Dispatch January 2008

What's Next for Wall Street?

The presidential campaign has financial executives more concerned about who wins than they have been in years—or it ought to

Here in Washington, there isn't much that can overshadow the presidential race. But the recent turmoil in the stock market that prompted the Fed's dramatic rapid-fire rate cuts and the forthcoming $150 billion stimulus package from Congress have managed to do the trick. Suddenly Washington is obsessed with Wall Street. It's a useful reminder of the broader relationship between power and money.

If you're on Wall Street, now might be an opportune time to start thinking about Washington.  This year's presidential election seems certain to have an even bigger effect on the economy than will the stimulus package and the Fed cuts—regardless of who wins. "From an investor perspective, the stimulus package is important in the short term," says Blair Levin, a Washington-based managing director for the financial services firm Stifel Nicolaus. "But the next president is going to have to tackle a variety of areas that will have a bigger long-term effect on the economy."

It's not news that government action moves the markets, or that elections can be pivotal to certain industries. Wall Street consensus holds that oil, pharmaceuticals, defense, tobacco, and HMOs prosper under Republicans, whereas alternative energy, infrastructure, environmental services, and Freddie Mac and Fannie Mae do well under Democrats (who are strong proponents of government-sponsored mortgages). Two additional factors make this year different. President Bush has ignored huge problems, problems that a combination of fiscal and political pressures will compel the next president to tackle. And the differences between how Democrats and Republicans would tackle these problems are more pronounced than they've been in years.

Big changes are coming—but what they'll be and whom they'll affect is wide open. "This election," says Kim Wallace, chief political strategist for Lehman Brothers, "will be more meaningful for the market than any we've seen since Reagan."

Here's why. New administrations always attempt the biggest things first, when momentum is strongest and opponents are weakest. Clinton famously led with his economic plan, Bush with a record tax cut. Under typical conditions, Washington can process one, maybe two, big changes in any single session of Congress—but no more. (Clinton got his economic plan, but he didn't get health care.) However, next year will be anything but typical. The new president will take office against a background of looming entitlement problems, with Medicare tipping into deficit for the first time and Social Security peaking and beginning to decline. At least one market-moving big change—Bush's tax cut—is certain to be addressed because it's about to expire. And three more areas of similar scope, all with major implications for the economy, will compete for the next president's immediate attention.

TAX CUTS

Problem: Bush's tax cuts begin to expire in 2010, pushing economic policy to the forefront. At stake is about $300 billion in annual revenue, and Democrats and Republicans hold sharply different views on what to do. "George H. W. Bush's and Bill Clinton's economic policies were so similar that, if you were looking at them on paper, you wouldn't notice that a Democrat had been elected in 1992," says Jason Furman, an economist at the Brookings Institution. "This time you definitely would notice."

Likely Republican response: Initially, all the major candidates pledged to extend the cuts (though some, like McCain, did so reluctantly). Then, just recently, McCain and Romney rocketed well beyond Bush and proposed further big cuts in corporate and individual rates in an apparent attempt to impress Republican primary voters.

Likely Democratic response: Under a Democratic president, all kinds of taxes could go up—marginal tax rates, dividend and capital gains taxes, the alternative-minimum tax, the "carried-interest" tax on private-equity profits, and possibly the estate tax would all be in play—collectively amounting to change on the order of Reagan's 1981 tax cuts.

Who it affects: Just about everybody.

HEALTH CARE

Problem: 47 million Americans don't have it. If the presidential race has created one area of consensus among the parties (and some in the business community), it's that something must finally be done about uninsured Americans. What that might be varies widely between the parties. But even legislation that stops far short of universal coverage—such as allowing the government to negotiate drug prices for Medicare recipients or import them from Canada—could roil the markets. "Historically, no industry is more sensitive to elections than pharmaceuticals," says Alec Phillips, a Washington analyst who has studied the issue for Goldman Sachs.

Likely Republican response: Tepid proposals from Romney and McCain to make health costs tax deductible. A Democratic Congress would push for much more.

Likely Democratic response: Universal or near-universal coverage proposed by all major candidates.

Who it affects: Health care accounts for 16 percent of GNP (and pharmaceuticals for about 12 percent of the S&P 5000), and any change to the current employer-based system would touch nearly everyone. "In large, structural ways, the shape of our entire economy will be in play," one hedge-funder told me.

ENERGY/ENVIRONMENT

Problem: carbon emissions. The speed with which climate change has become central to the Washington debate has startled even insiders—and it’s not all Al Gore.  Industry lobbyists now accept that carbon-emissions legislation is imminent: the fight is over when, and who will be affected. During the 2004 campaign, John Kerry decided that an economy-wide cap on carbon emissions was too radical to propose. This time, one such cap is supported not just by the top Democrats but by some Republicans, too. A further signifier of how much has changed: the carbon tax Gore couldn't get during Clinton's first term is now preferred by the electric-power industry. "The Democratic programs," says Furman, the Brookings economist, "are more ambitious than anything anyone has ever proposed." It's enough of an issue that major institutional investors last year began pushing corporations to disclose greenhouse-gas emissions.

Likely Republican response: Mixed. McCain and Huckabee (like the Democrats) support a cap-and-trade system like the one featured in the 1990 Clean Air Act to cut the sulfur-dioxide emissions that cause acid rain. Romney advocates only voluntary cutbacks but might be forced by a Democratic Congress to go further.

Likely Democratic response: A cap-and-trade system or carbon tax, the economic effects of which could be nearly as widespread as those from universal healthcare.

Who it affects: Almost every sector of the economy. Carbon emissions are spread broadly (utilities account for 40 percent; transportation, 33 percent; manufacturing, 17 percent). Limiting emissions would impose new costs on the oil, gasoline, electricity, and natural-gas industries (making air travel and many other things more costly), while benefiting hydroelectric, nuclear, and wind power.

FINANCIAL SERVICES

Problem: Caused a recession! The subprime mortgage mess placed the financial-services industry squarely in Washington's crosshairs. Legislation on predatory lending seems likely even before Bush leaves office. Strengthening or replacing the ratings agencies that signed off on the creditworthiness of so much bad debt seems possible this year, too.

But Washington insiders think that new regulations will be an "iterative" process, one that carries over to the next administration. A severe recession probably would lead to scapegoating and punishment on an industry-transforming scale—along the lines of the dreaded (on Wall Street, anyway) Sarbanes-Oxley Act, which stemmed from accounting scandals earlier this decade. Recession also would increase the likelihood that financial-services regulation will jump ahead of climate-change legislation on Washington's agenda because any significant attempt to control carbon emissions would further burden the U.S. economy.

Likely Republican response: Too soon to tell, though a reformer like McCain could be nearly as aggressive as a Democratic Congress.

Likely Democratic response: Severe, though still too soon to tell. Even before the recession, the private-equity industry was set to face greater scrutiny and a likely tax increase on profits. Depending on the severity of the downturn, a Democratic president could effectively transform the industry.

Who it affects: The sizable financial-services industry (21 percent of the S&P 500), and future mortgage buyers at all income levels.

During an election year, stocks trade partly as a function of the expected outcome and tend to move with the polls. Right now, Wall Street's focus is on near-term actions: yesterday's Fed cut, the stimulus package. But eventually the scale of what's likely to happen when a new administration takes power next year should begin to sink in; assuming that it does, the magnitude of the presidential election's effect on Wall Street should be greater than it has been in a very long time.

Presented by

Joshua Green is a former senior editor at The Atlantic.

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