Top of Mind

Issue 5

US Election Inspection
El The fast-approaching US presidential election is perhaps one of the most important in recent history, with the fate of near-term US economic growth, medium-term US fiscal stability (and, with it, the US sovereign debt rating) and monetary policy hinging on the outcome, as discussed by our Washington DC political expert, Alec Phillips, in Why the 2012 election matters more than most. With the race abruptly shifting from a likely Obama victoryand potentially a convincing oneinto a neck-and-neck race following the momentous first debate between the presidential candidates, the US election on November 6 is clearly Top of Mind. To address this topic, we sit down with David Gergena CNN political analyst and Harvard Kennedy School Professor who has advised four presidents. We asked why Obama has been ahead for much of the campaign despite the weak economy (in large part because he avoided drawing challengers during the primary), how Romney as President would deal with the conservative House Republicans (it may actually be the other way around, with power exercised from the House rather than from the White House in a Romney administration), and what the likely focus of foreign policy might be in a second term for Obama (he would prefer to focus on China, but it would be difficult for him to divert attention from the Middle East and especially Iran), among other key questions about the election and the (somewhat sorry) state of US politics. We also lay out the key dates and likely paths to resolution of the fiscal cliffthe most important and most imminent challenge that the elected candidate will be forced to face just after the election (page 5) as well as a handy summary of where the candidates stand on key economic issues (page 7). We then look at asset implications of US elections. In Election cycles and assets Jose Ursua (with contributions from Silvia Ardagna, George Cole and Thomas Stolper) looks at the performance of assets within the four-year US election cycle and finds that equity markets tend to underperform noticeably in the first half of the cycle relative to the second half, a pattern that is echoed in equity markets abroad. This pattern is the opposite of what occurs in rates, suggesting an asset rotation story may in play around election cycles. Stuart Kaiser then takes a closer look at the sensitivity of equity market returns to election outcomes, finding that the S&P500 doesnt care about what party is in the White House, but certain sectors do. Our snapshot table on page 6 summarizes all of our views on election impacts across assets, with impacts clearest for equities, but many assets vulnerable to the looming fiscal cliff, which the election outcome will certainly have bearing on. For those readers less familiar with the US political process, we also include a guide to the US electoral process on page 12.

Allison Nathan, Editor

Email: Allison.Nathan@gs.com Tel: +212-357-7504 Goldman, Sachs & Co

Key dates

Oct 22, 2012 3 rd Presidential debate (Boca Raton, FL) Oct 26, 2012 US 3Q GDP release Nov 2, 2012 Oct job report (unemployment, payrolls) Nov 6, 2012 US Presidential and Congressional elections Oct 2012 Nov 2012

ELECTION
Jan 3, 2013 New Congress takes office

Jan 20, 2013 Presidential inauguration

Feb Jan Dec 2013 2013 2012 Late Nov/early Dec Jan 2, 2013 Debt ceiling likely Sequester formally reached takes effect although measures Dec 31, 2012 can likely extend Fiscal cliff financing capacity takes effect until Mar 2013 Nov 26, 2012 Dec 15-21, 2012 Fiscal cliff debate likely Most likely period for a (shortto begin in earnest term) resolution of the Fiscal cliff Nov 12 year end Lame duck period for Congress begins

Mar 2013

Late Feb/early Mar Debt limit likely reached

FISCAL CLIFF
Source: Goldman Sachs Global ECS Research. Goldman Sachs Global Economics, Commodities and Strategy Research 3

