Investing Ahead of the Mid-Term US Elections

How should investors prepare for the US mid-term elections...?

NOW THAT many US primaries are past, and the November 2010 mid-term elections are less than five months away, it is worth taking a look at what policy changes we might expect from the next US Congress, writes Martin Hutchinson at Money Morning.

Both the political and economic worlds have changed one hell of a lot since the last elections, in 2008. Thus, even though US President Barack Obama is slated to remain in office until at least 2013, the Congress elected in November will be very different from the one that was elected in November 2008.

The results of the primaries have already given us a lot of information about US voter intentions. Voters have rejected two sitting senators (Arlen Specter, D-PA, and Robert Bennett, R-UT), which suggests a general dislike for incumbents. On the other hand, moderate-Democrat Sen. Blanche Lincoln, D-AR, won her primary handily, defeating an opponent who'd enthusiastically backed the policies of the current Democrat-controlled Congress, the Obama administration, and the unions.

That suggests that the moderate-Democrat policies represented by the 1990s Clinton administration still have appeal with US voters. As an overall entity, however, government is viewed with disdain – or even outright contempt.

Taken together, for instance, the stunning January victory of little-known Scott Brown, R-MA, plus the current 63% approval in opinion polls for repealing the new national healthcare plan, suggest that the rapid expansion of government attempted by President Obama and the current Congress is very unpopular.

There's other evidence, too. Take the proposed "cap-and-trade" environmental legislation: As drafted, it would give government huge new powers over the economy. The upshot? It's out of favor.

None of this means the Republicans will sweep the country. For one thing, memories of the inept Bush administration and the corrupt GOP Congress of 2004-2006 remain fairly fresh. Furthermore, while the Tea Party movement has aroused considerable enthusiasm, voters appear to be developing doubts about its radicalism and sometimes "nutty" views.

Thus, the likelihood is for considerable Republican gains – but not outright dominance.

In the US Senate, it's almost impossible when only 17 Democratic Senate seats are up for re-election for the Republicans to go from 41 to 51, thereby giving the GOP the 10 additional seats it needs to get a majority (ties would be broken by Vice President Joe Biden – in favor of the Democrats).

Even if the popular mood favored Republicans strongly enough, too many of their candidates have weaknesses that could lose them some apparently winnable races. For example, Sharron Angle, who won the Nevada primary to run against the apparently vulnerable Senate Majority Leader Harry Reid, D-NV, is a Tea Party candidate whose views and past statements make her vulnerable to attack from the well-funded Reid.

Over in the House of Representatives, removing incumbents in large numbers is similarly quite difficult. The greatest turnover in a midterm election since World War II was 54 seats – which occurred in 1946 and again in 1994.

Thus, excited Republican calculations of a possible swing of 80 to 100 seats are just not realistic. For the Republicans to get the 270 seats that such a turnover would imply might be possible if they already had 210 to 220 seats. It is not realistic from the GOP's starting position of 179 seats (the Democrats have 255 seats, and two are vacant).

A Republican pickup of 39 seats – which would give it a bare majority – is certainly possible, although I place the odds at less than fifty-fifty.

It seems equally unlikely that the GOP will gain less than 25 seats or so. Thus, the 112 th Congress is most likely to be close to evenly divided, but partisan – with fewer "blue dog" moderate Democrats than there are right now, and very few floor-crossing Republicans. Either President Obama will control both chambers of Congress, albeit with small majorities, or Congress will be split, with a Republican House and a Democratic Senate, again with small majorities.

With President Obama remaining in office, the Republican "wish list" will not pass. But the Democrat wish list will also be in trouble. The US budgetary position will be dire, so large new spending programs will be impossible. Taxes will increase, beyond the reversal of most of the 2001 tax cuts. However, whatever the Deficit Commission reports in December, it's very unlikely that the huge revenue-raising device of a value-added tax (VAT) will be granted to a Democrat president by a Congress where Republicans are strong.

However, it is possible that the two sides will compromise on a moderate carbon tax, which would have the dual virtues of combating global warming and raising revenue. To force the Republicans to agree to this, President Obama will be able to use the threat of EPA regulation of carbon emissions.

The recent healthcare legislation will remain in force, coming into effect on schedule, although very likely subject to partisan fights. The big battle here will arise in 2013, as the legislation's major changes take effect in 2014.

Since 2007, it has been impossible to get trade agreements through Congress; this will not change, so the Colombia and South Korea Free Trade Agreements will remain in limbo. Other protectionist actions are likely – in moderation.

The banking legislation passed this year will not be significantly amended, but there will be a massive partisan battle over what to do with Fannie Mae and Freddie Mac. These housing finance behemoths each continue to absorb $100 billion in taxpayer money ach year, and no significant reform has been attempted by the current Democrat-led Congress.

So if anything, this outlook for the Congressional elections underscores just how intractable the US budget deficit will remain, with an annual shortfall in excess of $1 trillion that will refuse to budge, unless the US economic recovery really takes off. And that's not likely to happen.

The massive financing needs of the federal government will "crowd out" the private sector in the bank and bond markets, so small business investment will be low, unemployment will remain high and economic growth limited.

Equally, the chance of an economic crisis will probably be lower than with the current Congress. Policies will be moderate and a consensus between the President, Congress and the Bernanke Fed will agree to postpone problems until after the 2012 Presidential election. Interest rates will remain low, resulting in rising inflation.

It's not a very pretty picture, but it involves less structural change in the US economy than if the current Congress had been re-elected. There will be no "new" New Deal – a program that would result in additional sharp increases in government involvement in the economy.

For US investors, the best haven is probably gold – and emerging market stocks.

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