CIO WM Research

18 September 2012

US economy
Election Watch 2012 - Implications
• In this report, we sort through the likely outcome of the US election,
the potential impact on the economy and the implications for investors.
Katherine Klingensmith, strategist, UBS FS Jürg de Spindler, PhD, economist, UBS AG

This report was originally published in the US on 12 September 2012. This report has been customized for outside the US distribution. Related reports • 17 April 2012: Elections 2012: the risks beyond

• While the policy paths may not diverge as radically as some suggest,
there are still important distinctions that could create selective investment opportunities and risks.

• It is also important – particularly with an election so difficult to call
– to consider investments that are likely to perform well regardless of the victor. With the elections less than two months away, the outcome is still very much in question. However, based upon current polls and the electoral calculus, it would appear that President Obama will win a closely contested reelection, the Republicans will retain a comfortable majority in the House and the Democrats will hang on to the Senate by the very narrowest of margins. The policy issues • While the candidates present vastly different ideologies about the role and size of government, many of the policy outcomes ironically would be quite similar.

• 7 Feb: US elections: basic scenarios
Economic and market implications • Both Romney and Obama would have to address a slowgrowth economy and the ongoing pain of austerity measures. However, we think that a Republican administration could produce fewer and clearer regulations and more spending and tax reform, which could enhance growth prospects in the long run.

A Romney presidency could also bring greater uncertainty in the near term amid a more substantive realignment of the political balance, which could in turn lead to slower growth in 2013. A moderately better intermediate-term growth outlook, fewer regulatory threats and higher chances of long-term tax reform therefore paint a slightly more positive equity outlook under Romney. Republican leadership would likely eliminate or soften certain elements of reform for the Healthcare and Financial sectors. While some may wish to speculate about “winners and losers” based on the outcome of the election, we choose to focus on equity sectors, such as Technology and Consumer Staples, whose fortunes are less “outcome-dependent.” Interest rates are unlikely to be dramatically affected by the elections, though somewhat higher long-term growth could imply a sharper rise in bond yields. A credible commitment to deficit reduction targets of $4 trillion is probably sufficient to avoid another downgrade to the US government’s credit rating. Municipal bonds could be impacted by a potential increase in marginal tax rates as well as wholesale reform that subjects interest on state and local bonds to federal taxation. While the former would likely enhance the value of municipal bonds in general, the latter would create a two-tiered municipal market with a premium placed on “grandfathered” bonds.

• We think some sort of “grand bargain” that would cut deficits by
$4 trillion over the next 10 years is likely, regardless of who wins in November. Taxes would be part of such a deal, but under Republican leadership, broad-based tax code reform would be more likely.

• Policy differences are much sharper regarding specific elements of tax and fiscal reform as well as financial sector and healthcare policies. •

Election outcomes
A close contest, likely shaded more blue than red With the conventions now behind us and November 6 rapidly approaching, the 2012 election race has continued to tighten. The UBS US Office of Public Policy’s current base case scenario is that President Barack Obama will serve a second term in the White House, Republicans will retain control of the House with a comfortable majority and the Senate will remain Democratic by the narrowest of margins.

This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Please see important disclaimers and disclosures that begin on page 16. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

US economy

That said, the odds of both a Mitt Romney victory and Republican sweep of the House and Senate have increased amid a lift from the naming of Congressman Paul Ryan as running mate and continued weak economic data. Given how the electoral calculus works on a state-by-state basis, it would appear that the White House and Senate would both end up under control of the same party (both Republican or Democrat) following the November election (see Fig. 1). A less likely scenario at this point would be for a split government where the Democrats retain control of the White House while Republicans take the House and the Senate. But no matter the outcome of the election, we see virtually no chance that Republicans would lose the House or that either party would gain a 60-seat filibusterproof majority in the Senate. This suggests that we are much more likely to see a divided government following the November elections, rather than one in which a single party controls all the branches of power. History paints a mixed picture for the president Evidence suggests that economic trends and public approval ratings can be helpful in predicting an incumbent president’s likelihood of being elected to a second term. Our own analysis tends to bear this out, and suggests that two economic factors in particular were most closely tied to a successful bid for a second term: manufacturing momentum and job creation. The level of manufacturing activity as measured by the ISM Manufacturing Index and health of labor markets reflected in nonfarm payroll growth in the year of the election appear to have impacted the margin of victory or defeat of previous incumbents(see Fig. 2). The health of the economy over the next few months will therefore play a crucial role in determining the next president. The job approval ratings of sitting presidents have also been a fairly reliable indicator of an incumbent’s reelection success. What we found in our analysis was that the public approval ratings during the first three months of an election year were most helpful in determining a president’s reelection prospects: Keep in mind that no president with an approval rating below 50% during this period has ever been reelected. Obama’s approval during this period was just 48%. So, with an unemployment rate above 8%, an ISM index hovering just below the 50 mark and an approval rating now just above 50%, the president’s prospects for being reelected seem mixed at best. Keep in mind, however, that although the economic data would appear to work against the president, there are mitigating factors that might make simple historical comparisons less relevant. While the economic data remains weak, President Obama took office amid the deepest economic recession since the Great Depression. So although the unemployment rate remains well above the 7%threshold that some view as the critical level for reelection, the jobless rate has fallen from a high of 10% back in October 2009. It should be noted that President Ronald Reagan was reelected despite an unemployment rate above 7.5%.