Top of Mind El

Issue 5

Why this election matters more than most

Alec Phillipsour Washington DC political expertexplains why this election is exceptionally important to the economy
The 2012 US presidential election is perhaps one of the most unique and important elections in recent history from an economic perspective. In choosing its leader for the next four years, the country will likely be determining the path for near-term economic growth, medium-to-longer term fiscal stability and monetary policy at a time when the stakes are exceptionally highwhether or not the US economy returns to recessionary conditions in 2013, the US sovereign debt rating and the broader credibility of the US government to Americans and foreigners alike all hang in the balance. There are three factors that set the 2012 election apart: Legislative inaction now a greater risk than legislative action The potential for legislative inaction may pose a greater risk and more uncertainty than legislative action, suggesting that the one almost foregone outcome of the current electiondivided governmentposes greater challenges than in the past. Typically, divided government is viewed as a constructive political outcome by markets as it (normally) reduces the likelihood of major policy change and hence policy uncertainty. But in the current environment the opposite may be true, as Congress must take action (by year-end in many instances) to avoid large (and mostly undesired) shifts in policy. This is because policy has become more temporary, mainly owing to the congressional budget process, which measures the cost of legislation over ten years and thus makes temporary legislation appear less expensive than longer-lasting policies. The glaring risk in front of Congress is the fiscal cliffroughly 3.5% of GDP in tax increases and spending cuts set to occur at year-end. This makes the 2012 election one of only a few contests in which such a large fiscal policy shift was on the table so soon after the election took place (2008 is arguably another example, when the election represented, in part, a referendum on the size and composition of a stimulus package expected to be passed early in the following year). Our base case is that Congress will just barely reach an agreement before the end of the year, averting most of this fiscal restraint, but it is quite possible that Congress could fail to address the issue by that deadline, leading to a substantial fiscal drag on growth, at least temporarily. A status quo political outcome raises the risk of a game of fiscal chicken at year end, in which policy goes off the cliff unless one party reverses their long-held position on the upper income portion of the 2001/2003 tax cut (luckily for the US economyand unlike the real game of chickena retroactive extension is possible in early 2013). A Romney win seems more likely to lead to a shortterm extension of the 2001/2003 tax cuts and some aspects of the fiscal cliff. In either scenario, it is imperative that Congress act, which is a unique and important difference from typical elections, with the economic consequences of them failing to do so potentially recessionary. The fiscal stakes are higher than they have been in decades Beyond the fiscal cliff, the winner in November will face a potentially frustrating fiscal landscape: on one hand, the elevated level of debtaround 75% of GDP and risinglimits the fiscal room to maneuver. On the other hand, the Treasurys exceptionally cheap interest expensearound 1.4% of GDP, less than half the level that prompted deficit reduction efforts in the late 1980s and 1990shas dulled the pressure on lawmakers to tackle these issues. This should be a recipe for inaction. But two issues will likely raise the stakes in reaching a longer-term fiscal agreement early on in the next administration: (1) the need to once again increase the debt ceiling which congressional Republicans would like to match with deficit reduction (over ten years) of an equal amount, and (2) the renewed threat of a sovereign downgrade by the ratings agencies, who have signaled as much if the US doesnt stabilize its debt ratio by mid-decade. A deficit reduction agreement of $2 trillion over ten years could resolve both issues, but with the easy cuts already made in last years debt limit agreement, only the most difficult aspects of a fiscal grand bargain remain. Monetary policy in (political) focus Elected officials have hardly been indifferent to monetary policy in the past, but there have been few elections where Fed policy was as widely debated as it is today. Compounding this is the expiration of Chairman Bernankes term in January 2014; Romney has already indicated that he will not nominate Chairman Bernanke for another term. While Romney is not alone in making his intentions to replace the chairman clear, what makes this situation unique is that it comes at a time when the Fed is pursuing unconventional policy that depends much more than usual on a forward commitment that occurs mostly past the end of the current Chairmans tenure.

Monetary policy becoming more political

Fed Chairman Senate confirmation votes, % Senators voting
100 90 80 70 60 60 votes needed to overcome filibuster 50 40 30 20 10 0 1978* 1979 1983 1987 1992* 1996 * Unanimous consent or voice vote (i.e., no roll call vote held) 50 40 30 20 10 0 2000 2004* 2006* 2010 The more politicized, the less voters 100 90 80 70 60

Source: Library of Congress, Associated Press.

Any of these issues would make the upcoming election an important one for the economic outlook, but the combination of a near-term risk in the fiscal cliff, increasingly problematic mediumterm fiscal dynamics, and election-driven uncertainty on monetary policy at a time when the credibility of future commitments is necessary for its success make this a unique election, with potentially substantial and far-reaching economic impacts.

Alec Phillips, US Political Economist

Email: Tel: Alec.Phillips@gs.com 202-637-3746 Goldman, Sachs & Co.

Goldman Sachs Global Economics, Commodities and Strategy Research

Top of Mind

Issue 5

Fiscal Cliff and the election

El

US Election November 6 November 12 - Lame duck congress convenes

Obama wins

Romney wins President-elect would likely call for a shortterm extension of most of the expiring policies likely with the intention of undertaking major tax reform in the new year as a basis of a longer-term plan 80% chance of no cliff

White House likely to publish a formal proposal on how to resolve the fiscal cliff, probably coupled with a longer-term fiscal consolidation plan

A very close election could delay progress on the fiscal cliff, especially if it takes days or weeks to declare a winner

L A M E D U C K C O N G R E S S

D House D Senate 80% chance of no cliff

Status quo R House D Senate <60 55% chance of no cliff

R House R Senate 30% chance of no cliff

Congressional Republicans may offer a longerterm plan of their own

Bipartisan "Gang of Eight" senators might release a longterm fiscal reform proposal

November 26 December 21 Earnest debate likely to take place

Private negotiations + Press conferences Agreement, most likely for a short-term resolution No agreement, and we go over the fiscal cliff at year end December 15 December 21 Most likely period of agreement

January 3 Lame duck session ends with new Congress seated; January 20 Presidential inauguration Negotiations continue until a deal is reached early in January, and potentially applied retroactively Agreement not reached until there is another catalyst , (e.g. debt limit in Mar); expiration of upper income tax cuts Fiscal drag in 2013 would likely be +2%, with the worst case likely to be a 3.5% drag = RECESSION New President and new Congress would draft/negotiate longer-term fiscal consolidation plan

Mainline view of 1.0%-1.5% fiscal drag in 2013

Fiscal drag may be slightly larger than our mainline1.0%1.5% drag in 2013, but not much

Mainline view of 1.0%-1.5% fiscal drag in 2013

ECONOMIC IMPACT

Mid-February/March debt limit is hit, requiring congress to raise it in order for the US to continue to pay its bills
Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research

Top of Mind

Issue 5

Where they stand

El

OBAMA

ROMNEY

Economy
Stimulative policies to grow the economy in the short term. Cut spending and raise taxes on wealthy to reduce the deficit in the long term. Cut spending to reduce the size of the government and return more power to the states. Cut taxes/keep taxes low to motivate more household/corporate spending to boost the economy.

