A new landscape awaiting investors?
The momentous power shift on Capitol Hill last week briefly sounded alarm bells on Wall Street.
Some investors quickly dumped healthcare and defense stocks on fears that the Democratic takeover of Congress would hurt those industries.
But apart from those sectors, the market couldn’t identify many other potential casualties of the changeover.
If the end of the 4-year-old stock bull run is near because Republicans no longer rule the House or the Senate, it wasn’t apparent in broad market indexes. The Standard & Poor’s 500 gained 1.2% for the week.
Technology stocks certainly showed no regrets over voters’ mood swing. The Nasdaq composite index ended Friday at a five-year high, surging 2.5% for the week.
For the moment, many investors remain focused on the facts as they know them: the economy still is growing, third-quarter corporate earnings rose at a double-digit pace, long-term interest rates are falling again and a lot of money worldwide is looking for opportunities.
And, of course, Republicans aren’t the only ones who own stocks and bonds. Plenty of Democrats and independents invest, and many of them certainly felt better, not worse, about the country’s future after Tuesday.
Even so, Democratic priorities put forth last week by the party’s leaders raise a fundamental question: Can Wall Street stay happy if Congress now aggressively pushes policies that may be better for workers than for corporations, and better for America at the expense of economic globalization?
Some 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 markets.
“Only those strategies that can find support in both parties have a reasonable chance of getting enacted,” said Ernie Ankrim, investment strategist at Russell Investment Group in Tacoma, Wash., echoing a common post-election refrain in the money management business.
That may be true. But sooner or later, financial markets are bound to have trouble ignoring rousing Democratic calls for a rollback of the policies that Wall Street believes have underpinned corporate earnings growth and kept inflation low.
Case in point: Democratic leaders including the likely House speaker, Rep. Nancy Pelosi (D-San Francisco), have made clear that an increase in the federal minimum wage -- the first in nine years -- will be a high priority.
Would a hike in the minimum wage, now $5.15 an hour, be a socially responsible thing to do? It would, according to more than 600 economists who signed a statement in October sponsored by the Economic Policy Institute in Washington.
“We believe that a modest increase in the minimum wage would improve the well-being of low-wage workers and would not have the adverse effects that critics have claimed,” the statement said.
What adverse effects? Potentially higher inflation, for one, if restaurants and other low-paying industries pass on their increased costs to consumers.
Millions of Americans may be happy to absorb higher prices on behalf of the working poor. Stock and bond markets could have a different view, if they fear that the risk of higher inflation would make the Federal Reserve more likely to raise short-term interest rates in 2007 even if the economy slows further.
Since July, the robust 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 know they would be lambasted if they suggested that a higher minimum wage would be inflationary, said Ethan Harris, an economist at brokerage Lehman Bros. in New York.
For workers at the bottom of the pay rung, “It’s taken so long for [prosperity] to trickle down that it looks like you’re taking away the punchbowl before the average working-class person has his first glass,” Harris said.
But this isn’t the best time to add another source of possible inflation to the Fed’s worry list, he noted. Oil prices have fallen since mid-summer but prices of many other commodities, including grains and zinc, have continued to soar. And with the U.S. unemployment rate at a five-year low, and worker productivity measures waning, policymakers already are nervous that cost pressures in the economy could increase in 2007.
In the healthcare sector, it’s expected that Democrats will push to lower drug costs in the Medicare program, hurting pharmaceutical firms. Unless, that is, the companies simply raise prices for other customers.
It’s on the issue of trade, however, that the Democrats most risk antagonizing investors and dimming their bullish mood.
Some Democrats -- and some Republicans as well -- contend that the global trade boom of the last two decades has been unfair to U.S. workers as jobs have shifted to low-wage nations such as China, and as U.S. companies have used the threat of cheap foreign labor to limit wages.
Sens. Charles E. 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, especially in the job-challenged Midwest, raise the prospect of new momentum in Congress for what Republicans label protectionist sentiment.
More so than in the case of the minimum wage, a protectionist agenda could fuel inflation in the long run, some on Wall Street believe. For one, that agenda could directly raise 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 and 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, when America tipped into net debtor status.
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 foreign 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.
That put downward pressure on the buck, which fell to a two-month low against the euro late last week.
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 say that dangerous protectionist moves either won’t be on Democratic leaders’ agenda or will be foiled by Bush -- or simply are too far out on the horizon to worry about.
Nevertheless, investors shouldn’t discount the possibility that a new era has begun in American politics -- and that the economic and market repercussions could be dramatic.
