10 Nov 2006 Where To?

The polls tell us that the Republicans lost the election over the Iraqi War and scandals. But, scandals are a part of the political fabric and largely accepted. It’s obvious that the Bush’s administration’s handling of the war is the major reason for the Republicans’ historic defeat. Even at the outset, the war was fraught with political risk. The world was not behind it nor was a significant minority (at that time) of the country. Wars are never as quick or efficient as hoped. In time and with daily reports of increasing chaos, support at home quickly diminished. The no-war minority grew more vocal, and with the help of opportunistic politicians and an Administration deaf to outside voices, an unstoppable groundswell began.

Americans wanted change, but what kind of change? Tuesday, voters showed that they were willing to turn the reigns of government over to the minority party out of disgust with the current one, but with little knowledge of what they plan to do. Greenspan said yesterday that Democrats didn’t win the election, Republicans lost it. They were simply standing there.

Political division and rancor handed the Democrats a sweeping victory, but cynicism and criticism are not effective leadership styles. In the hours and days following the election, the tone of party-leaders like Howard Dean and House Leader Nancy Pelosi has been conciliatory in victory. But their plans for what to do are as varied as the party is.

Assuming bigger mistakes are not made in Iraq going forward, the question for us as investors is what will the Democrats do in other key areas and how will those decisions impact business and the economy? Who will be the winners and losers? We can look to history, party ideals, as well as Nancy Pelosi’s “First Hundred Hours Plan” to make some educated guesses.

The Winners (at least in the short-run) 

Minimum Wage Earners: President Bush has indicated some willingness to deal on this one, but it could be costly for jobs. Significant increases in the minimum wage usually result in a decline in low paying jobs as small businesses (the largest source of new employment in the US) lay off workers under the weight of higher payrolls. The jobs come back if inflation allows them to raise their prices.

Labor: Unions will grow more powerful under Democratic control of the government. Wages, benefits, and employment related regulations will increase putting further inflationary pressures on an already tight labor supply. Business profits will decline and inflationary pressures will increase.

Trial lawyers: Tort reform is dead on arrival in the Congress leading to a possible increase in frivolous lawsuits and higher damages. The cost of doing business in theUS rises.

The Greens: The positive atmosphere for cultivating natural resources on government lands is likely over. Higher prices in commodities like timber and energy may follow unless imports increase. On the positive side, if the greens prove to be politically flexible, it may be possible to craft a truly comprehensive energy program that both penalizes our foreign dependency on oil while promoting both domestic production and alternative fuels. According to WSJ, President Bush is said to be interested in climate change, and he has repeatedly spoken in favor of alternative fuels, making them an area where potential exists for successful legislation.

Medicare Dependents: It is part of Democrats’ DNA to raise entitlements wherever possible. We can only hope that they are as faithful in paying for them as they were in holding Republicans’ feet to the fire for their legislative initiatives.

The Losers

Free Trade: With Democrats in control there is a growing threat of protectionism.

According to the WSJ, several victorious Democrats campaigned as trade skeptics, arguing thatU.S.manufacturers are being battered unfairly by companies inChinaand other low-wage countries with weaker environmental and labor protections. Trade watchers on both sides of the issue say President Bush will have a tough time winning a free hand from Congress to negotiate trade accords. 

Tax Cuts: The Bush tax cuts which are to expire at the end of the decade will likely do just that. Historically, Democrats have largely been the tax-and-spend party, so there is a fear that taxes will rise across the board. Many Dems make no apologies for their intentions to take it from the rich and give it to the poor. Unfortunately that’s just bad economics. For the rich are the producers and they hold the capital. They will go and invest elsewhere if the pendulum swings too far left.

Higher taxes might be good for deficit reduction in the short term, but not the long. Unbiased studies show that tax cuts are actually more beneficial than tax hikes in increasing government revenues over the long run. Lower taxes offer significant incentives to investors of capital and to enterprising people willing to risk it all for an idea. Entrepreneurship keeps an economy vibrant and improves standards of living. The socialist policies in Europe have all but silenced entrepreneurial growth inEurope, while the Bush Administration’s policies have encouraged both small and large business growth.

A key difference since the last time the Democrats controlled both houses is that technology and improved trade relations have made the world a much more fluid global marketplace. If any country over taxes or over regulates, they stand the real possibility of losing the very enterprises and jobs they wish to protect. Capital as well as the entrepreneurs that demand it will simply go where the business climate is friendlier; Malaysia, Taiwan, Mexico, China, to offer but a few examples.

Businesses: Profits will be further squeezed if wages, benefits, regulations, and taxes increase. The global economy with cheaper labor in abundance makes it extremely difficult for businesses to raise their prices to counter higher costs. And if they can raise their prices, inflation becomes a problem.

Another concern: Any company considering relocating abroad likely just ramped up plans to do so. If the Democrats gain the White House in 2008, one of the first things they might do is tighten restrictions on businesses leaving the country.

Productivity: Tax cuts and credits provide incentives for business to make the kinds of capital investments that improve productivity. Measures of productivity reported by the government have been declining for the last couple of quarters. Further declines will likely worry the Fed about further inflation, prompting them to raise rates higher, jeopardizing the economy further. Pelosi’s plan does seem to offer the possibility of some tax incentives for business.

Missile defense: I don’t know about you but I’m a little more comfortable with kooks in the world like Mahmoud Ahmadinejad, and Kim Jung II with the notion that theUS might one day be able to defend against nuclear missile attack from a rogue state. At a minimum, the possibility of such a system should make any would-be attacker think again. I hope this program survives.

Big Ticket Defense Items: Even some influential Republicans want to dramatically cut spending on large weapon systems that are made to fight conventional wars from the past. It is small companies that will benefit over the big defense titans if Congress moves to better equip the soldier on the ground at the expense of the large weapon systems. We are all for a thorough and responsible reevaluation of our defense spending and hope the Dems can work with Robert Gates, the new Secretary of Defense to do just that.

Social Security: If not addressed soon, from the BENEFITS side, this behemoth of a government entitlement program will slam our economy back into the 1970’s or even the 20’s with double-digit inflation, recession, and soaring taxes. Management and labor alike will be unable to keep up with the huge drains on their earnings. Can or will the Democrats undertake to fix it? President Bush was stymied every step of the way by Democrats when he tackled the thorny issue. And his political capital was at an all time high then.

So What Lies Ahead?

As a new Democratic client said yesterday, the dog caught the bus, now what does he do with it? For now, the Dems have control of Congress, the support of the country’s majority, and the opportunity for significant legislation – IF they and Mr. Bush can work together and IF Nancy Pelosi can hold together a coalition of perhaps the broadest political spectrum ever gathered on the left side of the isle.

In the weeks ahead we will gain further insight into the Democrats’ agenda and how it will affect our strategy. But even before the election we believed that equity performance abroad would soon surpass domestic stock performance. Certain US industries such as technology and communications will likely continue to outperform, but the broader domestic markets will probably under perform those of emerging markets, Europe, and Asia. The election only strengthens these views.