WASHINGTON, Aug 2 (Reuters) - With U.S. congressional elections approaching, the actions of legislators and the administration will be watched closely by investors in the coming months. Here are the main political risks to watch in the United States.
Republicans are likely to gain ground when all 435 seats in the House of Representatives and 37 of the 100 seats in the Senate come up for grabs in the Nov. 2 midterm elections.
The high jobless rate is dragging on the Democrats’ poll ratings and Republicans might win control of the House and probably pick up seats in the Senate. [ID:nN2947678]
That would make it difficult for Obama to win the kind of legislative successes he had in his first two years in office.
What to watch:
-- Obama will probably have to deal with resurgent Republicans in Congress. The question is whether he will be able to work with them to slash the budget deficit and boost job hiring or whether politicians will be stuck in gridlock while the economy languishes. An early and crucial test of this will come in December when a bipartisan commission makes recommendations on how to cut the deficit.
-- Republican electoral gains are likely to be welcomed by financial markets keen to dampen Obama’s zeal for regulating business, like healthcare reform and the crackdown on Wall Street. While there are always other factors such as company earnings to push shares, historically the S&P 500 index does well in the year after midterm elections regardless of the result partly because the third year of a presidential term is seen as a stable period politically. The last time the Republicans did well in a midterm vote under a Democratic president was in 1994. Stocks rose 25 percent in the 12 months from October that year.
-- Republicans have threatened to repeal Obama’s healthcare and financial regulation laws but that is improbable as they would need a two-thirds majority in both the House and Senate. Legal challenges to healthcare reform by states could win more traction.
Deficit projections have soared to $1.47 trillion and public debt is at $13 trillion. The Republicans doing well in the election is seen as positive for deficit reduction. No one party then has to take the blame for tough cuts.
What to watch:
-- Despite the hefty debt burden, the U.S. Treasury has had no difficulty so far 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. That could also make it more expensive for companies and consumers to borrow, slowing the economy. 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. One worry would be that the Federal Reserve might begin printing money to buy Treasury debt, which could devalue the dollar and drive up inflation. Political gridlock is often welcomed by markets when an economy is doing well but Wall Street would punish failure to reach agreement on the deficit.
-- A bipartisan commission will make recommendations by December on how to reduce the deficit. A leading Democrat on the panel has suggested a cap on government spending, putting him more in line with Republican thinking and increasing the chances of the commission producing feasible ideas.
-- In the end, implementation of the commission’s ideas by Congress in 2011 is everything and bipartisan cooperation will be needed. Republicans will push for spending cuts while Democrats are expected to seek tax increases.
-- 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.
-- New White House budget director Jack Lew, a Clinton administration veteran who is trusted by markets and Republicans. He will set the tone for deficit reduction.
BUSH-ERA TAX CUTS
The U.S. Congress is likely to vote by the end of the year on whether to extend tax cuts dating back to George W. Bush’s presidency. Letting the cuts expire would help plug a hole in the deficit but would be unpopular with voters.
What to watch:
-- 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 from 15 to 20 percent.