Fiscal Policy
Cut projected deficits by $4trn over 10 years through a combination of spending cuts and tax increases, primarily on the wealthy. Cut unspecified federal spending by $500bn/yr by 2016 and cap it at 20% of GDP (as opposed to 23.5% now). Institute a Balanced Budget Amendment to the US Constitution.

Tax Policy
Extend Bush-era tax cuts for everyone making under $200k, or $250k for couples. Ensure taxpayers with over $1mn income pay at least a 30% tax rate. Increase the top two tax rates back up 3 to 4 points to 39.6% and 36%. Limit tax preferences for upper incomes. Raise rates on capital gains (to 20%) and dividends taxes for earners over $250k. Lower top corporate tax rate to 28%; give tax breaks to US manufacturers. Maintain worldwide tax system. Extend Bush tax cuts for all people; make permanent, across-the-board 20% cut in marginal rates. Lower highest tax rate to 28%. Limit or eliminate tax preferences to offset budgetary effects of rate reductions. Maintain current tax rates on dividends and capital gains. Eliminate capital gains, dividends, and interest taxes for any taxpayer with adjusted gross income under $200k. Eliminate the estate tax. Repeal the Alternative Minimum Tax (AMT). Lower the corporate income tax rate to 25%. Transition to a territorial tax system (income is taxed only in countries where it is earned; in the current US worldwide tax system income is taxed at the US rate regardless of whether the income is earned within US borders or overseas.)

Regulatory Policy
Continue to uphold and support the Affordable Care Act and Dodd-Frank. Repeal the Affordable Care Act. Repeal and replace Dodd-Frank. Cap new regulatory costs at zero dollars. Require Congress to approve all major regulations. Reform legal liability system. Amend Sarbanes-Oxley to reduce the burden on small firms.

Goldman Sachs Global Economics, Commodities and Strategy Research

Top of Mind

Issue 5

Interview with David Gergen

El

David Gergen serves as a senior political analyst for CNN and is a professor of public service and director of the Center for Public Leadership at the Harvard Kennedy School. He has served as a White House adviser to four US presidents: Nixon, Ford, Reagan and Clinton, and is a NY Times best-selling author on these experiences. Below he shares his insights on the upcoming US elections, the state of US politics today, and where theyre potentially headed in the future.
The views stated herein are those of the interviewee and do not necessarily reflect those of Goldman Sachs.
Allison Nathan: What are the key issues of this presidential election? David Gergen: The creation of jobs and taming of the deficits by far and away are the most important issues in the campaign. But it should be understood that for certain voters who are key to the outcome there are additional issues. Women, for example, care deeply about abortion and pay equity. Latinos care deeply about immigration. Both groups could swing the election. Allison Nathan: Why has Obama been mostly ahead in the polls despite such a weak economy and high unemployment? David Gergen: That's been one of the biggest mysteries of the campaign. For a full year, from October 2011 to October 2012, the President was ahead. I think that's mostly because of two factors. One is that his team effectively discouraged anyone from running against him in the Democratic primaries. In ten elections since World War II, an incumbent president has sought a new term. The only three presidents who lost were men who drew a primary challenger: Ford, Carter and Bush Senior. Obama squelched that early. The other factor is that the Obama team is more experienced and was able to get the jump on the Romney team last summer with advertising and organization, remaining one step ahead until the first debate. Allison Nathan: Are there unique challenges that a President faces in a second term? David Gergen: Historically, second term Presidents have faced two problems. First, there tends to be a sense of arrogance that can dull the political capacity of any team. Secondly, second term Presidents tend to be weaker at home than in the first term. Typically, a president has about a year in his second term when he's strong and people look to him to exercise authority, but after the end of that year power just sort of seeps out of the White House. People start looking over the Presidents shoulder to the mid-term elections where the incumbent party often loses badly, and attention also turns to the next presidential election. Allison Nathan: Would Obama approach foreign policy differently in a second term? David Gergen: Because presidential power declines so rapidly at home over the course of a second term, the White House tends to pay much more attention to foreign affairs. This President has made it clear that he wants to "pivot" his focus toward the Far East and to China in particular, and away from the Middle East where much of his focus has been aimed during his first term. But it's going to be impossible for him to turn away completely from the Middle East where there's so much turmoil. The greatest near-term threatone that could have enormous consequences for whoever is electedis the growing possibility that the escalating conflict with Iran could come to a boil in 2013.
Goldman Sachs Global Economics, Commodities and Strategy Research

