Bob Doll and Peter Fisher of BlackRock On The Post-Election Outlook

The new administration and Congress will face a host of problems that will ultimately play a role in investors' strategy over the next several years. If you've tried to keep score how the election of either McCain or Obama might affect each part of your portfolio, you've probably given up in frustration by now. But a report produced by BlackRock, "What Will the Elections Mean to Investors," sheds considerable light on the post-Election Outlook.

"The most asked question among investors when it comes to the elections is 'how much will the outcome affect my portfolio?' In our view, the answer is probably not as much as most think" say the authors of the report, Bob Doll and Peter Fisher. Doll is BlackRock's vice chairman and global chief investment officer. Peter Fisher is co-head of the firm's Fixed Income Portfolio Management Group.

Because any campaign promises eventually will have to be passed and funded by Congress, Congressional elections may be a more important factor on how markets react. The authors point out that currently in the Senate there are 51 Democratic senators (more precisely, 49 Democrats and 2 Independents who caucus with the Democrats) and 49 Republicans. If Democrats increase their margins in the Senate (which most observers agree is likely), Democrat President Obama would have a far easier time having his legislation passed than would Republican President McCain.

In the House of Representatives, Democrats currently have roughly a 55% to 45% advantage. They should gain additional seats in the next Congress and will be able to increase their power, but the Republican Party will be able to continue exerting influence on the legislation.

Keep in mind, notes the BlackRock report, elections are just part of the long list of variables that affect financial markets. "Market fundamentals historically have proved to be far more important. We believe asset allocation, valuations, earnings, yields, the economic outlook and the other basic determinants of market performance will have far more influence on an investor's portfolio than will the election outcomes."

Prospects for the Economy

The economy is certainly the major issue of the campaign. Economic growth has been slowing, credit issues continue to dominate the headlines, the labor market has come under pressure and consumer confidence has been taking a hit. By our analysis, say the authors, the reality is that no matter who is elected, the U.S. economy will have to weather at least several more quarters of weakness.

An environment of weak economic growth will complicate matters for the new administration and the new Congress, and will likely make it more difficult to enact some of the wholesale changes of the candidates. On healthcare for example, Obama has been promising to create a new program for low-income Americans that would provide them with subsidies to purchase health insurance. McCain has proposed ending the current system of employer-sponsored health insurance in favor of individually purchased plans. Both plans would require significant tax incentives and/or spending increase. Says the report, the realities of the federal budget will force the new administration to curtail some of its plans. From an investment perspective, this again means that proposed healthcare changes are unlikely to affect the markets as much as some think.

"The flip side of this economic picture is that we are almost certain to see some form of additional fiscal stimulus next year as well as additional legislation aimed at helping the housing market. On the stimulus front, we may see additional tax rebate checks for individuals. These helped bolster consumer spending levels in the middle of 2007, but did not have much carry-through to the rest of the economy."  We believe, say Doll and Fisher, business stimulus packages focused on tax incentives for investment or hiring might have a longer-term effect. On the housing front, there has been some discussion about legislation focused on limiting the short-term risks to home prices and bank lending.

The Reality on Tax Issues

Investors are justifiably concerned about taxes.  "With the economy almost certain to be weak at the beginning of the new administration, we think it is a foregone conclusion that the government will be forced to borrow more money and to increase tax rates simply to keep the government running," comments the report. But it notes that while tax rates will likely climb during the next president's administration, the repercussions are not likely to be as severe or as sudden as many fear.  That is because the economy is still in the midst of a period of economic weakness; politicians are not likely to dramatically increase tax rates when times are difficult for their constituents.

The proposed tax policies of the two candidates vary widely, For example, Obama has been pushing for higher marginal tax rates for individuals in the highest tax brackets and reductions for those in the lowest. Furthermore, he has proposed taxing "carried interest" from hedge funds and private equity investments at marginal income tax rates, says the report.   But McCain rejects tax increases for higher-income Americans and would prefer to maintain the status quo on carried interest. Most objective analysts agree that if Obama becomes president, overall tax levels are likely to go up more than they would should McCain get elected (specifically for higher-income Americans).

One area of tax policy that could see some additional change is the current structure of the Alternative Minimum Tax (AMT). The AMT has been affecting an increasing number of Americans in recent years, and has become less and less popular, and it is a possibility that the AMT could be adjusted as part of the next tax package.

