Governing & Campaigning In A De-Leveraging Environment

May 2012Daniel Clifton

dclifton@strategasrp.com

219 Days Until Election DayHere Is What Was Happening 219 Days Ago

• 8/26: Hurricane Irene Was Expected To Hit The East Coast But Didn’t

• 8/25: Berkshire Hathaway Invests $5BN In Bank of America

• 8/24: Steve Jobs Resigns As CEO of Apple• 8/23: 5.9 Magnitude Earthquake In VA That Is

Felt Up To Boston.

Punch Line: A Lot Can Happen Between Now & The 2012 Election

1. 2012 Pre-Election

2. 2012 Election Outcome

Mapping Out The Next 200 Days

3. 2012 Lame Duck Congress

4. 2013 Policy Implications

2012 Pre-Election

Countries Representing 50 Pct

World GDP Changing Presidencies # of G20 Presidential Elections &

G20 GDP w/ Presidential Elections

0

1

2

3

4

5

6

7

8

'04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '140%

5%

10%

15%

20%

25%

30%

35%

40%

GDP of G20 Elections As Pct of World GDP

(Right Axis)

# of G20 Presidential

Elections (Left Axis)

Struggling Economy = Unpopular Incumbents

G20 Presidential Re-Election Trial Heats

46 4747

53

25

30

35

40

45

50

55

60

65

70

Obama Romney Sarkozy Hollande

FranceIFOP-Fiducial4/ 10/ 2012

United StatesGallup

4/ 30/ 2012

Large Budget Deficits & Debt Limit New Fiscal Policy Stimulus…

Countries with Sovereign Rating of AAA2011 Surplus/Deficit & Debt as Pct. of GDP

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

-10% -8% -6% -4% -2% 0% 2%

US

UK Fra

CanAut

AusDen

Ger

Che

SweLux

Fin

Nld

Deficit/Surplus, Pct. of GDP

Net Debt, Pct. of GDP

…And Austerity Is Needed, Which Is Not A Winning Political Strategy

House Seats Changing Hands Between Parties By Election Year

-100 -50 0 50 100

1956

1954

1952

1950

1948

1946

1944

1942

1940

1938

1936

Seats Gained by Republicans

Seats Gained by Democrats

Avg Change In House Seats 1938 - 1954,

39 Seats

2012 -2021 Forecast , Congressional Budget Office

Net Debt To GDP

0

20

40

60

80

100

120

'40 '48 '56 '64 '72 '80 '88 '96 '04 '12 '20

Current Law

Current Policy

Pre-Debt Ceiling

CBO Forecast 2012 -2021

Austerity or Stimulus?

Post WWII Employment Cycles Peak to 27 Months Post Cycle Trough

88

90

92

94

96

98

100

102

104

106

108

1 9 17 25 33 41 49 57

# Months From Peak

Sep '48 Jul '53 Apr '57*Apr '60 Mar '70 Jul '74Jul '81 Jun '90 Feb '01Dec '07

* 22 months after Apr '57 cycle troughs, there is another recession

We are here

Real GDP (% Change Since 2007)

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

2007 2008 2009 2010 2011

FranceGermanyJapanUnited States

Traditional Political/Equity Cycle Did Not Materialize In 2011

S&P 500 Total Returns by Presidential Cycle (Since 1926)

8.2%9.0%

18.7%

11.0%

26.5%

15.1%

2.1%

0%

5%

10%

15%

20%

25%

30%

1 2 3 4

Historical

Obama

Equity Markets Wait To See Who The Election Winner Is

S&P 500 Price Return, YTD Pct Change'96 & '04 Presidential Re-Election Years

90

95

100

105

110

115

120

125

J F M A M J J A S O N D

1996

2004

Election Day

S&P 500 Index

600

700

800

900

1000

1100

1200

1300

1400

1500

1/ 2/ 2009 1/ 2/ 2010 1/ 2/ 2011 1/ 2/ 2012

Bernanke's Jackson Hole Speech: QE2

QE1 Expanded

Operation Twist

QE Avg Monthly Return= 2.7%

NonQE Avg Monthly Return = -2.8%

Monetary Policy Is Now Shouldering The Stimulus Burden…

…But The Bill Comes Due Post-Election

Net Federal Fiscal Stimulus, $BN

-200

-100

0

100

200

300

400

500

600

700

800

'01 '03 '05 '07 '09 '11 '13 '15 '17 '19

The fiscal cliff approaching is about $537bn in 2013. The election will have an outsized impact on how the issue is resolved. But we are skeptical the entire drag can be offset in 2013.

