WASHINGTON (Reuters) - The political landscape changed with the midterm elections in early November when President Barack Obama's Democrats took a beating from the Republicans.
Here are the main political risks to watch in the United States:
With Republicans winning control of the House of Representatives and Democrats still in charge in the Senate, political gridlock is very possible.
What to watch:
-- Obama and Republican and Democratic congressional leaders who met at the White House on Nov 30 said they hoped to work more collaboratively, including on renewing Bush-era tax cuts that expire on December 31. A team of top people from the two parties and the White House were named to work on details.
-- Democrats still dominate both chambers of Congress until the end of the year and there is plenty of scope for discord before the new Congress is seated in January. Issues include Senate approval of a START nuclear arms treaty with Russia and extending unemployment benefits. Following the meeting with Obama, Republicans appeared to soften their opposition to Obama's request for a vote on START this year.
-- Political gridlock is seen as not great for stocks. On average, the S&P 500 index rises only two percent a year when the president's party controls only one of the chambers in Congress, according to Standard & Poor's Equity Research.
BUSH-ERA TAX CUTS
Time is running out for lawmakers to reach a compromise on renewal of tax cuts. Obama wants to let the lower tax rates run out for individuals with income above $200,000 a year but the Republicans want to extend the cuts for everyone, including the wealthiest tier.
Obama has put two top economic advisers -- Treasury Secretary Timothy Geithner and Budget Director Jack Lew -- in charge of negotiating a deal with Congress.
What to watch:
-- A possible temporary extension of all the cuts for between one and three years. This is still the most likely outcome as neither party wants to be blamed for raising taxes.
-- "Decoupling." Democrats have threatened to hold votes in the House and Senate on extending the tax cuts only for the middle class, leaving a decision on wealthier taxpayers to a separate vote. This strategy, known as decoupling, is an effort to portray Republicans as inordinately interested in tax breaks for the rich and it could scuttle any bipartisan deal.
-- Action on a tax on company dividends for upper income groups that will shoot up to 40 percent from 15 percent now if lawmakers do not extend the cuts. Capital gains taxes would also rise to 20 from 15 percent.
-- Whether tax incentives for ethanol, wind and solar energy are part of any bill.
RISE OF THE TEA PARTY MOVEMENT
The conservative, mostly Republican movement was the U.S. political phenomenon of 2010.
What to watch:
-- How much pressure will new Tea Party favorites in Congress like Senators Marco Rubio and Rand Paul put on mainstream Republicans next year to cut government spending?
-- How tough will Rep. Ron Paul, father of Rand Paul, be on the Federal Reserve when he takes over as head of the House subcommittee that oversees monetary policy in January as expected. Ron Paul, a fierce critic of the U.S. central bank, has threatened stricter oversight of the Fed.
Disruption to U.S. relations with China can move bonds, currencies, stocks and commodities globally. Beijing is the biggest single holder of U.S. Treasuries, with around $900 billion. Some in Washington have long feared that China could dump the bonds because of a political dispute, say over Taiwan, bringing prices tumbling down. But that would be counterproductive to China and is seen as unlikely.
What to watch:
-- Political and military friction like the crisis in North Korea and whether Washington's sending of warships to exercises in the area will upset Beijing. Taiwan lingers as a potential flashpoint in China's relations with Washington but trade ties between the island and Beijing have improved.
-- Senators led by Democrat Charles Schumer might press ahead with a bill to punish Beijing by charging duties on exports to the United States if it does not revalue the yuan -- a big deal for foreign exchange and bonds. U.S. companies with most to benefit from a stronger yuan include Caterpillar, Alcoa and General Electric but they also stand to lose from any tit-for-tat trade fight with Beijing. A yuan revaluation might stimulate Chinese demand for commodities but that could be offset by reduced export competitiveness.
-- Friction between multinationals and the Chinese government after Google and Beijing locked horns over the Internet giant's search engine. That dispute has been fixed but companies like GE, Siemens and BASF have also complained of the tough investment climate in China.
The U.S. budget deficit was at a near-record $1.29 trillion in fiscal year 2010. Republicans favor spending cuts to close the fiscal gaps but Democrats are not keen on austerity, at least until the economic recovery picks up more pace.
What to watch:
-- A presidential panel's revised plan to balance the budget proposed deeper spending cuts than an earlier draft and a more modest tax code overhaul, seeking wider support among lawmakers. It cut discretionary spending more aggressively, offered more alternatives to reforming the tax code and softened proposed changes in Social Security pensions. But the plan still needs to find support from 14 out of the 18 members of the bipartisan panel to trigger a congressional vote on it.
The plan recommended capital gains and dividends be taxed at ordinary income tax rates -- instead of the lower present rate of 15 percent -- or taxed at a lower rate if paid for by higher rates of ordinary income tax.
-- Despite the hefty debt burden, the U.S. Treasury has had no difficulty so far in finding willing buyers of government bonds and interest rates remain very low. The concern is that buyers may one day lose faith in politicians' willingness to put finances back on a sustainable path. They might refuse to cheaply finance U.S. spending and borrowing costs would spike. In an unlikely doomsday scenario, the United States would have so much difficulty attracting debt investors that it would be forced into taking stern measures to curb spending and raise taxes.
-- Austerity measures. While markets are keen on keeping the deficit under control, an austerity program that crimps consumer spending could hit company earnings or stunt economic growth.
(Reporting by Alistair Bell, Editing by David Storey)