Allison Nathan: Would Obama use a second term to pursue another big deal? David Gergen: Yes, I think he's extremely likely to pursue a grand bargain on fiscal issues. I imagine the starting point would be the negotiations that he and John Boehner (R-OH; Speaker of the House) were engaged in around the debt limit debate in 2011 that fell apart. That will raise two major questions: will House Republicans agree to increase revenue by at least $800bn over 10 years, an idea that Boehner was entertaining? And second, will Democrats be willing to tolerate social spending cuts and serious structural changes in Medicare and other entitlements that Republicans will insist upon as the price of a deal? We don't know the answer to either question. Please note that as part of revenue raising, Obama wants to decouple income tax rates so that the Bush tax cuts would be extended for every couple earning below $250k in income, while the rates would go up for people earning above $250k. Republicans have strongly opposed that in the past. If Obama wins there is a possible compromise that would entail decoupling for people with annual income above $1mn. Allison Nathan: It is widely known that Treasury Secretary Geithner would not stay on for a second Obama term. How might a new Treasury Secretary approach the role differently? David Gergen: The focus of the next treasury secretary is expected to be more on domestic affairs than international, and trying to negotiate a grand bargain that gets the deficit under control and the US economy back on track. One person often mentioned in terms of succession is Jack Lew, the current Chief of Staff at the White House and previous budget chief. Generally, the indications are that a second Obama term would bring a game of musical chairs, with the people who are already there switching places and fewer outsiders coming in. The inside wisdom about succession is that it's no longer possible for any Wall Street figure to be confirmed. The one exception from the financial community who is often mentioned as a possible nominee is Larry Fink. Allison Nathan: How has Romney managed to improve his chances so much, so quickly? David Gergen: The first debate was a defining moment for Romney and for the election. It is now apparent that there were many voters who were open to a Romney candidacy early on but were possibly turned off by what they perceived as the extremism of the Republican Party or by a very effective negative advertising campaign by the Democrats. Whatever the reasons, the Romney who showed up at the first debate was a compelling figure and brought a lot of the soft voters who were tilting toward Obama back to the Republican camp. And so we've gone from what looked like a sure Obama victory and maybe even a landslide to a horserace that Romney could win. Allison Nathan: What would be the focus of a Romney administration? David Gergen: There's no question that Romney's focus would be on the creation of jobs and the taming of the deficit. His grand bargain would clearly have much less emphasis on raising
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Top of Mind El

Issue 5

revenue (through taxes) and much more emphasis on cutting spending and structural reform of entitlements. But whether he could sustain that in the Senate is the harder question. Its very likely that the Senate will remain Democratic so there's a big question about whether he, like Obama, will find that Washington is paralyzed and it will be very difficult to get things done. Allison Nathan: Beyond obstacles in the Senate, how would Romney deal with conservative House Republicans? David Gergen: If this had been a landslide for Obama and Democrats had gained a number of seats in the House, that might have sent a ripple of fear through the House Republican and they might have been more willing to compromise. But if it's very close and they maintain their majority the incentives for compromise are diminished sharply. There are hard line conservatives who have argued that in a Romney administration power should be exercised from the House rather than from the White House. The House would create the legislative packages, negotiate with the Senate, and then send the resulting legislation to the White House to be signed as opposed to the Presidents agenda serving as the centerpiece of negotiations. I think that's possible. Much of the intellectual creativity in the Republican Party is centered in the House and people like Paul Ryan. Ryan is going to be a pivotal player whether or not Romney wins. Hes either going to be a chief negotiator for Romney should he get elected. Or he's going to be a chief negotiator in the House in an Obama second term. Allison Nathan: Is there a chance that the balance of power in the House and/or Senate shifts? David Gergen: Had President Obama broken this open there was a real possibility that his coattails could have brought a larger number of Democrats into the Senate. Because it now looks like a much closer election, the likelihood is that the changes in the Senate will be fairly modest, with Democrats maintaining a small majority. On the other hand, its unlikely that the Republicans gain a majority in the Senate at this point. The best indications are also that changes in the House will be modest. Bottom line, if President Obama is reelected, it could well be a status quo election. And if Romney is elected, he will very likely have the benefit of a Republican-dominated House, but have to contend with a Democratic majority in the Senate. Allison Nathan: Will the election affect the fiscal cliff outcome? David Gergen: Its striking to me how many insiders are growing optimistic that we will not only avoid the cliff, but reach a grand bargain this year. My bet is that no matter who gets elected we won't go over the cliff. The Congress and the White House will find a way to postpone resolution of these issues until 2013. People in Washington can be seen as dumb but they're not crazy. Allison Nathan: Will the election affect US monetary policy? David Gergen: Yes, it clearly will affect who's running monetary policy given that Bernanke's term runs out in 2014. And Mitt Romney has promised that he will replace Bernanke. He said that to please the Right, but it was one of those campaign events that he may end up regretting. I was in the Reagan White House when Reagan came to office and Paul Volcker was the Fed Chairman, but appointed by Jimmy Carter. We went through a serious process inside about whether Volcker should be reappointed. President Reagan fortunately decided to reappoint him, but Reagan kept his powder dry until he had a chance to really examine the issue.

