What a Republican Victory Means for Equity Markets
Reducing GNP will hurt businesses and consumers, so any attempt to cut the deficit will be met with huge opposition.
The recent rally in the equity markets has been at least partly attributed to the increasing likelihood of a Republican victory at the polls on November 2 , leading to Republican control of the House and possibly the Senate. While this may well happen, remember the old adage: "Be careful what you wish for, you might just get it."
A Republican victory, it's widely believed, will lead to a significant cutback in government spending and a continuation of the Bush tax cuts. What a panacea! Less wasteful spending at bureaucratic government institutions, low taxes on income so that consumers and businesses can spend and invest more, the world regains confidence in the US economy, and the dollar appreciates! What a great victory!
So let's look at what actually happens when these policies are in place. Growth in the US economy is the holy grail. It means we all have more money and there are more jobs and investment opportunities. Gross National Product (GNP) is how we define growth. GNP is simply a function of government spending, plus business spending, plus consumer spending, plus the change in the trade balance. So, let's look at each element.
Government spending is so considerable that the present deficit is about 10% of the entire GNP. That is, the government is borrowing, or creating money, equal to 10% of the entire economy. So, effectively, 10% of the GNP exists only because the government has the world's cheapest credit card to borrow upon. Imagine that if you were making $100,000 per year and you had a special credit card that allowed you to borrow $10,000 per year at nominal interest and the credit card company never expected you to pay any of it back! Most likely you'd borrow that $10,000 and use it for vacations or for your kids' school or something else that you considered to be pretty important.
Now, let's assume that the credit card company (better known as the Republican party) decides that it can't lend you $10,000 anymore and is reducing it to $5,000 -- and it would like to stop doing it altogether. Whoa! What do you do? No vacation? Less shopping? No 3D TV? It's a problem!
So with the government deficit running at 10% of the GNP and Republicans wanting to cut it to 5% and eventually to 3% or less, this is what happens. There are no new taxes so spending gets cut back. It doesn't come from defense and it can't come from the mountain of interest due, so it comes from spending of domestic agencies -- less money for the states, less money for entitlement programs, less money for capital programs, etc. The effect on the GNP = negative 5%. That's a fact and facts are stubborn things.
What then happens to business spending? On the positive side, perhaps business leaders will stop worrying about the next Obama curveball. No more ObamaCare, cap and spend, higher taxes, villainization; no more huge scary government deficit! No more preaching from an angry leader about the evils of capitalists -- or at least no one will be listening… yes, time for a drink (or two).
The morning hangover though is a tough one. Your sales manager walks in and says that the tunnel we were building on the Hudson is being replaced with a kayak! You go home at night and your wife says that your local school terminated five teachers and you have to buy a special hearing aid for your son so he'll be able to hear the teacher 40 rows back in his class. You get the picture…
A mixed bag for business. The road ahead is more clear, it's just that there's one less lane on the superhighway. Business does benefit from the deficit; it just doesn't like the other stuff that comes with it.
Then there's the consumer. Of course we're all glad we're not going to pay more taxes. The problem is that 40% don't pay taxes anyway. The other problem is that more than one out of every six of us isn't working, or barely working (including people who have stopped looking for jobs and those working part time but want to work full time, the current unemployment rate is 17.1)! So even without more taxes, we're very, very stressed. So how happy are we that the government deficit is coming down? We really don't care. What we're concerned with is that governments (federal, state, city, municipalities) will now also be cutting jobs and spending less on programs that led to jobs or made our quality of life a little better (maybe we'll do less shopping at night because there are now less police on patrol). So, we as consumers aren't going to be spending a lot more money because the government deficit is lower.
As far as the trade deficit, let's give this a pass. "King dollar" makes imports cheaper, but it's tough to believe that the demand will be there to buy a lot more.
So what's the impact on the equity markets of a Republican victory leading to a significant cutback in the government deficit? It's a great party, leading to a horrific hangover.
The problem is you can't materially cut the government deficit without causing great pain to the economy for years. Some Republicans say it's necessary to "take the medicine" or "suffer the pain" to provide for long-term sustainable growth. That may be right, but I bet they have jobs now!
"Taking the medicine" also means lower growth for business as the GNP goes flat or perhaps negative again. It means no hope for tens of millions of Americans. It means huge popular unrest.
It means it won't happen. The Republicans will try to cut the deficit, but the opposition among their own constituents will be so immense that very little will happen. So we'll just continue to muddle along… as long as the rest of the world keeps funding us.
By the way, I'm both long and short in the market, but hold a negative opinion right now.
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