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Investment Research — General Market Conditions

31 October 2012

Research US: election update – political uncertainty to continue 

There is now less than one week left before the presidential and congressional election on 6 November. The situation has moved from a clear lead for Obama to a close race between the two presidential candidates over the past two months.



We expect the knee-jerk reaction in financial markets to be positive (risk on) if Romney wins and muted if Obama is re-elected. Focus will quickly shift to the negotiations about the fiscal cliff as Congress convenes again in the lame duck session.



The discussions will be intense and we are likely to get very close to the December deadline before a compromise is found. This implies that political uncertainty will be a negative for markets and the economy for the rest of 2012.



Next year’s challenge will be to find a compromise on reforms that will secure sustainability of the long-term debt outlook. We are not optimistic about a major political deal and expect rating agencies to downgrade the US once again in 2013.

A close race but Obama still favourite Over the past two months Obama has lost his clear lead over Romney and the presidential election has evolved into a very close race. The most recent national polls show Romney leading Obama by 0.9%-point and the more important polls on electoral votes have also shifted to show a closer race between the two candidates. A close race in the presidential election

Source: Real Clear Politics

Senior Analyst Signe Roed-Frederiksen +45 45 12 82 29 [email protected]

Important disclosures and certifications are contained from page 8 of this report.

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Several states have moved from leaning towards Obama to undecided1 and one toss up state has moved in favour of Romney2. This now leaves the Democrats with 201 ‘certain’ electoral votes and the Republicans with 191, while the 11 statistically undecided, socalled toss up states, hold the key remaining 146 electoral votes. The battle is focused on the toss up states

Colorado Florida Iowa Nevada New Hampshire North Carolina Ohio Virginia Wisconsin Michigan Pennsylvania

# of electoral votes 9 29 6 6 4 15 18 13 10 16 20

August polling averages, %-point lead Obama +1.0 Obama +1.7 Obama +1.0 Obama +5.3 Obama +3.5 Romney +1.0 Obama +3.0 Obama +2.2 Obama +5.4 New toss up state New toss up state

Current polling averages, %-point lead Tie Romney +1.4 Obama +2.3 Obama +2.4 Obama +2.0 Romney +3.0 Obama +1.9 Tie Obama +2.3 Obama +4.0 Obama +4.7

Source: Real Clear Politics, Danske Bank

A closer look at the latter however, shows that Obama is still the favourite to occupy the Oval Office in January next year. Obama leads the polls by more than 2%-point in six of the 10 toss up states. while Romney only has a clear lead in North Carolina. In terms of electoral votes, this gives Obama a lead of 281 votes, with 270 votes needed to win, compared to Romney’s 235.

Obama in the lead in the toss up states Toss up state votes Leaning/Likely state votes Total overall votes

Obama 80 201 281

Romney Tie 44 22 191 235 22

Source: Real Clear Politics

Congress holds the key to new legislation While focus is centred on the presidential election, the election for Congress is even more important for how the legislative process will unfold after 6 November. The legislative process in the US requires that both chambers in the Congress pass new legislation. Recent polls show that the House of Representatives is solid Republican, while the race is close for the Senate. Most recent poll for the Senate

Most recent poll for the House Toss up 26 seats

Toss up 11 seats (7 democratic, 4 republican)

Republicans 43 seats

Democrats 46 seats

Source: Real Clear Politics

Republicans 226 seats

Democrats 183 seats

Source: Real Clear Politics

Currently, the Democratic party (including two senators who caucus with them) holds a narrow majority of 53 seats against the Republicans’ 47 seats and this year 33 of the 100 members of the Senate are up for election. The majority of seats being contested are held by Democrats, 23 against 10 Republican, and with the US Congress widely unpopular 1

2

Michigan, New Hampshire, Pennsylvania, Wisconsin and Ohio Missouri

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with an approval rating of just 13%, voters might prefer voting for ‘change’ instead of the incumbent candidates. Despite this, current polls point towards a minor lead for the Democrats in the Senate. Whoever wins the race for the Senate, the majority party will be a long way away from having a so called ‘super majority’ – a 60-seat majority, which allows the ruling party to pass legislation easier, since it prevents filibustering on the senate floor (that is a situation where the opposition is able to drag out the legislative process by extending the debate). This means that in all likely scenarios, new legislation will need to be backed by Senators from both sides of the political spectre to get through Congress.

A divided government makes political progress difficult A so-called divided government, with different parties controlling Congress and the presidency, remains the most likely outcome of November’s election. This would imply a continued unfriendly environment for political accords on key economic issues. When it comes to a deal on the fiscal cliff and more generally securing a sustainable path for government debt in the longer term, the two parties stand in stark opposition to each other, in particular on reforms to the tax code (see the overview below).

Key features of Mitt Romney’s economic policy 

Make Bush tax cuts permanent for all incomes.



Lower corporate tax rate from 35% to 25%.



Eliminate capital gains taxes for incomes under USD200,000 a year, maintain 15% rate for those earning more.



Eliminate estate tax (inheritance tax/death tax).



End ‘Obamacare’ (the Patient Protection and Affordable Care Act of 2010).