Forecast 2012-2021, Joint Committee On Taxation, Congressional Budget Office, Strategas

The Fiscal Cliff Could Serve As A Catalyst For A Grand Fiscal Deal

• Expiration of the Bush Tax Cuts

•  Expiration of the AMT Patch

•  Expiration of the Payroll Tax Cut/UI

• Obama Healthcare Tax Increases Begin

•  2009 Stimulus Spending Rolling Over

• Sequestered Spending Take Effect

•  Debt Ceiling Will Need To Be Raised

2012 Election

Framework For Analyzing The 2012 Election

Campaign

Narrative

Which Is It?:

•Retrospective

Referendum

•Prospective Choice

Economic

Outlook

Trajectory:•Jobs, Gas

Prices•Real Per

Capita Disposable

Income

Swing States

State By State•State

Economy•Demographi

cs

Approval Ratings Are Key: Obama In A Grey Area

Presidential Approval Rating in March of Re-Election Year

0

10

20

30

40

50

60

70

80

Tru

man

Eis

enhow

er

Johnso

n

Nix

on

Car

ter

Rea

gan

Bush

I

Clinto

n

Bush

II

Obam

a

Either Lost Re-Election or Didn't Run

Won Re-Election

President Is Slowly Inching Closer To 50 Pct Approval Rating

President Obama's Approval Rating(Gallup)

30

35

40

45

50

55

60

65

70

'09 '10 '11 '12

Growing Economy = Growing Probability For Obama Win

S&P 500 & Intrade Odds That President Obama Is Reelected

950

1,050

1,150

1,250

1,350

1,450

1,550

1/ 3/ 11 4/ 3/ 11 7/ 3/ 11 10/ 3/ 11 1/ 3/ 12 4/ 3/ 1240

45

50

55

60

65

70

Intrade Odds That Obama Is Reelected (Right)

S&P 500 (Left)

Bin Laden Death

Employment Headed In The Right Direction For Obama Victory

Presidential Re-Election & Change In The Unemployment Rate

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-3 -2 -1 0 1 2

Bush II

Clinton

Carter

Bush I

ReaganEisenhower

NixonMargin of Reelection

Victory

Change In Election Year Unemployment Rate

No President Has Been Re-Elected With An Increasing Unemployment Rate. Conversely, Every President With A Decreasing Unemployment Rate Won Re-Election

Employment Growth Helps But Is Not The Entire Story

President Obama Approval Rating & Unemployment

30

35

40

45

50

55

60

65

70

1/ 1/ 2009 11/ 1/ 2009 9/ 1/ 2010 7/ 1/ 2011 5/ 1/ 2012

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

Obama Approval Rating, Left

Unemployment Rate, Right, Inverted

Pre-Midterm Election

Post-Midterm Election

As Gasoline Prices Are More Correlated Than Employment

President Obama Approval Rating & Retail Gasoline Price

30

35

40

45

50

55

60

65

70

'09 '10 '11 '12

1.40

1.90

2.40

2.90

3.40

3.90

Regular Grade Gasoline,

(Right, Inverted)

Obama Approval Rating (Left)

Last Click: $3.94

Bin Laden Killed

Elevated Oil Prices Could Lead To Broader Economic Concerns

U of Michigan Consumer Sentiment & Retail Gasoline Price

50

60

70

80

90

100

'04 '05 '06 '07 '08 '09 '10 '11 '12

1.50

2.00

2.50

3.00

3.50

4.00

Regular Grade Gasoline,

(Right, Inverted)

U of M Consumer Sentiment (Left)

