In the week before the Nov. 2 Presidential election, brokerage and pharmaceutical stocks sank as Democratic challenger John F. Kerry stayed dead even with George W. Bush in pre-election polls. Then, after Bush won, investors piled into those stocks, figuring that the sweeping Republican victory would cut the odds of drug price controls and drive up chances for enacting a Social Security reform that could bring billions in fees to Wall Street.
If only playing the Washington investing game were always so easy. Unfortunately for investors, President Bush's second-term agenda isn't likely to sweep through Congress as quickly as his first-term tax cuts did. And on Bush's biggest initiatives -- overhauling Social Security with private accounts and reforming the tax code -- the President hasn't filled in the crucial details that will largely determine which sectors win or lose. Investors hoping for policy plays must be patient and attentive as Washington hammers out painstaking compromises. Big uncertainties -- from the makeup of Bush's economic team to the President's promise to squeeze spending to the replacement of Federal Reserve Chairman Alan Greenspan in 2006 -- will cloud the crystal ball for much of the year.
Still, alert investors will find opportunities to capitalize on Bush's initiatives. Here's how:
SOCIAL SECURITY OVERHAUL
Early in 2005, Bush is expected to unveil his plan to create private investment accounts as part of Social Security. Policy wonks are betting that the White House will model its proposal on one of three plans studied by Bush's 2001 reform commission. In that version, workers could choose to divert four percentage points of the 12.4% Social Security payroll tax to accounts they would own and could invest in stocks and bonds. Account owners would still collect a basic government-paid benefit, but the monthly check would be cut back over time. Supporters argue that by tapping the higher returns available in the market -- 5% to 7% after inflation, vs. the 2% that Social Security effectively pays -- account owners would have as much or more retirement income than the current system promises.
The prospect of 100 million workers setting up new retirement accounts -- and paying fees to brokers or fund managers -- fueled the post-election surge in financial stocks. But the Street is a long way from collecting, because Bush isn't guaranteed a win on Social Security. "Reform is still a very big 'if,"' says Chip Dickson, chief U.S. equity strategist for Lehman Brothers Inc. (LEH ) Under any likely plan, the accounts would start out small and be limited to a few investment options, such as diversified index funds. Big mutual-fund managers would be best positioned to capitalize on those -- especially the low-cost players such as Vanguard and T. Rowe Price. Full-service brokers could justify going for what's likely to be low-fee business only if they see the accounts as loss leaders to gain new clients.
The near-certain losers in a Social Security overhaul: bond investors. The transition to private accounts could cost up to $2 trillion over the next decade. To cover benefits due to be paid from the taxes diverted into accounts, Congress is likely to borrow the funds, and the added debt would push up interest rates and cut the value of existing bonds. "The bond market may look at this and say, 'This doesn't pass the smell test,"' says Gregory R. Valliere, managing director of independent policy analysts Stanford Washington Research Group.
Bush hasn't given investors many clues as to how his tax-reform push will affect portfolios. The White House is expected to name a commission to consider tax options by January and recommend a plan to the Treasury by mid-2005. The final result is widely expected to be a system that replaces today's patchwork of tax-favored plans for retirement and college and exempts all savings, in whatever form, from income taxes.
A tax code tilted toward saving would favor manufacturers with hefty capital needs -- think the Big Three auto makers, General Electric (GE ), or pharmaceuticals. The code would tilt against knowledge-intensive service businesses with lighter funding needs. Brokers and money managers could also benefit from increased business, but such life insurers as Lincoln National Corp. could suffer: Under the revised tax code, the simplest bank account could enjoy better tax breaks than insurers' complicated and expensive variable annuities.
In his first term, Bush gave all his attention to tax cuts and none to spending control. He now has the deficits to show for it: a $348 billion gap projected for fiscal 2005. For his 2006 budget, the President has ordered a strict hold on spending for everything except entitlements and security -- and some analysts think he'll actually follow through. "Bush needs to show the bond market and foreign dollar buyers that he's finally getting serious," says Valliere. Among the likely victims: hospitals, nursing homes, and managed-care plans that serve the Medicare health plan for the elderly, all of which will face stricter limits on their reimbursement rates.
November's GOP gains guarantee hard times ahead for Fannie Mae (FNM ) and Freddie Mac (FRE ). Coming off accounting scandals at the mortgage giants, Congress is likely to move their regulator to the Treasury with stronger powers. The result could be higher capital requirements and other restraints that will rein in future growth.
Lawsuit reform, a sleeper issue, could drive stocks, too. Capitol Hill negotiators are hoping to agree on a settlement fund to pay damages to workers and others with asbestos claims. The Administration also wants to make it easier for defendants to move class actions to federal courts, where rules are more uniform and judges are thought to be more independent. Homebuilders and manufacturers -- especially medical-equipment makers and auto makers -- could get a lift. Another big winner would be property and casualty insurers, which would face smaller bills for legal defense costs.
Investors hoping to capitalize on Bush's agenda will need to take a long perspective -- and make some bold choices. What promises to be an exciting year in Washington could provide many a thrill for Wall Street as well.
By Mike McNamee