Romneys commitment to removing Bernanke would make it more difficult for the White House and the Fed to get along in the interim in a Romney administration. I think the Fed will pursue the same course its on as long as Bernanke is there, but it's going to create uncertainty in the US and overseas about where Fed policy goes post Bernanke, and that's not a good thing. Allison Nathan: What has driven the current polarization in DC and in the country as a whole? David Gergen: There are a variety of factors that enter into it. Income inequality is clearly one of them. Redistricting (re-drawing electoral district boundaries) has made a big difference. The growing demographic gaps in the country are making a difference. And increased extremism within the political parties has been a factorDemocrats may have a point when they say that the influence of the Tea Party (a movement within the Republican Party that aims to reduce government spending and taxes) has made Republicans more recalcitrant. But I believe that a large part of it owes to the media. Media on the one hand reflects what's going on in the culture and on the other hand, drives it. The conversation in the media has become much rougher and more partisan. Social media in particular has become a fierce battleground for partisans of both sides and has contributed to a now deep-seated culture of polarization, with Americans even increasingly moving to likeminded red or blue communities. Allison Nathan: Do the President or members of Congress really want to do bipartisan deals? David Gergen: No. There are people on both sides who feel strongly that there has already been too much compromise. I disagree with that. Almost all of the major social milestone legislation that has been passed since the 1930s has been enacted on a bipartisan basis. The civil rights bills of '64 and '65 would not have been passed had it not been for spirited bipartisanship. Allison Nathan: Is there any hope that the political environment could improve? David Gergen: One of the great hopes for the future is that the millennial generation has the promise of being the best generation since World War II. I see two streams of people who are coming into politics and could transform politics over time. I'm on the Board for Teach for America, which recruits promising recent college graduates to teach in the roughest schools in the country for two years. The number of volunteers who are coming in from schools all over the country is just unbelievable. Today, one out of every five Harvard seniors say they would prefer teaching the eighth grade in an urban school rather than going into investment banking. Also, the silver lining of twelve years of war is the young people coming back, taking off their uniforms and pitching in to improve life in our country. I have been very impressed with this group of young individuals. Allison Nathan: Any early views on 2016? David Gergen: Incredibly enough we could have a Clinton/Bush election! It would not be a surprise to see Hillary Clinton on the Democratic ticket. On the Republican side, should Romney lose, well have to wait and see how the party shakes out. But clearly moderate Republicans would love to see Jeb Bush jump in the race. Paul Ryan is also going to come out of this campaign as a major contender in 2016 if the Romney/Ryan ticket goes down.

Goldman Sachs Global Economics, Commodities and Strategy Research

Top of Mind

Issue 5

Election cycles and assets

El

Jose Ursua of our Global economics team reviews patterns in equities (and other assets) around election cycles/the Big Day
The 2012-2013 election season is exceptional, with more than 100 elections in economies accounting for approximately 60% of global GDP. So far, markets have navigated through elections in Russia, Egypt, Greece, France, Mexico and Venezuela, among others. The closely watched Presidential election in the US will take place shortly, followed by the culmination of the political transition in China. Later on, markets will see countries like Italy, Iran, and Japan go to the ballots too. This extraordinary election season brings several questions to the forefront: Why are elections important market events? How do equities reflect the US electoral cycle? And does it affect markets abroad, and other assets? Why elections matter There are at least three reasons why elections matter for markets. First, the political stakes in elections often translate into policy changes that reshape the economic environment. Second, the regularity with which elections take place may lead to cyclical patterns in government and investment behavior. Third, elections can markedly increase uncertainty. These factors can affect all asset classes, especially equities because of their strong sensitivity to changes in the economic outlook. Election cycles and equities: Bad news for the first 2 years The US Presidential election cycle matters for equity returns, at home and abroad. US Presidential election cycles (four-year cycles that always start between the second and eighth of November) since 1928, have tended to produce considerably lower US equity price returns in the first two years of the fouryear cycle than in the last two (with historical averages around 3%-4% vs. 10%-12%). This is true even when attempting to account for other seasonal, market and economic factors. Considering those other factors, returns during the first and second years are only a quarter and a sixth of those in the third year. The second year in the cycle also tends to show the highest volatility (by around 150bp-200bp). Those patterns also travel abroad. The data are not as good outside of the US, but nevertheless also show that US election cycles are important drivers of equity returns in other developed and emerging markets alike.

resolved, returns gradually bounce back. There also tends to be a blip in volatility immediately following elections, which may reflect concerns on policy changes, close-calls, or surprises.

Bad (equity) news for the next two years?

Yearly S&P 500 average price returns from election year to the next since 1928 in % (lhs); Returns standard deviation in % (rhs)
16 14 12 10 8 6 4 2 0 18 19 20 21 22

Y1 (Nov-)

Y2 Returns (LHS)

Y3 Volatility (RHS)

Y4

Source: Haver Analytics, Goldman Sachs Global ECS Research.