Key features of President Obama’s economic policy 

Extend the Bush tax cuts for one year for families with incomes below USD250,000. Allowing tax rate for families earning more to rise from 35% to 39.6% in 2013.



Gradually raise the dividend and capital gains tax from 15% to 20%.



Supports so-called ‘Buffet rule’ that persons making more than USD1m should not have a lower tax rate than that of the middle classes, which means a minimum tax rate of 30%.

Repeal the Dodd-Frank Act (financial regulation act).



Lower corporate tax rate from 35% to 28%.



Cut federal non-defence discretionary spending by 5%, reducing the annual federal budget by USD20bn.



Cut budget deficits by USD4000bn over the coming 10 years



USD50bn investment in rebuilding infrastructure.



Cap federal spending at 20% of GDP and cut USD500bn per year from the Federal budget from 2016.



Introduce a balanced budget amendment to the constitution.



Voted against budget control act due to cuts in military budget.



Supports changing the Federal Reserve act to remove the employment mandate.



Energy policy allowing for more oil drilling, fracking and nuclear power.



List China as a currency manipulator and take counteractions if it does not change practices

Source: Believe in America – Mitt Romney’s Plan for Jobs and Economic Growth

Source: www.barackobama.com

Regarding the fiscal cliff negotiations, these will be held in the lame duck session where the ‘old’ Congress and President are in place. This means that even with a Republican sweep in the election, which will definitely make it easier to put through new legislation next year, a deal on the fiscal cliff will have to be negotiated with a Democratic Senate 3|

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majority. Hence, once we are on the other side of the elections, there is one less unknown but political uncertainty will remain a drag for the remainder of the year.

US election timeline

Oct 5

Nov 6 Nov 13

Jan 3

2012

Jan 20

2013

Source: US treasury secretary, White House, Danske Bank

We expect a final deal on the fiscal cliff to imply a fiscal contraction of between 1.1% and 1.4% of GDP next year. Below we have scheduled the likely compromises under different constellations of the government following the election.

Fiscal contraction in 2013 – scenarios

FY 2013

Cal. year 2013

% of GDP

61

76

0.5

18

23

0.1

43

53

0.3

Most likely Payroll tax cut expires Obamacare tax increases Budget control act overturned but replaced by other savings

143

179

1.1

85

106

0.7

18

23

0.1

40

50

0.3

Plausible downside Bush tax cuts not extended for high incomes Payroll tax cut expires Obamacare tax increases Budget control act overturned but replaced by other savings

185

231

1.4

42

53

0.3

85

106

0.7

18

23

0.1

40

50

0.3

Worst case Bush tax cuts not extended Payroll tax cut expires Obamacare tax increases Budget control act Extended emergency employment benefits *Other tax measures

411

514

3.2

144

180

1.1

85

106

0.7

18

23

0.1

65

81

0.5

34

43

0.3

65

81

0.5

Best case Obamacare tax increases Payroll tax cut by 1% instead of 2%

*Including 50% bonus depreciation allowance for capital investment/ partial expensing of investment property Source: CBO, Danske Bank

Obama is re-elected and the Congress is split with the Republicans in majority in the House of Representatives and Democrats holding majority in the Senate. This situation is very similar to the current. We will likely see intense political debate during the lame 4|

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duck session but a final deal on the fiscal cliff will likely imply a fiscal contraction of around 1.0-1.5% of GDP. A similar outcome is likely in the case that Obama is reelected but the Republicans gain majority in both the House and the Senate. These are our main scenarios and the assumptions underlying our ‘most likely’ and ‘plausible downside’ scenarios in the table below. Romney wins the Presidential election and Republicans gain the majority in Congress. This increases the chance that a final deal will extend all Bush tax cuts and overrule the Budget Control Act and Obama’s health care reform. Regarding cuts in government spending outside the Budget Control Act (BCA), the picture is more blurred. As the Republicans will most likely not be able to get a majority in the Senate, new legislation will require at least some Democratic votes. This means that some of the further reaching suggestions from Romney and in particular Vice President Candidate Paul Ryan are unlikely to make it through Congress in its current form. If Romney wins the presidential election and the Congress is split with the Republicans in majority in the House and Democrats in the Senate, we still expect a deal to go through Congress during the lame duck session. With Romney in the lead it makes Bush tax cuts extensions for all and an overruling of the BCA more likely. It will however, be very difficult for Romney to pass his suggested cuts in government spending through Congress without considerable amendments.

