U.S. financial markets went into last week's congressional election showing little concern about the potential for Democrats to retake the U.S. House.
But Democratic control of the House and the Senate was more than some investors could stand. They began to flee many health-care stocks on Wednesday and Thursday, fearing that Congress' new makeup could pose a threat to health-care pricing and thus industry profit margins.
Just how worried markets should be over the power shift on Capitol Hill is a matter of debate on Wall Street. Many investment pros see no point in getting too worked up about the Democratic victory because they believe President Bush would veto any legislation that would unnerve investors.
And of course, it would be absurd to presuppose that everyone who owns a stock or bond is a Republican. Plenty of Democrats and independents also invest, and many of them certainly felt better, not worse, about the country's future after Tuesday.
Still, in the markets, perception often substitutes for reality. In the big picture, a key question is whether investors will begin to perceive that the new Congress' priorities--particularly on trade issues--will add to inflation pressures in the economy.
If the Federal Reserve were to perceive the same, policymakers might be less willing to begin cutting short-term interest rates in 2007, even if the economy slows further. Worse, they might lean toward more rate hikes.
Since July, the powerful rally in stocks and the plunge in long-term bond yields have been powered in large part by the Fed's decision Aug. 8 to halt its two-year-long credit-tightening campaign. Markets aren't prepared for that campaign to restart.
Fed officials would never publicly say they're worried about the Democrats, but they aren't deaf to the party's complaints about free trade.
Some Democrats--and some Republicans--contend that the global trade boom of the last two decades has been unfair to U.S. workers as many domestic jobs have shifted to low-wage nations such as China.
Sens. Charles Schumer (D-N.Y.) and Lindsey Graham (R-S.C.) have written legislation that would levy tariffs on imports from China. They say China unfairly controls the value of its currency to keep export prices low.
Treasury Secretary Henry Paulson succeeded in September in talking Schumer and Graham out of calling for a vote on the bill, saying it could provoke retaliation by China and spark a trade war.
Now the Democrats' gains in the election raise the prospect of new momentum in Congress for what Republicans label protectionist sentiment.
A protectionist agenda could fuel inflation in two ways. One would be by directly raising import prices, either via new tariffs or by U.S. jawboning of China and other goods producers to change government policies that keep prices down.
That, in turn, could give U.S. companies greater flexibility to raise prices or to stop pushing hard for improved productivity.
A second trigger for higher inflation could be a further, and abrupt, decline in the dollar that would automatically make foreign goods or services more expensive for Americans.
What would make the dollar go down? A wave of selling of U.S. stocks, bonds and other dollar-denominated assets by foreign investors who decide their capital would do better elsewhere.
Of course, the threat of a massive foreign exodus from U.S. assets has hung over markets since the mid-1980s. Since then, as the nation's trade deficit has ballooned, so has foreigners' stake in U.S. assets. The feared rush out has been a rush in.
But in recent weeks there have been renewed rumblings about the risk of capital fleeing the dollar. On Thursday, Zhou Xiaochuan, the head of China's central bank, said at a conference in Frankfurt that China was following "a very clear diversification plan" for its $1 trillion in foreign currency reserves, the bulk of which now are in dollar-denominated assets.
A Democratic push to restrict trade for the sake of domestic jobs could accelerate a move out of the dollar, warned Joseph Quinlan, market strategist in Bank of America Corp.'s global wealth and investment management unit in New York.
"Any signs of growing U.S. protectionism or a shift toward more isolationism will hardly be welcomed by foreign investors," he said.
Stock and bond market optimists can argue that dangerous protectionist moves either won't be on Democratic leaders' agenda, will be foiled by Bush or simply are too far out on the horizon to worry about.
In the meantime, for stocks in particular, the backdrop still favors the bulls. The economy continues to grow, albeit at a slower pace; corporate earnings remain robust; and the market historically has been a big moneymaker for investors in November and December.
Besides, if protectionist fears do begin to deepen, it will be obvious enough: Just watch the dollar.
Tom Petruno is a columnist for the Los Angeles Times, a Tribune Co. newspaper.Copyright © 2015, Los Angeles Times