Now that President Bush has been re-elected and Congress has moved even further into the hands of the Republican Party, a stark realization is beginning to sink in on Wall Street: political gridlock is gone for another two years.
While many investors wanted to see Bush win and are hopeful that the president will make his tax cuts permanent, history shows that a divided government has been better for the financial markets.
What's more, analysts say a Bush victory doesn't change the fact that deficits are soaring, or that economic growth and corporate earnings are in the process of decelerating.
"None of these factors have disappeared with the passing of Election Day," said Tobias Levkovich, chief equity strategist at Smith Barney. "In our view, the market may not end up being as happy with a Bush administration as investors may assume."
The day after the election, stock prices jumped sharply, with the
up more than 100 points and the
closing above the 2000 level for the first time in four months. The gains came partly out of relief that an outcome had been reached so swiftly, but also because investors were happy with the result. Stocks put in another strong performance on Thursday.
Under Bush, a reversal of tax cuts on stock dividends and capital gains is highly unlikely. In fact, many believe that Bush will push to make these and other tax cuts, which expire at various dates over the next few years, permanent.
"The overwhelming view of investors is it's good for the economy, good for stocks," said Andrew Laperriere, managing director of the International Strategy & Investment Group.
Still, investors also like a government where power is more evenly split, because the chances of a legislative curveball are vastly reduced.
While Republicans don't have a 60-vote majority in the Senate and bills can still be filibustered by the opposition, the past four years have shown that Bush has considerable power when it comes to advancing his agenda.
and Wall Street has preferred a divided government in the past, such that power is not concentrated," said Levkovich. "Investors might respond negatively to any major push for controversial Republican approaches."
During periods when only one party held power in both the legislative and executive branches, the
rose at an average annual rate of 3%, according to data from Merrill Lynch. But when power was split between the two levels, the market was up at a 9.7% average annual rate.
The bond market has also performed much better under a divided government, with yields typically falling by 25 basis points. When one party was in control of both the White House and Congress, bonds historically sold off and the yield on the 10-year Treasury note rose at an average of 48 basis points. Bond prices and yields move in opposite directions.
Vincent Boberski, chief fixed-income strategist at RBC Dain Rauscher, thinks bonds are more at risk this time than they have been in the past.
Under current laws, he said, the budget deficit is expected to swell by $1.8 trillion over the next 10 years. But an extension of the tax cuts would add another $1.9 trillion to the government's debt.
"An additional $3.7 trillion or so is a tremendous amount of new supply in Treasuries, even over the course of 10 years," he said. "Eventually the supply of Treasuries does matter to interest rates, even if that has not proven to be true in the context of a somewhat slow recovery, a tame inflation environment and a weak labor market."
The Congressional Budget Office projects a cumulative 10-year deficit of $4.5 trillion if the tax cuts are extended and the deficit could be even larger if Social Security is partially privatized.
Although the government has issued vast quantities of debt to pay for tax cuts and defense spending in recent years, strong demand for Treasuries from foreign central banks in Asia has kept interest rates low so far.
But some analysts speculate that this demand could slow over the next few years, as the dollar continues to decline amid a yawning trade deficit. When that happens, interest rates are likely to rise, making it harder for companies to borrow money and invest.
Stephen Roach, chief economist at Morgan Stanley, said the chances of a "traditional fiscal policy fix" to reduce the budget deficit are low. In other words, a tax increase is very unlikely under the Bush administration.
"The only hope for meaningful relief from such daunting imbalances is for the U.S. to grow its way out of this mess," he said. "This, of course, would be consistent with one of the basic tenets of supply side economics -- the so-called self-financing nature of reductions in marginal tax rates."
Supply-siders believe that tax cuts encourage economic growth and spur job creation, which in turn drives up tax revenue enough to pay for the tax cut.
Still, Roach said this approach would require sustained rapid productivity growth and a willingness from other countries to suppress their own domestic demand and remain the suppliers and financiers of excess American consumption.
He thinks both are unlikely and said the 1981 tax cut, which resulted in sharply lower-than-expected tax receipts between 1982 and 1987, proved that supply-side initiatives are not self-financing.
Analysts are worried about the financial markets for other more immediate reasons, too. They note that economic growth in the
fourth and first quarters is likely to weaken, as the pace of consumer spending slows down.
The decelerating pace of earnings growth is another reason for caution. In recent weeks,
have all issued disappointing guidance. Thomson First Call notes that fourth-quarter estimates for the S&P 500 overall have been dropping in recent weeks.
"While equity markets could bounce near term on the Bush news, we doubt such a lift will be lasting in the face of likely further downward earnings estimate revisions," Levkovich said.