“While economic data and approval polls would seem to favor the challenger, they may not fully reflect the critical factors that will ultimately determine the outcome of this election.” Fig. 1: Congressional seats by party affiliation House seats projected and current
17 23 23 28


3 191 Current 241


Democrat Leans Republican

Likely Democrat Likely Republican

Leans Democrat Republican

Toss up

Source: RealClearPolitics, as of 27 August 2012 (projected); Office of the Clerk of the U.S. House of Representatives, as of 27 August 2012 (current)

Senate seats projected and current
5 5 7 3 1






Democrat* Leans Republican

Likely Democrat Likely Republican

Leans Democrat Republican

Toss up

*Democratic count includes Joe Lieberman and Bernie Sanders, two Independents who caucus with the Democrats Source: RealClearPolitics, as of 27 August 2012 (projected); Office of the Clerk of the U.S. House of Representatives, as of 27 August 2012 (current)

Fig. 2: Job creation important for President Obama Incumbent party’s margin of victory/defeat, % of popular vote
25 20 15 10 5 0 2008 1980 1960 1992 1956 1996 2004 1948 2000 1952 1968 1976 1988 1964 1972 1984







Change in nonfarm payrolls, in % (Jan-Sep of election year, annualized)

Note: Red dot indicates predicted outcome based on 2012 annualized change through August. Source: Bureau of the Census, St. Louis Federal Reserve, UBS as of 7 September 2012.

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US economy

Election Snapshot
Democrat Independent / undecided 29%
Source: Gallup poll, 12 August 2012

Republican 15% 26%

The US Elect orat e
15% 15%

270 Electoral votes needed to win
The Elect oral College Current 2012 projection
270 votes needed to win
Source: Data from RealClearPolitics, as of 11 September 2012






221 Obama
Democratic Leaning Democratic

126 Toss Up
Independent / undecided

Romney 191
Leaning Republican Republican

President Barack Obama Approval on Issues (Gallup poll, 12 August 2012) Do you approve or disapprove of the way Barack Obama is handling _____?

Approve Disapprove Not sure

Follow t he money
Obama Romney



38% 43% 49% 54%
587.7 524.2 502.8 395.1







36% 60% 64%


Cash on hand

Creating jobs

The economy

The federal budget de

Note: Figures are in millions of US dollars. Totals include money raised and spent through July by the presidential candidates, the national parties, and the primary ACs ( for Romney).

Source: Data from the New York Times, as of 31 July 2012

The Nat ion State-by-state breakdown of 2012 Electoral College projection
VT 3 WI 10 ME 4 MI 16 IN 11 KY 8 TN 11 MS 6 AL 9 GA 16 OH 18 PA 20 WV 5 VA 13 NC 15 SC 9 NY 29 CT 7 NJ 14 DC 3 NH 4 MA 11 RI 4 DE 3 MD 10

WA 12 OR 7 ID 4

MT 3

ND 3 SD 3 NE 5 CO 9 KS 6 OK 7

MN 10

WY 3 UT 6

IA 6 MO 10 AR 6 LA 8

NV 6 CA 55

IL 20

AZ 11

NM 5

TX 38 AK 3

Democratic Leaning Democratic
FL 29

HI 4

Toss up Leaning Republican Republican

Source: Data from RealClearPolitics, as of 11 September 2012

UBS CIO WM Research 18 September 2012


US economy

Standard approval ratings may also turn out to be less reliable than in the past given instant access to information, the increased polarization of the two parties and an everlarger portion of the voting public that identifies itself as independent. Given how the electoral map shakes out, this election will likely be decided by the swing voters in just 10 states (Colorado, Florida, Iowa, Michigan, Nevada, New Hampshire, Ohio, Pennsylvania, Virginia and Wisconsin). President Obama currently leads Governor Romney in six of those states, is tied in three of them and trails in only one. So while economic data and approval polls would seem to favor the challenger, they may not fully reflect the critical factors that will ultimately determine the outcome of this election. It is therefore our view that President Obama will be reelected President – albeit by a narrow margin.

"Virtually everyone in Washington wants to see some sort of change to personal taxes, especially given that the Bush tax cuts are set to expire in 2013.”

Election issues
The legislative agendas under Democrats or Republicans The Democratic and Republican parties are advancing decidedly different visions for the future role of the government; however, we think that many of the policies would actually only be different at the margin under either an Obama or Romney administration. Keep in mind that even with a Republican sweep, the large minority of Democrats in the Senate would make bipartisan support necessary for any major policy changes. Although opinions vary, our own discussions with economists and policy analysts suggest a bipartisan fiscal deal that includes reductions in deficit spending and some changes to the tax code is likely under either candidate. A Romney administration is more apt to achieve fundamental tax reform and potentially some long-term reforms to entitlement programs, such as Medicare. However, energy policies would likely be similar under either candidate, with both looking to promote natural gas production. Recent healthcare and financial regulations would admittedly be vulnerable under a Republican sweep, but probably not as much as the campaigns would have voters believe. The fiscal cliff and the debt ceiling The most immediate challenges facing the president and Congress after the election will be addressing the fiscal cliff and raising the debt ceiling. January 2013 will see four major fiscal initiatives expire and soon thereafter yet another potential showdown on the debt ceiling (see Fig. 3). If Congress fails to renew or replace these measures, taxes will rise and US government spending will contract sharply (see our June 26, 2012 publication, No US fiscal cliff, but beware the pothole). Our view remains that a crisis likely will be avoided. However, if Republicans do take both the White House and the Senate, sitting Republicans may simply refuse to make a deal during the “lame duck” session. While we expect the Bush tax cuts to be temporarily extended, automatic spending cuts to be avoided and the debt ceiling to be raised under either electoral scenario, the payroll tax holiday will likely expire and emergency unemployment benefits will likely be phased out. A grand bargain? Following an increasingly familiar high-stakes game involving threats of sequestration and/or a government default, reductions in deficit spending could materialize under Democratic or Republican leadership. President Obama’s second term could well resemble President Clinton’s, with a shift toward the center. We think a deal under Obama could result in up to $4 trillion in deficit reduction over the next 10 years, comprising a spending cuts/revenue increases ratio of potentially 3 to 1. This would likely include deficit reduction measures that would replace the discretionary spending caps and the across-the-board spending cuts currently on the books (i.e., sequestration). While Democrats have insisted and will continue to insist upon increases in tax revenue, expenditure reductions are still likely to be the bulk of any major fiscal deal.
UBS CIO WM Research 18 September 2012 4