Capital Gains

Investors are also concerned with the outlook for continuing the favorable tax treatment of long-term capital gains and qualifying dividends (the 15% tax rate currently is set to expire in 2010). "Obama has indicated that he plans to eliminate this favorable tax treatment (although he has stated that dividend income for lower-income Americans would not be affected). It seems quite likely that under an Obama administration, dividend income and capital gains tax rates will increase for many, if not most, investors."

McCain would like to see the current favorable treatment stand." In our opinion, however, President McCain would have extreme difficulty convincing Congress to go along with his tax plans. In particular, it is almost impossible to imagine a Democratic-controlled Congress extending the current capital gains and dividend tax treatment," say Doll and Fisher.  They add that higher tax rates for investors will be a "headwind for equities (albeit not an insurmountable one)" in the next administration.

What's Ahead for Fixed Income

The amount of private credit (e.g., corporate and mortgage-backed bonds) in the fixed income marketplace has increased as a share of the total marketplace at the expense of public credit (i.e., Treasuries and municipal bonds) over the past ten years, according to the BlackRock election report. "This is likely to change during the next administration. Because of the weak economic backdrop, the federal government (as well as state and local governments) will be borrowing more and issuing more debt, while at the same time private borrowers will likely scale back their bond offerings. Theoretically, expanding the supply of Treasuries should mean yields would move higher (since demand would drop), but in the current environment, weak economic growth should keep Treasury yields from climbing excessively."

Results of the elections will not have a highly significant impact on relative opportunities within fixed income sectors, say the authors. At current yields, Treasuries appear overvalued, and we do not see the political landscape changing that outlook in the near future. "In contrast, we do believe that higher-quality investments continue to represent attractive investment opportunities. In particular, government-guaranteed Ginnie Mae mortgage securities are trading at attractive premiums, as are some higher-quality credit-backed areas of the market."

Municipal Bonds Should Perform Well

While the likelihood of higher tax rates is a negative for some investments, municipals are one of the few areas of the market likely to benefit from increased taxation. As tax obligations increase, the tax-exempt nature of municipal bonds becomes more attractive to a wider audience. This, in turn, should help municipal bonds to perform well relative to other fixed income assets.

The potential for increased infrastructure spending in the next administration would be another factor that would make municipals attractive.  "Obama in particular has been emphasizing the need for more spending on projects such as highway improvements and bridge renovations, many of which would be financed through the issuance of bonds. Some of these would be traditional municipal issues and some would take the form of corporate bonds (since some infrastructure elements have been privatized). In any case, we believe that during the next administration, we will witness an increase in investment opportunities in infrastructure financing" comments the BlackRock report.

Equity Sectors

It is important to remember, that earnings and other fundamentals will have much greater impact on markets than legislative decisions, say the authors.  But the report points that an Obama or a McCain administration might affect various industries differently, with implications for equity portfolio positioning. Below is a rundown.

Sector Obama Administration McCain Administration
Energy Obama's administration likely would be more "green friendly," and will focus more heavily on climate change and global warming, which could benefit alternative energy companies. Traditional energy companies likely would benefit under McCain, due to his preference for expanding production. McCain also has been a proponent of increased nuclear power, which could help that industry.
Healthcare Universal healthcare has been a key pillar of Obama's campaign. It is difficult to predict exactly what impact his plans might have, but there is a general sense that managed care companies would face increased costs under his initiatives. A McCain administration would likely adopt a more "hands-off" approach to the current healthcare system, and an absence of increased regulation would likely be beneficial to pharmaceutical and insurance companies.
Manufacturing Obama has been emphasizing his goal of keeping more manufacturing jobs in the United States, which could benefit some traditional manufacturing companies. Additionally, his focus on infrastructure improvements could be a boon for construction-related companies. Globally oriented multinationals would likely benefit from McCain's free-trade stance.
Defense There is a perception that defense industries would fare worse under Obama, but the reality is that there would likely be little difference between the two since overall defense spending is unlikely to be reduced in the current environment. One area that could be affected is missile defense systems. McCain has been committed to these systems, while Obama has been more skeptical of their effectiveness.
Retail Obama's tax policies likely would benefit less-wealthy Americans, which could, in turn, help mass-market retailers. McCain's tax policies would stimulate spending among high-income consumers, which should help upscale retailers.

(Source: BlackRock Report: "What The Elections Mean To Investors," www.blackrock.com)