Economics: Politics and Change
New York: November 13, 2006
By John R. Stephenson

Does it matter? Will there be any real change in policy in the wake of the resounding trouncing that the Republican Party suffered in the recent U.S. mid-term election? No one knows for sure, but one thing is clear — the public is fed up with sex scandals, budget deficits and a war in Iraq that is clearly going nowhere. While the impact on the economy and the stock market may be modest, this was surely a repudiation of the Bush Administration's Iraq strategy.

Look no further than the abrupt resignation of Defense Secretary Donald Rumsfeld for proof that this was an election referendum on the Iraq war and nothing else. While it may have been billed as a "resignation", the quick appointment of former CIA Director Robert Gates to the post of Defense Secretary, suggests it was not. This was an election that was run on a national issue (the war in Iraq) rather than on the economy or local issues. What all this means is that the only real item on the Administration's agenda over the next several years is the war in Iraq.

Little else was decided in the recent election. The Democrats lobbied hard for change and change is what they got. But no one clearly defined what change would look like other than it wasn't going to be more of the same. As for the economy, it is likely to be locked in a political quagmire of bickering, hearings and political rancor. In other words, expect nothing to change over the next two years.

The Democrats that were elected were, for the most part, more conservative than the average Democratic Party member. If they were to move too far to the left, the conservative districts that sent them to Washington as a protest vote might likely send them packing again.

So what can you expect from Washington? Probably nothing. Tax cuts are a non-starter, so if the housing situation continues to deteriorate, there will be little relief on that front. Social Security reform is likely dead in the water as is health care reform but immigration reform of the kind that George Bush favors could move ahead. Likely, the economy will continue to muddle through. Congressional gridlock like the type we witnessed in the 1990's is most likely the order of the day — but not all that bad.

For big oil and big pharma the outlook looks a little darker as congress is hell bent on taxing their outsized profits. Never mind the tremendous capital investments both industries have made (for oil recovery and drug development), profit is now a bad word.

But nowhere is there likely to be more friction than on the China file. For Democrats and their unionized base of workers, China bashing resonates loudly. With a monstrous trade deficit (exports less imports), politicians can score some points at home by trying to bring China to heel by slapping tariffs on goods or trying to de-link the Chinese currency from the dollar.

While pressuring China may make political sense, it makes little, if any, economic sense. China holds massive quantities of U.S. dollars in their foreign exchange reserves. By buying up massive quantities of U.S. treasury bonds, China has helped to keep bond yields low and keep the U.S. consumer in the shopping malls. If China were to dump these bonds on the open market, then the cost of borrowing would soar, the housing market would plummet and consumer spending (72% of U.S. GDP) would crater.

The other big issue with the strategy is that China is no longer dependent on the U.S. for its growth. The percentage of China's exports that are destined to the U.S. is a scant 7 percent and most of the growth globally in the last three and a half years is between Asian nations. The U.S., once the engine of global economic activity, represents only some 15 percent of global economic activity over the last three years. China, not the U.S., is driving the global economic bus.

Figure 1: Contribution to Global GDP by Region

Source: CIBC WM

The real change, if any, from Washington will be on the Iraq file. A disingenuous beginning and a disastrous performance so far have led to a change of heart in the American population. While a full-scale retreat is unlikely, the U.S. Administration will try to get out of Iraq as quickly as possible while creating the necessary conditions for the Iraqi people to govern themselves.

The basic problem has been that while the U.S. has been trying to create a coalition government comprised of all the various ethnic and religious groups within the country, no consensus exists amongst the various Iraqi fractions as to what the future of the country should look like. Not only that, but the country is being destabilized by various external forces — namely the Iranians and Syrians who are trying to gain influence in the region.

Over the next few years, look for the U.S. military to re-deploy forces away from the center of the country and more towards the periphery in an effort to deter foreign influences in Iraq. By withdrawing from the center of the country, the U.S. will force the Iraqi people to reach consensus on their governance or face the prospect of civil war. By re-deploying forces along the border, the U.S. will try and prevent Iran and Syria from gaining further power and influence in Iraq. At the same time, the U.S. government will need to begin talks with the Iranians on both the nuclear issue and the shape of the region in the future.

For investors, the change of government will have little impact on their investing strategies. Interest rate sensitive stocks (utilities, consumer staples and financials) should continue to do well, particularly if the economy starts to stall, large capitalization energy and pharmaceutical stocks should be avoided as an increasingly protectionist and anti-business congress is set to take the helm in Washington.