Fig. 3: US debt poised to hit limit soon US statutory debt limit and public debt level, in trillions of US dollars

Source: Bloomberg, UBS, as of 5 September 2012

US economy

Under a Republican sweep, the size of the package would be roughly similar, but spending cuts could exceed revenue increases by a ratio of 4 to 1. Such reforms would likely be inspired by Representative Ryan’s proposals, including some long-term changes to large social safety net programs. The reforms would be limited, in part, because of the Republicans’ narrow majority in the Senate as well as the political challenge of cutting such popular programs. A Republican Congress would likely be forced to use the reconciliation process to achieve such spending cuts, since this process would require only a majority vote in the Senate and thus avoid the threat of filibuster. Reconciliation can generally be used for legislation that has an impact on government spending or revenues with some limits. Personal tax reform comes into focus Virtually everyone in Washington wants to see some sort of change to personal taxes, especially given that the Bush tax cuts are set to expire in 2013. A Democratic White House is unlikely to pursue major reforms, but rather would work to extend the Bush tax cuts for all but the highest earners. This would likely affect households earning over $1 million dollars annually, but the threshold could be set even lower, depending on revenue needs and projected spending cuts (see Fig. 4). Tax reform likely would be an early focus under Republican leadership, although implementation would prove difficult. Romney would likely seek to reduce personal income tax by 20% for all brackets relative to the preBush levels; however, identifying the deductions required to offset the loss in revenue would be challenging. The UBS US Office of Public Policy has a high conviction that the final outcome would be at least as progressive as the current tax code, since most deductions are currently disproportionately enjoyed by the wealthy. However, major tax reform is politically challenging and takes careful study and analysis given the potential impact on certain critical sectors of the US economy as well as the almost certain opposition by entrenched special interests. It is only likely to be achieved if Congress initiates a serious process to remedy these challenges in a comprehensive manner, since a last-minute deal and/or piecemeal approach cannot address the complexity of the tax code. Deductions: very few sacred cows All deductions are vulnerable under either party’s leadership, especially in the event of comprehensive tax code reform. Among the most likely changes are both the elimination of second-home mortgage interest deductions as well as the reduction in the size of a primary mortgage from which interest can be deducted. Municipal bond tax exemption is another likely target. However, it is still unlikely to be completely eliminated and interest on existing bonds would be grandfathered in under the existing tax rules, in our view. The most sacrosanct and therefore the least vulnerable deductions are the defined contributions to qualified retirement plans. Only modest changes to capital gains and dividends Under either political alignment, but especially under Republican leadership, capital gains and dividends are unlikely to be taxed as ordinary income. However, the rate could rise from the current 15% to as high as 25% in a second Obama administration – once the additional 3.8% tax on unearned income for high earners mandated by the Affordable Care Act (ACA) is included. Romney, on the other hand, would seek to maintain both dividend and capital gains rates at the current 15% level.

Fig. 4: Marginal income tax rates at historic lows Top marginal federal income tax rate, in %

Source: Internal Revenue Service, UBS, as of 30 August 2012

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US economy

Corporate tax reform likely in either scenario Corporate tax reform appears to be a goal, of both parties – albeit a challenging one. US statutory rates are high relative to the rest of the world (see Fig.5). However, US corporations don’t pay higher effective rates, nor have these effective rates gone up over time, as many take advantage of loopholes and companies have increasingly taken advantage of lower tax rates outside the US. Reform is challenging precisely because so many firms have been structured around these loopholes. Corporate taxes are likely to be reduced under either party’s leadership, with a goal of a 25% rate, although something closer to 30% is probably more feasible. Democrats would look for some revenue enhancement and would be more willing to close many loopholes. On the other hand, Republicans would seek a revenue-neutral proposal. Pass through entities such as S corporations, MLPs and REITs with more than $50 million in revenue could be at some risk of facing corporate income tax, especially under an Obama administration. A one-time reduction in the tax rate on the repatriation of overseas corporate cash is likely – but only as part of a broader tax deal. Healthcare reform in jeopardy While it should come as no surprise that the ACA would remain largely untouched under a second Obama administration, we believe significant components of the law could be modified by a Romney administration and Republican Congress. Republicans would try to use the congressional reconciliation process to repeal the individual mandate and block the expansion of Medicaid. Additionally, a Romney administration may be much more inclined to grant waivers exempting states from establishing insurance exchanges. Given the breadth and complexity of the law, it is unlikely that it would be entirely repealed and there may be substantial uncertainty for some time. In addition, Medicare reimbursement cuts would be likely under any budget deficit reduction initiative. However, comprehensive entitlement reform is more challenging, in light of the need to reach 60 votes in the Senate. Cheap natural gas, not politicians, driving energy Campaign rhetoric suggests a bigger difference in policy than is actually likely to materialize in the Energy sector. Under either Obama or Romney, natural gas extraction through hydraulic fracturing (fracking) is likely to expand and the Keystone Pipeline is likely to be approved. Obama could push for regulations that encourage alternatives to carbon-intensive fossil fuels, promoting green and renewable energy, but would likely only achieve policies with small price tags. Alternatively, Republicans could reduce or simplify some environmental regulations and facilitate on and offshore drilling. Wind power subsidies could continue despite the election outcome given that GOP-leaning states are major wind power producers. Coal usage could face incremental pressure under an Obama reelection, but a Romney EPA will likely not roll back the coal regulations that have been put in place over the last four years. We see the nuclear industry as being largely unaffected by the election. Financial regulation could lighten If Obama returns to the White House, Dodd-Frank likely will be fully implemented. But even under a Romney administration, Dodd-Frank would also remain largely intact – although certain measures could be revised in the all important rule-making process. If Romney wins, regulations that have not been finalized before the election may be subject to a more industry-friendly interpretation. Of note, the Volcker rule, which limits proprietary trading at large banks, will not likely be finalized before the election and a Romney administration could pursue a more industry-friendly interpretation of this rule. The Basel capital accords which regulate bank capital levels could potentially also be applied more leniently.