Less stark and more mixed for rates and FX The impact of the US Presidential election on other assets is less stark in some cases, and altogether less clear in others. In fixed income markets over the four years of the presidential cycle, total returns from investing in an index of 10-year US government bonds on average peak in the second year after an election and decrease in the third and four years. This pattern is the opposite of what is observed in the equity markets, suggesting that investors may change their asset allocation from bonds to equities in the second half of the mandate. The pattern is similar for shorter maturities, including 2- and 5-year Treasuries. However, the difference in returns between each of the years is only moderate. In contrast to equities, there is very little evidence that uncertainty around elections impacts bond returns. Looking at average volatility of returns over a 6-month window centered on presidential elections, there is no significant impact on volatility before elections, and only a slight increase in the months afterwards. For FX, there is substantial focus on election impacts, given several examples of large Dollar moves surrounding elections over the last two decades: a 5% appreciation of the Dollar on a trade-weighted basis in the 6 weeks surrounding the election of President Clinton in 1992, a 4% depreciation surrounding the re-election of President G.W. Bush in 2004, and a 7% appreciation surrounding the 2008 election of President Obama. But, on closer inspection, all of these moves had unique drivers apart from the election: the Exchange Rate Mechanism (ERM) crisis in September 1992 (when the UK was forced to give up its attempt to adopt the euro, with UK Sterling depreciating by 11% against the Dollar, and the Italian Lira depreciating by 7%), a broader Dollar-down trend that began in 2002, largely caused by a worsening BBoP, rising public debt and weak economic growth, and increased risk aversion post the Lehman bankruptcy in 2008, which tends to be Dollar positive. On net, its tough to make the case that elections have had any meaningful impact on the Dollar in the past.

DID YOU KNOW?

Over the past 30 years, the frequency of elections has dramatically increased in EMs. While the average frequency remains 1 per month in DMs, it has increased from about 2 to 4 in EMs. It is now common for there to be around 55 elections per year around the world. Why do equities follow this pattern? Promising explanations from various studies touch on the role of political business cycles (expansive policies in the later part of the cycle, which could leak out to other countries), market sentiment (expressions of early disappointment followed by second-half optimism), and behavioral patterns on the side of investors (rules of thumb or myopia). The Big Day increases equity volatility Beyond the four-year cycle, elections have an impact on equity markets during the surrounding months of the Election Day itself. In the run-up to US elections, returns tend to move sideways as a reflection of unresolved uncertainty. Later on, as the unknowns are

Jose Ursua, Global Economist

Email: Tel: Jose.Ursua@gs.com 212-357-2234 Goldman, Sachs & Co.

A special thanks to Silvia Ardagna/George Cole and Thomas Stolper for their contributions on rates and FX.

Goldman Sachs Global Economics, Commodities and Strategy Research

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Issue 5

Do election outcomes matter to equities?

El

Stuart Kaiser of our US Portfolio Strategy team discusses the insignificance of political parties to US equity index returns, but significance to sector returns
The interaction of equity performance and political outcomes has garnered significant attention over the past four years thanks to a charged political environment and important regulatory actions, particularly in the Financials and Health Care sectors. Still, the historical relationship between equity returns and which party controls the White House has been loose. In contrast, sector performance reveals some divergence across party lines. Index indifference: Its the economy, stupid Since the mid-1970s, equity markets have proven indifferent to political outcomes with median total returns all but identical whether the White House is Republican or Democrat. It has been the economy rather than investors responses to partisan changes that has ultimately driven stock market performance over the medium term. For the past 40 years, S&P 500 median total returns have risen roughly 10% in the twelve months following a presidential election, regardless of which party wins. Performance is also very similar over shorter three- and six-month windows. However, returns are slightly better early in Republican administrations, while during an entire four-year term the equity market has somewhat higher median returns under Democrats. We focus on the more recent past (Jose Ursua instead looks at the history since 1928) so that results are comparable to the sector analysis below (where reliable data start in 1976), recognizing that our sample size is inherently limited.

Discretionary and Information Technology shares outperforming the market since Election Day 2008. Meanwhile, Financials, Energy, and Utilities stocks have lagged the market, with all three impacted by regulatory issues to varying degrees. In contrast, Health Care has outperformed the S&P 500 by about 550 bp.

Sector: Party preferences

Total return relative to S&P 500, presidential admin. (1976-present)
Sector (median return) Info Tech Industrials Energy Health Care Financials Telecom Utilities Materials Consumer Discretionary Consumer Staples S&P 500 Absolute Return Democrat Republican 52.2 pp (35.7)pp 8.1 (2.1) (11.4) (13.6) 9.2 9.4 (6.7) (2.9) (17.1) 12.4 (19.5) 11.8 (25.5) 10.7 (31.1) 6.9 (28.2) 65.3 72.9 % 62.6 % Difference 87.9 pp 10.2 2.3 (0.3) (3.8) (29.5) (31.3) (36.2) (37.9) (93.5) 10.4 %

Source: FactSet, Goldman Sachs Global ECS Research.

The current election: Energy, Financials, and Health Care Looking ahead, the areas of the market most likely impacted by the elections outcome are Energy, Financials, and Health Care given continued uncertainty over policy implementation. Historically, regulatory battlegrounds such as the Tobacco, Diversified and Specialty Chemicals, and Pharma subsectors have outperformed immediately following Republican victories. Within Energy, Integrated Oil & Gas and Refiners have outperformed after Democratic victories, while Exploration & Production and Equipment & Services prospered following Republican wins.