Political uncertainty to continue after the elections Overall, the climate should be more favourable for political compromises after the elections, as there is two years before voters go to the ballot boxes again in the mid-term elections. Hence we find it highly likely that a deal on the fiscal cliff will be reached before the 1 January deadline. Political uncertainty likely to weigh on markets in coming months

350

Index

Index

US economic policy uncertainty index

300

350 300

250

250

200

200

150

150

100

100

50

50

0 98

0 00

02

04

06

08

10

12

Source: www.policyuncertainty.com

However, the tail-risk scenario is that a deal is not reached before 1 January and that the US will temporarily ‘fall off’ the cliff as tax cuts are allowed to expire. This implies a temporary fiscal contraction of more than 3% of GDP come 1 January. In our view, the probability of this negative scenario is greatest in the case that Obama wins a narrow victory and the Republicans in a reaction drag out negotiations to give the President a difficult start to his second term. 5|

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In any event, markets are likely to attach increasing probability to this tail risk the closer we get to the cut-off date for a deal on the fiscal cliff issue. We expect to get very close to the December deadline before a deal is struck and the political process is likely to resemble what we saw last year during the debt ceiling debate. This will once again remind investors about the difficulties that US policymakers have in reaching political compromises when needed. We thus expect US politics to remain a negative factor for risk sentiment in the final months of this year.

Will markets cheer a change? Although conventional wisdom would say that the standard knee-jerk reaction in markets would usually be to praise a Republican winner, this is not supported by history. We have looked at all presidential election results from 1960 to today and the short-term reaction in equity markets has been positive in about 30% of the cases where the Republican candidate has won and the share is equal in the years of Democratic victory. It also seems that equity markets have historically responded more positively to an incumbent President than a challenger. Stock market changes from one day before the election to two days after, 1960 to today

Democratic President Republican President New President Incumbent President

Number of elections won 6 7 10 3

Postive stock market reaction Absolute Percent of elections 2 33% 2 29% 2 20% 2 67%

Negative stock market reaction Absolute Percent of elections 3 50% 3 43% 5 50% 1 33%

No stock market reaction Absolute Percent of elections 1 17% 2 29% 3 30% 0 0%

Source: Reuters EcoWin, www.thegreenpapers.com, www.infoplease.com, Danske Bank Note: Stock market is counted as not changing, when the change from the before to after the election is smaller than +/- 0.2%

Looking at Romney’s economic plan it does seem to be positive for equities overall with less regulation of the financial sector and lower income and corporate taxes. In addition, a Republican sweep in Congress and Romney as President would make it easier to pass reforms targeting the longer-term US debt problem. However, it might be a more difficult call this time. First, Romney and in particular his Vice President candidate Ryan have been very sceptical about Fed’s monetary policy and in particular the QE programmes. Although the US President has no direct power over the conduct of monetary policy, it is the President who appoints the Chairman of the Fed. Ben Bernanke’s term as Chairman of the FOMC ends in January 2014 and Romney could appoint a more hawkish Fed chief. Second, Romney has been a hardliner towards China during his election campaign saying that he would name China a currency manipulator ‘on day one’. If Romney keeps his promise, this could start a trade war with China. Third, the fiscal plan laid forward by Romney and in particular the proposals by Vice President candidate Ryan suggest a very tight fiscal policy in coming years. Spending cuts of the magnitude proposed by Ryan will be a risk to the moderate recovery in the US economy. The real risks regarding Fed and China are in our view not big. Once elected, Romney has no incentive to put a hawk in charge of the Federal Reserve and risk to kill off the recovery with an early tightening of monetary policy. In addition, the three most likely candidates to take over as Chairman of the Fed are Hubbard, Mankiw and Taylor. Especially the two first have backed Bernanke’s policy and are much more moderate in their rhetoric than Vice President candidate Ryan. Regarding China, we think that Romney is talking hard but that very little will eventually be done on the Chinese issue. 6|

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On fiscal tightening, as mentioned before, new legislation will need support from the opposing party in order to get through Congress. This makes it very unlikely that the more far reaching proposals will be implemented. If Obama is re-elected and the Congress remains split, we have a status quo compared to the current situation. If the Republicans gain majority in both chambers of the Congress, the risk is that political deal making will become even more difficult than it is currently. This largely depends on how much power the more radical part of the Republican party gains (i.e. the tea-party movement) and how many moderate Republicans are elected. Although we do believe that a deal on the fiscal cliff issue will be found before 1 January, the risk that the US will temporarily fall off the cliff is marginally higher in this scenario. Looking further ahead, rating agencies have demanded a fiscal reform that targets the longer-term debt outlook in 2013 in order to avoid another downgrade in the rating of US government debt. Work on this will be a key task in the coming years, no matter how the election turns out. In all of the most likely scenarios on the election outcome, reforms that target the longerterm debt outlook must have support from both parties. Although the mere fact that we are past the election should make it easier to find compromises, we still think that it will be extremely difficult to get major reforms through Congress next year. We therefore expect the US to be downgraded once again in the coming year.

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US downgrade likely

Standard & Poor's Moody's Fitch

Long-term sovereign Outlook credit rating AA+ Negative Aaa Negative AAA Negative

Source: Bloomberg

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Disclosure This research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank"). The author of the research report is Signe Roed Frederiksen, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorized and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of the regulation by the Financial Services Authority are available from Danske Bank upon request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts’ rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high quality research based on research objectivity and independence. These procedures are documented in the research policies of Danske Bank. Employees within the Danske Bank Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to the Research Management and the Compliance Department. Danske Bank Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the over-all profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. First date of publication Please see the front page of this research report for the first date of publication. Price-related data is calculated using the closing price from the day before publication.

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