Fig. 5: US corporations face higher statutory rates than peers Total corporate tax rate, including provincial and central government, in %

Source: Organization for Economic Co-operation and Development (OECD) Tax Database, UBS, as of 1 April 2012

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US economy

Economic implications
Large fiscal drag regardless of election outcome While the political messaging on the campaign trail suggests fundamentally different economic policies, we expect the differences between a second Obama administration and a Republican sweep are likely to be much more subtle. The four areas that we focus on are 1) the size of the deficit reduction package; 2) the composition of that package; 3) the level of policy uncertainty; and 4) the degree of regulation. Both candidates would have to contend with the same high de cits, entrenched entitlements and overall slow-growth environment. We expect that a deficit reduction plan emerging from either political scenario would come at substantial cost to GDP growth – either now or in the future. But foregoing deficit reduction risks an even bigger crisis down the road. However, we conclude that a Romney victory may lead to slightly lower growth in 2013 but higher growth in the years thereafter, relative to an Obama victory. Deficit reduction similar size under either party We envision deficit savings of up to $4 trillion over the next 10 years under either party’s leadership. This assumes an additional $3 trillion in deficit reduction beyond the nearly $1 trillion of savings in the form of spending caps agreed upon during the debt ceiling negotiations of 2011, but in lieu of sequestration, triggered by the Budget Control Act, or BCA. While $4 trillion may sound like a large number, the deficit projections would still not bring the US budget into balance anytime in the foreseeable future (see Fig. 6). However, this level of savings would at least begin to stabilize debtto-GDP levels over the next decade. The Congressional Budget Office (CBO) shows that under a continuation of current policy, deficits would improve from an estimated 7.7% of GDP in 2012 to about 5% by 2018, and then begin to deteriorate again thereafter. Savings of $4 trillion,1 spread evenly across 10 years, would lower the deficit to about 3.5% by 2018, with a subsequent deterioration thereafter. These cuts would therefore significantly improve debt sustainability relative to current policy, largely stabilizing the debt-to-GDP ratio close to current levels over the next decade (see Fig. 7). However, without significant reform, the rising cost of Medicare will drive an increase in debt-to-GDP levels beginning in the latter part of the decade. While Republican leadership may be more likely to implement some entitlement reforms, deeper cuts would subsequently be necessary to bring the programs into balance. Importantly, this level of deficit reduction would likely be enough to avert another US credit rating downgrade in the near term, while a smaller package of deficit cuts, or one that only promises to make cuts in the future, could prompt further credit rating downgrades. Small difference in composition of deficit reduction Based on their respective political preferences, we expect that the composition of a fiscal package would differ moderately under Democratic or Republican leadership. In the status quo scenario, we expect the ratio of spending cuts to revenue increases to amount to 3 to 1, compared to a 4 to 1 ratio under a Republican victory. These distinctions are likely too small to imply a materially different economic growth outlook. The International Monetary Fund (IMF) estimates that spending cuts have a larger drag on the economy than revenue hikes. Assuming for simplicity and illustration purposes that fiscal restraint starts in 2012 and is spread evenly over 10 years, we estimate that a 3 to 1 spending-to-revenue ratio would reduce real GDP by 2.1%, and 1.5% in the first and second year, respectively. Under a 4 to 1

“Polarization and gridlock in Congress have added to the sense of uneasiness among businesses and consumers that has discouraged hiring, investing and spending.”

Fig. 6: Grand bargain doesn’t drastically change projections Federal budget projections under different scenarios, in % of GDP

Note: The "grand bargain" is approximately 4 trillion US dollars in deficit savings. The CBO projection is from its extended alternative scenario, which is based on current policy and includes the savings from the discretionary spending caps from the Budget Control Act of 2011. Source: CBO, UBS, as of 29 August 2012

Fig. 7: Debt-to-GDP would stabilize with a grand bargain Federal debt held by the public under different scenarios, in % of GDP

Note: The "grand bargain" is approximately 4 trillion US dollars in deficit savings. The CBO projection is from its extended alternative scenario, which is based on current policy and includes the savings from the discretionary spending caps from the Budget Control Act of 2011. Source: CBO, UBS, as of 29 August 2012

USD 3 trillion in addition to the assumptions embedded in the CBO scenario.
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US economy

ratio, these figures would be insignificantly higher at -2.3% and -1.6% (see Fig. 8). In practice, political realities and the business cycle would probably make these cuts more back-end loaded but the relative impact under both scenarios should be similar. The key takeaways are that: 1. The fiscal restraint necessary to stabilize public debt ratios implies a significant drag on the economy in the coming years unless the deficit cuts are weighted toward the end of the decade. 2. A greater focus on spending cuts will have a stronger adverse impact on growth, but not significantly so. Policy uncertainty Economic policy uncertainty has been abnormally high since the financial crisis first broke. Polarization and gridlock in Congress have added to the sense of uneasiness among businesses and consumers that has discouraged hiring, investing and spending. In our recent Exchange publication focused on the upcoming election, industry experts discussed how this heightened uncertainty about everything from the tax code to the ability of the US to pay its debt has been detrimental to confidence and a drag on growth. This can be illustrated with the US Economic Policy Uncertainty Index2 (see Fig. 9), which has remained elevated since 2008. It is our view that a Republican sweep would allow for a greater political mandate that would ultimately reduce policy uncertainty. However, the first year of a Republican administration may actually see a spike in uncertainty, as the GOP is likely to attempt to overturn or revise previous legislation and embark on its own reform agenda. After this period of more heightened uncertainty, we expect the policy environment would become less volatile and uncertain than it has been in the past few years. Considering only this difference in uncertainty and relying on our estimates of the impact of uncertainty on GDP growth,3 we believe economic growth under a Romney administration would be 0.3% lower in 2013 but then 0.6% faster in 2014 vs. the Obama reelection scenario. These differences – while not extreme – do suggest that the election results will have some impact on both current and longer-term growth prospects. Regulatory burden The last aspect that is likely to distinguish between political scenarios is the amount of government regulation. We assume that under a Romney administration a lighter approach to regulation would ultimately prevail. We estimate that in 2014, the level of regulation might revert halfway to pre-crisis level. This may amount to a 0.2% boost to GDP growth in that year.4