INVESTMENT TAXES IN FOCUS Index: No preference for parties

S&P 500 median total return (%, not annualized) following Election Day, 1976-present
80

70

60

50

In our August 8th edition of Top of Mind, we discussed the impact of a potential increase in the dividend tax rate. Under current law, long-term capital gains taxes are also set to increase to 23.8% from the current maximum rate of 15%. If realized, this would be the largest single year increase in the top rate in modern history. Despite that context, the maximum rate would remain below the 28-29% range in place from 19871996, and only slightly above the 21% rate from 1997-2002. In addition, the planned 2013 level is below (or on par with) capital gains rates during 1934-1980. No matter who wins the election, capital gains taxes are likely to rise for upper income investors. Obama supports such an increase, contending that the 15% rate is anomalously low relative to history. While investors believe that Romney is more likely to defend lower top rates, he has placed greater emphasis on eliminating capital gains taxes for those making $200k or less as part of broader tax reform.

40

30

20

10

0 +3m +6m Republican +12m Democrat 4-year

Source: FactSet, Goldman Sachs Global ECS Research.

Parties matter for sectors At the sector level politicsand possibly policiesappear to matter more. Over the past 35 years, Democratic terms have been associated with the outperformance of cyclical stocks while more defensive and higher yielding sectors have outperformed during Republican administrations. In the near term, one year after a Republican president is elected, Consumer Staples, Health Care and Financials have generally outperformed the S&P 500 while Materials and Tech have lagged. Conversely, following Democratic victories, Information Technology and Telecom stocks have led the market while Materials and Health Care have fallen off the pace. The past four years have largely followed suit with Consumer
Goldman Sachs Global Economics, Commodities and Strategy Research

The markets response to previous increases was not definitive. The S&P 500 traded down 7% during the month after a 9.0 point increase from 1970-1972 was signed into law but rose 4% after an 8.0 point increase in 1987. More generally, there is no correlation between increases or decreases in the top rate and one month returns. This is somewhat intuitive: studies suggest that roughly half of all capital gains accrue to individuals in the top 0.1% of the US income distribution who may be less sensitive to tax rates while tax rate cuts are not associated with a deadline to act.

Stuart Kaiser, Senior US Portfolio Strategist

Email: Tel: Stuart.Kaiser@gs.com 212-357-6308 Goldman, Sachs & Co.

11

Top of Mind

Issue 5

US election process explained

El

The US presidential election is held every four years on the Tuesday after the first Monday in November. Voters do not, technically, participate in a direct election of the president. They choose electors, who are pledged to one or another candidate. This is known as the Electoral College. The Electoral College consists of 538 electors. A majority of 270 electoral votes is required to elect the President. Each state has a certain number of electors to the college, based on the size of its population. Specifically, each states entitled allotment of electors equals the number of members in its Congressional delegation: one for each member in the House of Representatives plus one for each of its two Senators. In almost every state, the winner of the popular vote gets all the electoral college votes in that state. Because of this system, a candidate can take the White House without winning the popular vote. The exceptions to this are Maine and Nebraska, where the state winner receives two Electors and the winner of each congressional district receives one Elector. The District of Columbia is allocated 3 electors and treated like a state for purposes of the Electoral College. On the first Monday after the second Wednesday in December after the presidential election, the electors meet in their respective states, where they cast their votes for President and Vice President on separate ballots. Each states electoral votes are counted in a joint session of Congress on the 6th of January in the year following the meeting of the electors. The Vice President, as President of the Senate, presides over the count and announces the results of the vote. The President-Elect takes the oath of office and is sworn in as President of the United States on January 20th in the year following the Presidential election. If no Presidential candidate wins 270 or more electoral votes, the House of Representatives decides the Presidential election. The House would elect the President by majority vote, choosing from the three candidates who received the greatest number of electoral votes. The vote would be taken by state, with each state having one vote. It would be up to the group of representatives from each state to decide among themselves how their state would cast its one and only vote. Smaller states like Wyoming, Montana and Vermont, with only one representative would wield as much power as California or New York. The House would have until the 4th of March to select a president.

Source: National Archives and Records Administration (NARA), US Federal Register.

