Method to Wall Street's election madness

Part of Wall Street's overnight fall is simply removal of the pricing of a Romney victory. But the bigger issue for the market is what will happen to the fiscal cliff.

The stock market’s 2 per cent fall this morning is part mathematics and part deep analysis. The first bit suggests the adjustment will be a once-off, but the analysis could take the market anywhere.

The mathematics simply refers to the removal of the chances of a Romney victory. Intrade, the so-called prediction market (actually, a gambling website) had an Obama victory priced at around 65 per cent, which means Romney was priced at 35 per cent.

A blog on Marketwatch.com by Steve Goldstein calculated last month that an 8 per cent shift in election probabilities produced a 0.5 per cent move in the stock market, so removal of the entire 35 per cent chance of a Romney win would shift the market 2 per cent, which is what happened overnight.

There is another element to the mathematics: one of the tax cuts due to expire on December 31 is George W Bush’s special 15 per cent tax rate on dividends. His way of removing the double taxation of dividends was to tax them as long-term capital gains. On January 1 dividends will once again be taxed at 39.6 per cent, which is more important than it used to be because dividends have gone up 18 per cent in the past year – the biggest increase in 20 years. It’s not clear that the US can afford to remove the double taxation of dividends.

Is there more to the market reaction than maths? Well, the fiscal cliff is still there and as predicted gridlock and dysfunction have won the election, with the Republicans still in control of the House of Representatives and the Democrats in the Senate and the White House.

At this stage there is nothing but more uncertainty, or rather the old uncertainty is still there. No change.

Analysts at SG Research estimate that policy uncertainty, recently about the fiscal cliff, has shaved 2.5 per cent from US GDP and 2.1 million jobs from employment since 2007, mainly because of the loss of business investment.

Business spending on equipment and software recorded zero growth in the third quarter and new orders have plunged to minus 22 per cent, the same degree of contraction seen before the 2001 recession. And of course if the $600 million of tax increases and spending cuts that are collectively called the fiscal cliff go ahead on January 1, then there will be another recession in the US.

But on the other hand if the conciliation rhetoric of Obama’s acceptance speech is followed up with a deal on the fiscal cliff, there could be a powerful rebound in investment and stronger GDP growth next year.

The next step is most likely to be a temporary extension to the expiring tax cuts and a delay to the spending cuts, probably of six months. Then the debt ceiling will have to be raised again – at the current rate of borrowing the ceiling of $US16.4 trillion will be reached in January.

Congress and the White House will then have six months to negotiate a permanent fiscal deal. Maybe they can’t do it because the civil war that’s about to take place in the Republican Party between the moderates and the Tea Party is won by the Tea Party, in which case uncertainty will drag on, and on, and the economy could slip into recession anyway because of a collapse in business investment. That’s the second worst-case scenario.

The best-case scenario is a deal before the cliff, whenever it is, that puts the US on a sustainable debt trajectory, and let’s face it – that’s what will eventually have to happen. It’s just a question of when.



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