Fig. 8: GDP suffers under austerity regardless of party First and second year impact of Grand Bargain on real GDP growth

Note: Ratios computed assuming that fiscal restraint starts in 2012 and is spread evenly over 10 years. Source: IMF Fiscal Monitor April 2012, UBS as of 7 September 2012.

Fig. 9: Policy uncertainty remains elevated postLehman US economic policy uncertainty index, standardized

Note: The indexes are standardized and have a mean of zero and a standard deviation of one. Source:, UBS, as of 29 August 2012.

The index was created by Baker, Bloom and Davis. See for more info. 3 We estimate that a sustained one standard deviation increase in the US EPUI curtails US real GDP growth by 0.6% after four quarters, as businesses and households pare back on their spending if they feel less certain about the economic and policy outlook. We assume that a Republican-dominated administration would lower the US EPUI halfway back to pre-crisis levels in year 2014 (a one standard deviation decline), while increasing uncertainty by half that amount in year 2013 (half a standard deviation increase), whereas under an Obama administration, uncertainty would be largely unchanged. 4 See UBS research focus, “The financial crisis and its aftermath,” March 2009, for estimates of the impact of regulation on economic growth. We assume that the Fraser Institute Economic Freedom Index’s regulation subcomponent corrects halfway back to its pre-crisis level under a Republican sweep scenario, but stays constant under an Obama victory.
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US economy

Market implications
Elections don‘t radically alter market outlook The market ramifications of policy decisions made over the next several years will be widespread and, in some cases, very important. However, we do not think that whoever controls the White House will radically alter the course of financial markets in general. Asset allocation implications at the broad asset class level will therefore likely be limited. However, equities are poised to perform somewhat better under a Republican administration, while bonds may come under greater pressure – especially after the first year. If there is indeed a major fiscal deal, US Treasuries will retain their current ratings. Municipal bonds run a not insignificant risk of losing their tax-exempt status, regardless of who is in power. Implications for municipal bond holdings will depend on how broad the application of such a change would be, and whether existing bonds would retain their tax-free status.

“The economic outlook under either election outcome is fairly similar and therefore earnings growth rates should not differ greatly under Romney or Obama. But there could be differences in equity market valuation multiples.” Fig. 10: Low valuation behind outperformance under Democrats

Equity markets
Fundamentals matter more than party control Average annual US equity market returns have been higher under Democratic presidents since 1928. But we also found that Democrats tend to take office when stock market valuations are lower, which we believe is the primary factor that explains the moderate outperformance (see Fig. 10). With less than two months remaining before the election, numerous historical “facts” (most lacking statistical relevance) will be bandied about regarding the relationship between elections and the stock market. The most well documented thesis is that stocks perform best in the second half of presidential terms as incumbent administrations promote pro-growth policies in order to improve their chances of remaining in power. Keep in mind that while “on average” stocks have historically performed better in the twoyear period that includes the presidential election, the sample size that goes back 84 years is still relatively small (21 data points per year of election cycle), and the premise has not been validated by the past two presidential cycles (See Fig. 11). While this type of analysis makes for fun cocktail party conversation, it tends to grossly oversimplify the investing landscape. We believe a better approach is to determine the outlook for corporate earnings and market valuations, i.e., core equity market fundamentals. As we describe above, the economic outlook under either election outcome is fairly similar and therefore earnings growth rates should not differ greatly under Romney or Obama. But there could be differences in equity market valuation multiples as we describe below. Obama victory – limited impact An Obama victory would more or less be a continuation of the status quo and therefore not likely alter our current stance on US equities, which we believe are close to fair value. Over the last four years, P/E multiples have averaged about 13x forward estimates, lower than the long-term average of 14.5x. We believe this valuation discount is a reflection of uncertainty about the longterm sustainability of US government debt dynamics, greater-than-normal threat of regulatory changes, consumer deleveraging, demographics and other factors that constrain economic growth and increase uncertainty. In an Obama second term, most of the factors that are weighing on equity market valuations will continue to linger. However, there could be some progress on budget sustainability although long-term entitlement reform is challenging. Romney victory – a modestly higher P/E A Romney victory could be mildly supportive for US equity markets. Policy uncertainty could increase in the near term; however, once the fiscal cliff
UBS CIO WM Research 18 September 2012 9

Note: Historical analysis begins in 1928. Source: FactSet, Office of the Clerk of the U.S. House of Representatives, Robert Shiller, UBS , as of 6 September 2012

Fig. 11: Stock market election cycle has not worked recently S&P 500 returns by year of presidential term