The votes
US electoral votes and presidential leanings

WA 12 OR 7

MT 3 ID 4

ND 3 SD 3 NE 5 KS 6 OK 7 TX 38

ME 4 MN 10 IA 6 MO 10 AR 6 LA 8 NY 29 OH 18 KY 8 TN 11 AL 9 PA 20 WV VA 5 13 NC 15 SC 9

VT 3 NH 4 MA 11 RI 4 CT 7 NJ 14

WY 3 UT 6 CO 9

WI 10

MI 16 IL 20 IN 11

NV 6 CA 55

AZ 11

NM 5

MS 6

GA 16

AK 3 HI 4 Solid D Lean D Solid R Lean R

FL 29

DE 3 MD 10 DC 3

Swing

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research

12

Top of Mind

Issue 5

US Election in pics
El

Economic confidence (surprisingly) high

Economic Confidence Index (30 day ma of 3-day survey period)
0

The horserace
% (unless specified otherwise); shaded = tossup, as of Oct 23
Obama Electoral vote Popular vote Poll Avg. Proj. Vote Poll Avg. Proj. Vote Poll Avg. Proj. Vote Poll Avg. Proj. Vote Poll Avg. Proj. Vote Poll Avg. Proj. Vote Poll Avg. Proj. Vote Poll Avg. 290.8 50.1% 47.6% 49.6% 47.0% 48.8% 49.0% 50.4% 49.1% 50.8% 48.9% 50.7% 48.2% 50.4% 47.6% 49.7% Romney 247.2 48.8% 46.6% 49.4% 47.7% 50.4% 46.2% 48.6% 46.2% 48.4% 45.4% 48.1% 45.3% 48.3% 46.9% 49.6% Margin 43.6 1% 1.0% 0.2% -0.7% 1.6% 2.8% 1.8% 2.9% 2.4% 3.5% 2.6% 2.9% 2.1% 0.7% -0.1% in favor of Obama Obama Obama Obama Romney Obama Obama Obama Obama Obama Obama Obama Obama Obama Romney Obama Obama

-10

-20

CO FL IA NH NV OH VA WI

-30

-40

-50

-60

-70

Source: Gallup.

49.8% 45.8% 4.0% Proj. Vote 51.4% 47.9% 3.5% Source: FiveThirtyEight, The New York Times, Nate Silver.

Employment matters, at least historically

Election year unemployment rates in %
President Year November of November Pre-election of Election Year Year 8.60% 8.30% 5.90% 7.00% 8.50% 5.60% 5.80% 6.00% 5.70% 4.20% 2.90% ??? 7.80% 7.50% 7.40% 7.20% 5.40% 5.40% 5.30% 4.80% 4.30% 3.80% Result

Location, location, location: employment higher in key states

%
Only three of the eight battleground states, Nevada, Colorado, and Florida are above the national average of 7.8%

Obama Ford Carter H.W. Bush Reagan G.W. Bush Clinton Nixon Johnson Eisenhower Truman

2011-12 1975-76 1979-80 1991-92 1983-84 2003-04 1995-96 1971-72 1963-64 1955-56 1947-48

??? LOST LOST LOST WON WON WON WON WON WON WON
OH

12.1%
unemployment
----------------------

FL

8.8%
unemployment
----------------------

CO

8.2%
unemployment
----------------------

WI

7.5%
unemployment
----------------------

since Nov. 2010

1.1%

since Nov. 2010

1.3%

since Nov. 2010

0.3%

since Nov. 2010

0.4%

7.2%
unemployment
----------------------

VA

5.9%
unemployment
----------------------

5.7% NH
unemployment
----------------------

IA

5.5%
unemployment
----------------------

since Nov. 2010

0.9%

since Nov. 2010

0.3%

since Nov. 2010

0.4%

since Nov. 2010

0.1%

Democratic Governor

Republican Governor

Source: Bureau of Labor Statistics, Larry Sabato (UVA).

Source: Bureau of Labor Statistics, Goldman Sachs Global ECS Research.

Divided government = Tighter fiscal policy

Net federal savings as a % of GDP
1.5 Budget balance improves when government remains divided 1.5

Election affection
Global elections 2012-2013
Country Russia
1.0

Type Presidential Parliamentary Presid. (1 round) President Parliamentary Legisl. (1 round) Presidential Pres. & Leg. Legislative Legislative Presidential Pres. & Leg. Presidential Presidential Parliamentary Presidential Parliamentary Presidential

Date 4-Mar 10-Mar 22-Apr April April 10-Jun 30-Jun 1-Jul Sep. Sep. 7-Oct 6-Nov Dec. Feb. Apr. June 30-Aug Dec.

Share of World's GDP (PPP)* 3.00 0.16 2.78 0.65 0.36 2.78 0.02 2.09 0.44 0.44 0.47 18.87 1.95 0.36 2.34 1.09 5.59 0.38

GDP per capita (PPP)* 14,808 20,757 29,819 5,547 22,558 29,819 33,618 12,776 36,353 43,844 11,258 42,486 27,541 23,967 27,069 10,462 30,660 15,272

1.0

Slovakia France Egypt

0.5

0.5

Greece France Iceland

0.0

0.0

Mexico Austria Hong Kong Venezuela U.S. South Korea Czech Rep. Italy Iran Japan Chile

-0.5

-1.0

Cyclically adjusted net federal saving (change from presidential election quarter): Split Control to Single Party Control ('76, '92, '00, '08) Split Control Continued ('72, '84, '88, '96)

Budget balance deteriorates when a single party takes control

-0.5

-1.0

-1.5 -7 -6 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 +6 +7 +8

-1.5

* Figures through 2011, except Iran.

Source: Goldman Sachs Global ECS Research, Congressional Budget Office. Goldman Sachs Global Economics, Commodities and Strategy Research

Source: CEPSS-Elect. Guide; World Bank; Goldman Sachs Global ECS Research. 13