William Creekbaum: Impact of 2010 elections

The last two years were characterized by President Obama and congressional Democrats implementing a significant part of their agenda.

During the next two years, the president and Senate Democrats will be trying to preserve their achievements as the newly elected Republican majority in the House of Representatives tries to reverse them. Moreover, the composition of the new Congress is unlikely to override any presidential veto in 2011 to 2012.

Thus, the combination of a split Congress and the threat of presidential veto will likely make gridlock the default option on major policy issues.

Jeff Applegate and Charles Reinhard of Morgan Stanley Smith Barney, along with Tom Gallagher, a political consultant, penned a summary of what may be the implications of the mid-term elections. I have provided some excerpts:

The GOP sweep might be reminiscent of the 1994 election, which came at the midpoint in President Clinton's first term. However, there is an important difference between then and now: In 1994, Republicans gained control of both houses of Congress and thus shared in the responsibility for governing. That gave President Clinton his opportunity to "triangulate" with the Republican Congress - and win a second term.

During the upcoming two years, we believe the Republican House will probably choose not to compromise with the Democratic-run Senate on key issues. Such a standoff means the potential for policy changes will be limited to bills that have to pass, such as those for appropriations and raising the debt limit.

Looking beyond 2011, it is worth noting that midterm elections are poor predictors of the subsequent presidential election. Of the three previous post-World War II presidents who lost at least one chamber of Congress in his first midterm, all won re-election. The state of the economy two years from now will be more important than any Congressional debates that occur in the interim.

POLICY IMPLICATIONS. Here is our outlook for the important items on which Congress and the president will have to engage:

• Taxes. The first tax issue likely to be addressed is what happens to the Bush-era tax cuts, set to expire on Jan. 1. While there are lots of potential outcomes, we think the most likely one will be bipartisan agreement that raising taxes is a bad political and economic idea, given subpar GDP growth.

Thus, we expect a lame-duck session of Congress will approve the extension of current tax rates, including the upper-income brackets and those on capital gains and dividends.

• Spending. We believe House Republicans will make a big push for spending cuts in 2011 and, though they will have to compromise with the Senate, they will achieve some success. However, they won't push for the targets in their campaign pledge - $100 billion in cuts next year and an ultimate goal of getting spending down to pre-2009 levels.

• Debt limit. The ceiling will need to be raised in the first half of 2011. It's another must-pass bill, and most newly elected Republicans will want to vote against it. We believe that it will pass.

• Financial reform. Despite some talk about repealing the Dodd-Frank financial-reform legislation, we believe that a material rewrite of the bill is unlikely.

• Health care. The Republicans priority of repealing the new health care law is a long shot, given their failure to take the Senate. The battle could be fought, however, by denying funding to implement parts of the legislation.

We believe some partial success on this issue is likely, since it would be part of a must-pass spending bill.

• China trade legislation. The Republican leadership is instinctively free trade, but it will not want to be perceived as soft on China. We believe the Republicans won't be silent on this issue, but the odds of protectionist legislation have come down significantly.

MARKET TAKEAWAY. Politics aside, the key conclusion about the mid-term elections is that once political uncertainty is removed - in favor of either party - equities tend to do well. Since 1950, measuring returns from Sept. 30 in mid-term election years, the forward one-year price return for U.S. equities has averaged 25 percent, with no negative observations.

The two prior scenarios where the House turned Republican under a Democratic president, 1950 and 1994, were associated with gains of about 20 percent.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of Morgan Stanley Smith Barney LLC. He can be reached at William.a.creekbaum@mssb.com or 689-8704.