Source: Bloomberg, Ibbotson, UBS as of 10 September 2012

US economy

is behind us and Republicans have left their mark on tax, financial and healthcare reforms, uncertainty should decline. Looking ahead a bit further, we believe a Romney administration may be able to achieve some long-term and marginal entitlement reform, likely more than under a second Obama term. However, a Romney administration would still have to address many of the same secular challenges, such as consumer deleveraging, demographics and the pain of fiscal austerity. But given our view that a Romney administration will be able to achieve some long-term fixes to personal and corporate income taxes and greater regulatory clarity, even with a rocky transition and potentially some growth slowdown in 2013, we believe equity market valuation multiples have a greater potential to improve in this scenario. Separating rhetoric from reality While economic policy may not be that different under an Obama vs. a Romney administration, there are still a number of areas where specific policies would vary. The policy agendas presented in the campaign may indeed be curtailed by a near evenly divided Senate, but whichever party controls the White House will be able to pursue and implement at least some changes. Dividend and capital gains taxes Under an Obama reelection scenario, we expect only a modest increase in dividend tax rates to 20-25%. A Romney victory could result in no change to current dividend tax rates (15% for qualified dividend income). Historically high valuations of the highest-yielding sectors of the market (Telecom and Utilities) would be vulnerable if dividend income tax rates were to rise. However, an increase in dividend tax rates under an Obama White House will likely be accompanied by an increase in ordinary income rates for the highest earners as well, which means that dividend yields may not lose their tax advantage relative to fixed income investments. Capital gains tax rates are scheduled to rise to 20% next year (from 15%), a level that is likely under an Obama victory. As a result, there could be some year-end profit taking in stocks that have performed well. A Romney administration would likely be able to achieve an extension of the 15% capital gains tax rate, mitigating this risk. Corporate tax reform: lots of moving pieces Any corporate tax reform will likely have to be at least revenue-neutral, which means that a lower tax burden for some industries has to be offset by higher taxes for others, creating winners and losers (see Fig. 12). One big ticket item that lawmakers would likely include as part of a larger tax reform, especially under a Romney win, is a one-time reduced tax rate on the repatriation of overseas income. While this would be modestly positive for Technology, Industrials, Pharmaceuticals and select Consumer Staples companies, there will be intense scrutiny around how companies deploy this cash, and management teams will have to be careful about distributing too much of this to shareholders. In addition, the quid pro quo for this onetime tax holiday will likely be restrictions on transferring intellectual property to overseas subsidiaries in locations with lower tax rates, which may be a modest negative for many Technology and Pharmaceutical companies. Finding opportunities regardless of the election outcome Not surprisingly, industries would likely face more change under a Romney administration rather than a second Obama term, as a new president tries to roll back some of the reforms put in place over the last four years and implement his own policy agenda. Therefore, in the run-up to the election, investors in Healthcare and, to some extent, Financials, will once again contend with some policy uncertainty. As the election is still a very close call, we recommend investors focus on sectors that are well-positioned regard-

Fig. 12: Corporate tax burden in line with historical average Corporate tax receipts as a share of GDP, in %

Source: Office of Management and Budget, UBS , as of 6 September 2012

Fig. 13: Current US sector strategy Tactical deviations from benchmark

Source: UBS, as of 6 September 2012

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US economy

less of the election outcome. Within cyclicals we highlight the Technology sector (low valuations, product cycle visibility, and strong balance sheets). Consumer Staples (dividend growth, emerging market consumer exposure) is our preferred defensive (see Fig. 13). In Fig. 14, we summarize the potential impact on all sectors of an Obama or Romney victory. Fig. 14: Sector implications of potential election outcomes
Impact Financials Medium/ High Obama vict ory · Small risk that quasi pass-through entities, such as REITs, will incur corporate tax, depressing earnings and valuations Romney vict ory · Reduced risk of regulation/threats of legal action, more industry-friendly interpretation of nancial regulations and potential scale back of rules to limit proprietary trading could li the current low valuations of large banks and brokers · Threat of additional regulation removed for coal- red generators · Potential bene t from extension of low dividend income tax rates

Ut ilit ies


· Some risk of lower industry valuations due to higher dividend tax rates · Wind power generators bene t from extension of subsidies beyond 2012 · Coal- red generators face further potential restrictions

Healt hcare


· Pharma bene ts from repatriation tax holiday but tax reform may limit ability to book pro ts in nonUS, low tax jurisdictions going forward

· Overall slightly negative for the sector · Healthcare product companies such as pharma, biotech, medical equipment hurt by lower volumes (less insurance coverage) and government reimbursement cuts · Managed care companies bene t from less regulation and move toward privatization of Medicare/Medicaid although possible government reimbursement cuts could hurt · Pharma bene ts from repatriation tax holiday but tax reform may limit ability to book pro ts in non-US, low tax jurisdictions going forward · Streamlining of drilling permits could bene t E&P and oil eld services companies · Coal mining companies bene t from lower threat of additional regulation on coal usage · Cable companies could bene t if allowed to prioritize internet traf c (scale back internet or net neutrality) at the expense of content owners · Modest possible bene t from repatriation tax holiday



· Small risk that quasi pass-through entities, such as MLPs will incur corporate income tax, depressing earnings and valuation

Consumer Discret ionary


· Homebuilders could bene t from possibly more aid to underwater homeowners

Consumer St aples Indust rials


· Modest possible bene t from repatriation tax holiday · Defense contractors hurt by continued defense spending reductions · Modest possible bene t from repatriation tax holiday · No signi cant changes likely


· Somewhat smaller defense spending reductions · Rails could bene t from less pressure on coal and threat of regulation · Modest possible bene t from repatriation tax holiday · Possible reduction to ethanol mandates could lead to reduced corn and fertilizer demand · Cuts in government spending could hamper Tech demand · Could bene t from repatriation tax holiday but tax reform may limit ability to book pro ts in non-US, low tax jurisdictions going forward · Could bene t from government green light on wireless industry consolidation · Pricing may improve if allowed to prioritize internet traf c (scale back net neutrality) · Potential bene t from extension of low dividend income tax rates

M at erials




· Could bene t from repatriation tax holiday but tax reform may limit ability to book pro ts in non-US, low tax jurisdictions going forward



