a Chicago-based hedge-fund firm focused on energy and utility industries that spun off from Morgan Stanley's FrontPoint Partners LLC. Republicans will reduce the prospects for alternative- energy subsidies and increase the likelihood of industry- friendly regulation of hydraulic fracturing, a technique for extracting gas from shale that some environmentalists say can poison groundwater, Flannery said.

Regulations

A national cap-and-trade program favored by the White House, in which companies buy and sell a declining number of carbon-dioxide pollution rights, will also probably be shelved for at least two years with a Republican takeover of the House, according to an Oct. 26 Bloomberg New Energy Finance report. Republicans may fight to remove provisions in Obama's health-care overhaul that reduce profits for hospital chains, and prevent additional regulation of financial institutions.

Obama signed the Dodd-Frank act, the most sweeping set of financial rules since the Great Depression, in July. Named after its principal authors, Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, the law gives the government authority to unwind failing financial firms that may threaten the entire system, imposes new rules on derivatives markets and creates a consumer-protection agency at the Federal Reserve to monitor everything from home loans to credit cards.

Views on Gridlock

Money managers had varying takes on the impact of a divided government. "While a gridlock in Washington won't allow progress to be made economically in the shorter term, it will be good in that it won't allow the current situation to get any worse," said Basil Williams, chief executive officer of Concordia Advisors LLC, a $1 billion hedge-fund firm with offices in New York and London. Gridlock wouldn't be good for the economy at this time, Pimco's El-Erian said.

"In a world with debt overhangs, housing problems and structural rigidities, you need the government to be active in removing obstacles to growth and jobs," he said. The shift in power also introduces a different risk, Copia's Flannery said, with the election of candidates backed by the conservative Tea Party movement.

"We really could see a lot of the angst toward government transform itself into angst toward big business" if the new Congress doesn't produce tangible results, such as lowering unemployment, Flannery said. "An exaggerated tone on immigration, free trade and corporate taxation — all are unambiguously bearish for equity markets and are possible narratives for these new people."


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