Active Fed and Conservative Congress to Pave Uncertain Way
Andrew Leckey

Government and politics don't drive investments but they do provide the road on which they travel.

The new Republican majority in the U.S. House of Representatives, coupled with highly active Federal Reserve policy that's designed to revive the economy, will make a difference in 2011. Yet based on history, the difference won't necessarily turn out the way everyone expects.

What everyone seems to agree on are interest rates.

"Investors should realize now that interest rates are going to stay low for a while," said Michael Ryan, head of wealth management research for the Americas at UBS Financial Services Inc. in New York. "The Federal Reserve is dictating policy at the long and shorter end of the curve."

The Fed's controversial recent purchase of an additional $600 billion of U.S. Treasuries through June to try to reduce unemployment and avert deflation has been defended by Chairman Ben Bernanke as likely to boost growth through lower borrowing costs and higher stock prices.

"Down the road there is going to be a day of reckoning in which all of this Federal Reserve easing of interest rates will have to be rewound, but it won't occur next year," believes David Kudla, CEO and chief investment strategist for Mainstay Capital Management LLC in Saginaw, Mich. "The recent $600 billion quantitative easing by the Fed is the equivalent of a three-fourths of a percent point reduction in the Fed funds rate."

Congress is tougher to predict, even though the assumption is that Republicans typically block Democrats' tax-raising strategies and also take it easier on business. Kudla believes that the major worry of the financial markets this year has been uncertainty over Congressional tax policy and whether the Bush tax cuts would be extended.

Don't expect mega-changes. Market analysis by Fidelity Investments has found that in the period from 1950 through 2009 large- and small-cap stocks performed better than average in the year after midterm elections -- but that the party in power hasn't made much of a difference.

In addition, there has also been little difference in stock market performance between periods of political gridlock and one-party rule. Many other considerations besides politics, such as economic trends and corporate profit cycles, influence stock movement.

"Political gridlock can prevent some big initiatives that might be detrimental to businesses and consumers from going forward, which can be positive," said Ryan, "However, dysfunction is not constructive because it prevents the most basic things from going forward -- and some things do need to get done."

With all of that in mind, UBS makes these investment-related predictions for the changed Congress in 2011:

-- It will find common ground on a temporary extension of the Bush tax cuts, with a likely extension of one or two years. A permanent extension is unlikely to make it through a Democratic Senate and White House.

-- While there will be considerable debate over how to reduce the federal deficit, the policy gulf between the parties is too wide for significant reform either by cutting spending significantly or by blocking healthcare reform.

-- It is unlikely to approve any additional large fiscal stimulus to boost economic activity. Stimulus remains too controversial. The Fed seems to have taken over that responsibility.

-- It will take a somewhat less activist role in regulating key industry groups.

"A lot of the change in Washington will be applicable to stocks in terms of earnings growth, gaining market share and offsetting the costs of doing business," said Andrew Fitzpatrick, director of investments for Hinsdale Associates in Hinsdale, Ill. "Companies have a lot of cash on their balance sheets that's been held up awaiting Washington, but I think we're closer to that cash moving off the balance sheet, resulting in more hiring and improving economic activity."

Dividend-yielding stocks would benefit from extended Bush tax cuts that would be a positive for dividend income. It is expected that cash-rich oil companies, pharmaceuticals, banks and consumer stocks will benefit most in the new scenario.

"The cyclical industries that are very sensitive to an improvement in the economy can do well going forward now," said Kudla. "As the economy improves and expands, their prospects improve and expand."

Yet rising deficits boosted by tax cuts don't bode well at all for bond investments. Don't be surprised to see gold investments, a harbor in uncertain investment times, continue their winning ways of the past 10 years.

"One area that jumps out to me with the new Congress is regulation of the financial sector, which I think will be a little less cumbersome now," said Fitzpatrick. "There needs to be some reform and I don't think it is off the table, but it will be more favorable to the financial institutions now than it would have been if the Democrats had retained their power."

But here's a reality check:

If the moves by the Fed and Congress don't make a dent in improving the nation's dismal unemployment figures, all bets are off. Those numbers must improve to the point where people become confident once again about their personal balance sheets. This also affects the housing market, because only when they have that confidence will it be possible to work down the inventory of unsold homes.

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