· Some risk of lower industry valuations due to higher dividend tax rates

Source: UBS, as of 11 September 2012

UBS CIO WM Research 18 September 2012


US economy

Financials Most of the changes we expect under a Romney administration, as laid out in “Election issues” section, would have only a modest impact on Financial sector earnings, but there could be notable valuation expansion, especially for the large banks and brokers which are trading at historically very low valuations (see Fig. 15), based on an improvement in the regulatory environment. These companies represent nearly 40% of the sector. Insurance companies (25% of the sector) would be largely unaffected, but there could be a “halo effect” that also boosts valuations for this industry. With the status quo largely maintained under an Obama victory, the sector would likely be unaffected if Obama wins reelection. Healthcare Contrary to consensus thinking, we believe a Romney victory would be slightly negative for the sector. The product companies (pharmaceuticals, biotech and medical devices), which comprise 80% of the market cap of the sector, would suffer from fewer Americans with medical insurance coverage and possibly lower government reimbursements (see Fig. 16). This would be somewhat offset by a higher valuation multiple due to less government regulation and a tax holiday on the repatriation of overseas cash. Furthermore, there is a small chance of Medicare eligibility changes that would reduce benefits in the long term. On the flip side, a Romney victory would be positive for the managed care industry, which represents about 10% of the sector. These companies would likely benefit from incentives for individuals to move to privately managed Medicare and Medicaid plans. Repeal of the individual mandate would translate into less growth for the commercial insurers, but we believe the market is skeptical of the profitability of this incremental business anyway. An Obama reelection would not have much impact on the sector as the status quo is maintained. Energy and power Despite the rhetoric, the divide between the two candidates on energy policy is actually quite narrow. Rather than policy, the sector is being reshaped by cheap natural gas, which we expect to continue under either candidate. On the margin, a Romney victory could boost sector valuations due to the perception that a new administration would be more supportive of the industry and could pave the way for slightly faster domestic drilling over time. Coal miners would probably also get a boost as the threat of further regulation diminishes. An Obama victory would not likely have a major impact on the sector, although coal mining shares could come under some pressure over fears of further restrictions on coal usage, and wind power generators could benefit from expansion of renewable power mandates. MLPs and REITs will face more scrutiny While not our base case, we believe there is some risk that MLP and REIT income (and other quasi pass-through entities) could become subject to corporate income tax as the government looks to raise revenue while reducing corporate tax rates. As a result, these securities could come under substantial selling pressure. This scenario has up to a 20% probability under an Obama victory with slightly lower odds under a Romney win. Once again, this is not our baseline view. However, given its potential significant impact on investors, we will be monitoring this issue very closely.

Fig. 15: Increased regulation has weighed on Financials valuation Relative price-to-book ratio of Financials vs. the market

Source: Thomson Datastream, UBS, as of 1 September 2012

Fig. 16: 80% of sector negatively impacted by ACA repeal Share of Healthcare sector, as % of market cap

Source: FactSet, UBS, as of 6 September 2012

UBS CIO WM Research 18 September 2012


US economy

Fixed income
Treasuries: not election-dependent in the near term Election results, while important over the long run, are less likely to drive yields in one direction or another. We expect economic fundamentals in the US and developments in Europe to determine the general direction of Treasury yields in the near- to medium-term. The fiscal cliff poses the most significant risk to this forecast as a failure to negotiate a political compromise may yet trigger another economic recession. The second main event risk is the extension of the debt ceiling, which could lead to technical default if the statutory borrowing limit is not increased. (see Fig. 3). However, we expect a satisfactory deficit reduction package and an increase in the debt ceiling regardless of the outcome of the election. Any signs of economic normalization could lead to an eventual tightening of Federal Reserve policy, consistent with our expectation for marginally higher yields over a 6- to 12- month horizon. To the extent GDP growth may be lower under Romney in 2013 but higher in 2014, a Romney victory may keep downward pressure on yields at first but then lead to a somewhat sharper rise thereafter. Longer term, however, the size of the federal budget deficit and elevated levels of debt-to-GDP should exert a powerful influence on yields – particularly as the cost of funding increases when growth picks up, as we expect. In the absence of credible longer-term fiscal reform, an additional credit risk premium has the potential to be built into Treasury yields, in light of the risk of future credit rating downgrades. This could contribute to Treasury yield levels that are considerably higher than current levels in the years ahead. However, a lack of viable safe haven alternatives would still serve to limit the magnitude of any repricing on credit concerns alone. And if a credible fiscal plan is indeed put into place, it would also prevent any such sizable uptick in yields. Rating agencies taking a wait and see approach S&P’s much publicized US sovereign credit rating downgrade in August 2011 initially triggered substantial consternation among market participants. Since then, Moody’s, S&P and Fitch have maintained a negative outlook on their Aaa/AA+/AAA ratings, respectively. A negative outlook represents the possible ratings path over the intermediate term, whereas a credit watch or review reflects prospects in the near term. We expect the agencies would first move from a negative outlook to a negative credit watch before changing the rating. While it is difficult to precisely identify when any of the rating agencies will act, all three have intimated that they would be in a position to alter their outlooks in mid-2013 to early 2014. As it relates to fiscal reform, the rating agencies are taking a wait-and-see approach over a horizon that spans the presidential election and subsequent lame duck session of Congress (see Fig. 17). All three agencies agree that some form of deficit reduction package in excess of last year’s Budget Control Act (BCA) is likely and have largely built this into their base case fiscal outlooks. We believe that a $4 trillion deficit reduction package is likely to placate the rating agencies for now, but still result in warnings about the long-term outlook and the commitment to control deficits. Political brinkmanship could yet threaten current credit ratings in the near term, especially as it relates to a potential showdown in raising the debt ceiling in early 2013. Over the longer term, US sovereign ratings could be at risk if debt/GDP ratios are not deemed to be within acceptable limits, which would likely necessitate more significant entitlement reforms. GSE reform not likely Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have been in government conservatorship since September 2008 and have received $188 billion in cash from the US Treasury in order to keep

