Grow
Republican Dollars and Sense
By Karen Hube
From taxes to markets, the new Congress will affect your investments. The question is, how? Worth presents eight sectors where a newly powerful GOP could make nice with your money.
Since Republicans claimed a majority in the House in the November midterm elections, investment strategists have been mulling over how the shift in political power may affect the markets.
Their take? Republicans’ pro-business, anti-tax, antiregulatory agenda will generally receive a positive welcome from the markets in 2011. Some argue that a divided legislature is, from Wall Street’s perspective, a good thing, as it’s likely to decrease government activism. Others like that the GOP now runs the House, which has power over the government’s budget. And “it’s not just any Republicans who have the majority in the House, it’s the new fiery, fiscally conservative tea party wing,” argues Gary Hager, an investment manager and president of Integrated Wealth Management in Piscataway, N.J.
Of course, as their successful defense of the budget-bloating Bush tax cuts shows, today’s Republicans aren’t always fiscally conservative. But many analysts worried that a tax hike now would undermine a still tentative recovery, and though the government has to pay for them at some point soon, the tax cuts should provide economic stimulus in 2011.
As Republicans attempt to win more political battles, here are some of the effects that Wall Street expects in the months ahead.
01. MUNI BONDS: TOUGHTIMES AHEAD
With the House now under the influence of Republicans’ anti-bailout sentiment, municipal bond defaults may rise, says Chris Cordaro, a financial advisor at RegentAtlantic in Chatham, N.J. “The divided Congress will make it much more difficult to bail out a municipality,” he says. “If we get a couple of high-profile defaults in the municipal bond space, you’re going to see a complete reassessment of the risk there. Muni bonds could be the next time bomb.”
Many state and local governments remain under tremendous fiscal pressure, and in some cases they’ve postponed financial decisions in ways that will only, as the pundits like to say, “kick the can down the road.” Financially strapped New Jersey, for example, has deferred making contributions to the state workers retirement plan. It still has to make those payments, though—just at a later date.
And that’s not all: Republicans are resisting propping up state budgets with stimulus funds and budget earmarks, “so federal support will shrink,” says Jason Pride, director of investment strategy at Philadelphia-based Glenmede.
Individual muni investors may not realize the level of risk they are assuming. Cordaro points out that the greater transparency and more stringent reporting requirements on many investments stemming from regulatory reform don’t apply to municipal bonds. “Compared to corporate bonds, the reporting requirements for municipal bonds are extremely lax.”
2. COMMERCIAL REAL ESTATE: STORM CLOUDS PERSIST
Over the next five years, the terms on some $1.5 trillion in commercial loans will expire, requiring borrowers to refinance. But with vacancies high and rents on the decline, about half of these borrowers owe more than their properties are worth, according to a report issued by a congressional oversight panel. This sad state of affairs isn’t new: The commercial real estate market has been in turmoil for the past two years. But “in many cases we’ve seen lenders turn a blind eye or renegotiate a loan,” Cordaro says. “Lenders don’t want ownership of these properties, because if they get it, they have to put the properties on their books”— presumably at values that reflect what the buildings are really worth.
But Republicans might be critical of the practice. “The Republicans will be less content to turn a blind eye to what’s going on and force some realization of these bad loans,” Cordaro suggests. “We’ll probably see a lot more distressed sales of commercial properties.”
3. BONDS: IN FOR A LOUSY RUN
In the Pledge to America, the GOP’s rather minimalist midterm platform, Republicans vowed to “slash” government spending. Problem is, their recommended cuts amount to a rather paltry $50 billion, while the federal budget deficit is $1.3 trillion.
“Not dealing seriously with the budget deficit is going to hurt bond investors,” says Ed Osborn, chief investment officer at Bingham, Osborn and Scarborough in San Francisco. Why? For one thing, the government will continue to issue new bonds, which puts downward pressure on prices. Moreover, any rise in inflation, a potential consequence of deficit spending, would also decrease the real returns of existing bondholders. That’s one reason why in recent weeks investors started moving out of overbought bond markets and shifting back into equities.
4. STOCKS: LOOK FOR GROWTH
Students of historical stock market data say that when the majority party changes in either the Senate or House in a midterm election, stock market gains tend to be modest over the next calendar year. Ned Davis Research, an investment research firm in Venice, Fla., has found that the average stock market gain in the six months after a congressional turnover is about half as great as the gain when there has been no upset. Arguing the other way: Historical data suggest that the stock market does well in the third year of a presidential term, perhaps because the Fed and the president are both courting consumers for reelection.
Two factors may tilt the balance in favor of the bulls. The biggest is the recent agreement in Congress to avert a capital gains tax increase. That likely avoided lots of year-end selling and should help keep equities attractive to investors, who might have looked to, say, fixed income should the capital gains tax have returned to its pre-2003 level of about 38 percent.
5. THE DOLLAR: FURTHER DECLINE LIKELY
At some point, Congress may actually cut spending and start reducing the budget deficit. If that happens, the dollar should strengthen relative to other currencies. “I’m optimistic,” says Pride of Glenmede. But in the near term, “we’re expecting continued dollar weakness.” The Fed’s second round of quantitative easing will pump another $600 million of borrowed money into the economy, which won’t help. “That and the recent tax cut extensions will have a negative effect on the budget deficit,” Pride says. “That will drive the value of the dollar down.”
David Kotok, chief investment officer of Cumberland Advisors, has other worries when it comes to the dollar: With Texas Republican Ron Paul newly appointed to lead a Congressional Federal Reserve oversight panel, the central bank may come under tremendous political fire. (Paul, the author of a book called End the Fed, claims that the Federal Reserve “is the chief culprit behind the economic crisis.”)
“When you subject your central bank to politics and threaten its independence, you introduce a risk premium into investments of all types—anything denominated in the U.S. dollar,” Kotok says.
6. DIVIDEND STOCKS: CONTINUED STRENGTH
With the dividend tax rate remaining at 15 percent, strategists are recommending dividend-paying stocks not only for their income but for their fundamentals: substantial corporate cash levels, solid earnings and reasonable valuations. “We believe dividend-paying stocks are attractive for several reasons,” says Mark Luschinni, chief investment strategist at Janney Montgomery Scott. “The first is that valuations among many high-quality companies that offer above market dividends are undemanding.” Second, “the tax advantaged treatment of dividends has been given a reprieve by the newly signed legislation. This should encourage buyers and/or dissuade sellers who thought the sunset of that provision would dull the allure of dividend-paying equities.”
7. ESTATE PRESERVATION: OUTLOOK FAVORABLE
If the Bush tax cuts had expired on schedule, the estate tax would have risen to 55 percent for estates above $1 million. The legislation passed by Congress and signed by President Obama keeps the estate tax at 35 percent with a $5 million exemption—meaning that, with prudent planning, couples can leave $10 million to their beneficiaries tax-free. “Never in the history of the estate tax has the exemption been so high and the tax so low,” says Alan Augulis, an estate planning attorney in Warren, N.J.
8. SENTIMENT: INVESTOR CONFIDENCE MAY RISE
Many strategists see signs of growing investor confidence. “A newly elected Congress motivated to entice growth and moderate spending, with a seemingly more business-friendly tone from the Obama administration, support a more constructive view for matters economic in 2011,” says Luschinni.
That may sound like cautious optimism—but at least it’s optimism.
“NOT DEALING SERIOUSLY WITH THE BUDGET DEFICIT IS GOING TO HURT BOND INVESTORS.” – ED OSBORN, CHIEF INVESTMENT OFFICER AT BINGHAM, OSBORN AND SCARBOROUGH