Economic crisis dictates debate in the US election

IN THE normal course of events, every four years sees major analysis of the US presidential candidates' positions on market-related matters as part of the run-up to the November election. This year, however, first a series of geopolitical events reverberating through commodity and currency markets and then the worsening global financial market situation have dominated the political agenda. This would have been the case whether or not it was an election year.

Governments have always been important for economic activity: after all, they hold the purse strings, raise taxes and control important areas such as infrastructure and health, and determine the regulation of key sectors.

Ahead of November's US election, there is a wealth of analysis of the election cycle, which tells us, for example, that the market rises more if the incumbent party wins. The dollar has benefited more under Democratic administrations, while bonds are favoured more under Republicans.

This time around, the sector-level consequences of a potential Democratic win are currently seen as more spending on health and a sympathetic hearing for alternative energy and environmental initiatives, while the potential losers are investment banks and brokers, credit card companies, oil majors and high-yielding energy and telecoms companies.

Despite recent falls in commodity and especially energy prices, energy security remains a major concern and McCain's support for cheap, abundant coal contrasts with Obama's preference for more costly, environmentally friendly alternatives.

Preoccupation with energy security reflects the recent upturn in geopolitical risks. A prime example would be the deteriorating relationship between Russia and other countries. This is partly political (Russia's hegemonic ambitions regarding its former satellite states) and partly commercial (Russia's intent to form a natural gas equivalent of Opec incorporating Central Asian, North African and Middle Eastern states).

The effect is seen in greater volatility in global asset prices, particularly in oil, energy and gold. Impacts on stock markets include elevated risk premiums relating to politics in the affected countries and capital outflows.

Defence spending looks set to remain high for the medium term, irrespective of which candidate wins in November. The traditional division between Republican and Democrat camps on defence has been eroded by ongoing commitments in Iraq and Afghanistan, precautionary actions as in the siting of missile defences in Poland, the recognition of rising geopolitical threats in other quarters, the need for modernisation of equipment and budgetary constraints.

As far as financial markets and regulation is concerned, there has been a reversal of the laissez-faire policy and calls for more government intervention as the system has unravelled in such a spectacular fashion.

Both candidates were initially reticent on detailed measures to resolve the financial sector crisis. Extrapolating from their known views suggests that McCain as a free market advocate would have, for example, favoured privatising the GSEs and allowing the investment banks to sink or swim without public support, while Obama foresaw a greater degree of ongoing Federal involvement.

That debate has been swiftly overtaken by events. The Bush administration, rather than the presidential candidates, is setting the agenda for Congress to consider in 2009. It is too early to conclude what distortions will ensue from the $700bn Troubled Asset Relief Program (TARP) currently being negotiated, which both candidates have reluctantly endorsed. However, it is inevitable that the diversion of such substantial funds, representing around 5% of US nominal GDP, will have major consequences for other spending plans.

November's election has significance in other areas. Congress already has Democrat majorities in both the Senate and the House of Representatives. Any changes to the balance of power will dictate the pace of future tax changes and protectionist measures.

Free trade has been a major driver of capital flows and corporate earnings. However, globalisation is changing: protectionism is on the rise as the global economy slows and the perceived competitive threat from emerging market competitors increases.

A prime example would be the rhetoric in the US elections, especially from the Democrats. This coincides with weakening of the outsourcing trend for other reasons such as rising domestic demand in emerging economies and erosion of their cost advantage due to skilled labour shortages and wage inflation.

A key trigger to monitor into 2009 may not be the WTO Doha round, which appears mired with little hope of recovery, but announcements on bilateral trade agreements.

Frances Hudson is a global thematic strategist at Standard Life Investments