“Longer term, the size of the federal budget deficit and elevated levels of debt to GDP should exert a powerful influence on yields – particularly as the cost of funding increases when growth picks up, as we expect.” Fig. 17: US sovereign rating agency outlooks

Source: Moody’s, S&P, Fitch, UBS as of 6 September 2012

Fig. 18: Market assigning little value to taxexemption Treasury, municipal, and corporate yield curves, in %

Note: GO stands for general obligations. Source: Municipal Market Data, Bloomberg, UBS as of 4 September 2012

UBS CIO WM Research 18 September 2012


US economy

the companies afloat. Since that time, no piece of reform legislation has made progress in Congress. The most significant changes were recently announced in August and seek to expedite the wind-down of the GSEs. This includes an accelerated permanent liquidation of their retained mortgage portfolios, submission of an annual plan to reduce taxpayer exposure to mortgage credit risk and turning over an future earnings to the Treasury. While the prospects for GSE reform could be higher under a Republican sweep scenario, we don’t believe any substantive reform will take place in 2013, as deficit reduction and tax reform will dominate the political agenda. Neither Obama nor Romney has expounded a specific view for the GSEs. Moreover, the recent announcement that GSE profits will be returned to taxpayers helps to bide additional time by enhancing the perceived safety of GSE debentures and mortgage-backed securities. This was noted by Fitch’s statement: “Absent a near-term requirement for more Treasury capital contributions to Fannie and Freddie, we believe pressure in Congress for a major overhaul of the agencies’ operations will be reduced.”5 Municipal securities: tax exemption at risk? While legislative initiatives to reduce or eliminate municipal bond tax exemption surface in Congress every few years, the proposals o en lacked widespread support. We now expect policymakers to target municipal tax exemption after the presidential election as part of comprehensive tax reform. Both Democratic and Republican members of Congress have expressed interest in reducing the value of tax preferences and deductions as a means of increasing revenues – and municipal bonds are unlikely to escape closer scrutiny. In our view, the municipal bond exemption is likely to be among the tax expenditures targeted by Congress for a variety of reasons (see Fig. 17). First, we believe the size of the implicit subsidy is significant enough to warrant closer scrutiny. Tax exemption ranks 12 out of the top 16 federal tax expenditures over five years at roughly $178 billion, according to the staff of Joint Committee on Taxation. Second, the public interest groups in Washington, such as the Government Finance Officers Association and the National League of Cities, exert less political influence than they once did. Third, according to the Internal Revenue Service (IRS), of the US households earning more than $200,000 that paid no taxes in 2009, more than 60% reported that tax-exempt interest was the primary reason. Finally, representatives in both parties have expressed skepticism regarding its utility value. Elected officials on the left have noted that the financial benefit skews toward the affluent investor, while their opponents on the right may see the tax preference as one that promotes borrowing and local government indebtedness. We expect a robust debate regarding municipal tax exemption in 2013 within the broader context of tax reform. The debates will create headwinds for the municipal bond market as investors attempt to sort out the impact of partisan negotiations on their investment portfolios. While it is still early in the process, and therefore too soon to be absolutely certain of the outcome, we do not expect the treatment of interest on outstanding bonds to be affected. Retroactive taxation is never popular with members of Congress. However, we do believe that Congress will impose some restrictions prospectively. The limitations can take any number of forms. For example,

“In our view, the municipal bond exemption is likely to be among the tax expenditures targeted by Congress for a variety of reasons.”

FitchRatings. “Improved GSE results may ease push for immediate reform,” 13 August 2012.

UBS CIO WM Research 18 September 2012


US economy

the sale of new tax-exempt bonds may be limited to just a few public purposes. Alternatively, tax-exempt interest on newly issued bonds may be taxed but at a lower marginal rate than earned income. A third option, the provision of direct federal subsidies toward the payment of debt service, was successfully tested by the Build America Bonds program. To the extent any of these options plays out, we would expect pre-existing municipal bonds to outperform other fixed income asset classes on the basis of scarcity value alone. The outcome could go one of two ways. Grandfathering outstanding bonds in conjunction with the imposition of new limitations should produce a rally as long as these bonds retain a relative tax advantage to other asset classes. Retroactivity, which we believe is far less likely, is more of a mixed bag. Provided the tax imposed on municipal bonds is relatively low, the tax advantage of municipals is preserved but the benefit is reduced. We do not recommend repositioning municipal bond portfolios now since there is little clarity as to the path either administration would likely take, but closer monitoring is warranted.

On the campaign trail, President Obama and Governor Romney advocate vastly different visions for the future role of the federal government. However, in practice, the two may not be able to exercise as much discretion as they promise and neither individual is likely to be able to radically alter the role and size of government. Both candidates would be faced with a slowgrowth economy and the pain of implementing fiscal austerity, and both would have to reckon with a closely divided Senate which would inhibit them from implementing or repealing ambitious reforms. In spite of the political and economic challenges facing the next president, we expect more progress on fiscal issues than over the past several years. While this may be the result of a more collaborative political environment, it’s more likely that the fiscal cliff – especially the unpleasant indiscriminateness of sequestration and the looming debt ceiling – will force such a deal. We believe a bipartisan deficit reduction package would look broadly similar under either administration, likely placating the rating agencies for now. A mildly more optimistic intermediate-term GDP growth expectation, coupled with incrementally greater policy clarity under Romney, may be more friendly for equity markets. While the big policy outcomes may not be vastly different under a Romney or Obama White House, there are still many specific areas that could differ, with important implications for financial markets. However, some important policy changes may transpire regardless of who wins in November. Elections do matter and the two candidates would pursue very different visions, but the difference between what each of them could actually achieve in office may not be quite as dramatic as current rhetoric would suggest.

UBS CIO WM Research 18 September 2012


US economy

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UBS CIO WM Research 18 September 2012


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