Consumer confidence declined in near

unison with rising gasoline prices from

'04-'08

Consumer Sentiment Has Been A Good Predictor of Reelection

U of Michigan Consumer Sentiment, Final Three Years of First Terms

40

50

60

70

80

90

100

110

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

Year 2 Year 3 Year 4

CarterObama

Reagan

ClintonBush II

Bush I

After-Tax, After-Inflation Income Is The Best Predictor of Re-Election

Real Per Capita Income Growth & President's Re-Election Share of the Popular Vote

35%

40%

45%

50%

55%

60%

65%

-2% 0% 2% 4% 6% 8%

Reagan

Johnson

Nixon

Bush IIClinton

Bush IObama

Carter2010 Midterm

Winning Campaigns

Losing Campaigns

Real Per Capita Disposable Income, 4 QTR Rolling, Y/ Y

Pct of Two Party Vote

This Number Has To Go Higher For The President To Win

Real Per Capita Disposable Income, Y/Y Pct Chg

-6

-4

-2

0

2

4

6

8

'06 '07 '08 '09 '10 '11 '12

Last Click: March-0.12%

Geopolitical Events Will Loom Large Over The Political Landscape In ‘12

Intrade Odds Of Strike On Iran & Price Of Brent Crude Oil

90

100

110

120

130

140

9/ 20/ 2011 11/ 20/ 2011 1/ 20/ 2012 3/ 20/ 20120

10

20

30

40

50

60Intrade Odds Of Strike

On Iran Before 12/ 31/ 2012, Right

Brent Crude Oil, Left

Consensus Pointing To A GOP Sweep In Congress

Intrade Odds Of Republicans Controlling The Senate & House

40

45

50

55

60

65

70

75

80

85

90

1/ 1/ 11 5/ 1/ 11 9/ 1/ 11 1/ 1/ 12 5/ 1/ 12

Republicans Control the Senate

Republicans Control the House

Congressional Approval Rating Points To Anti-Incumbent Election

Congressional Approval Rating & Incumbent Re-Election Rate

80

82

84

86

88

90

92

94

96

98

100

'74 '78 '82 '86 '90 '94 '98 '02 '06 '100

10

20

30

40

50

60Incumbent Re-Election Rate

(Left)

Congressional Approval(Right)

But Generic Ballot Is Not Showing A “Wave” Against GOP

Republican Lead Over Democrats in Rasmussen Generic Ballot

-7%

4%

8%

5% 5%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Oct. '08 Oct. '09 Oct. '10 Oct. '11 Mar. '12

Governing In Lame Duck & 2013

REMINDER: NEW CONGRESS FACES A MASSIVE FISCAL CLIFF

Net Federal Fiscal Stimulus, $BN

-200

-100

0

100

200

300

400

500

600

700

800

'01 '03 '05 '07 '09 '11 '13 '15 '17 '19

The fiscal cliff approaching is about $537bn in 2013. The election will have an outsized impact on how the issue is resolved. But we are skeptical the entire drag can be offset in 2013.

Forecast 2012-2021, Joint Committee On Taxation, Congressional Budget Office, Strategas

The Challenge: Below Trend Economic Growth…

Quarterly Real GDP, Pct Change, SAAR

-10

-8

-6

-4

-2

0

2

4

6

8

10

'92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12

Avg 1992 - 20073.2%

…With A Rising Debt to GDP Ratio…

Federal Net Debt To GDP

0

20

40

60

80

100

120

'40 '48 '56 '64 '72 '80 '88 '96 '04 '12 '20

If Current Polices Are Extended

CBO Forecast 2012 -2021

…& Net Interest Costs Set To Explode Despite Low Interest Rates

Net Interest Cost, Pct of Tax Revenues & Avg. Annual 10-Year Treasury Yields

4

6

8

10

12

14

16

18

20

'53 '59 '65 '71 '77 '83 '89 '95 '01 '07 '13 '190

2

4

6

8

10

12

14

16

10 Year Treasury Yield, Right

Net Interest Costs As Pct of Tax Revenues,

Left

Interest costs are set to explode despite

rates being kept low.

$537BN Fiscal Drag Is Broad BasedComponents of the 2013 Fiscal Drag, $BN

Healthcare Sequester, -12.0

Affordable Care Act Taxes, -26.0

Other, -14.8

Non-Defense Disc Sequester, -31.0 2010 Tax Cut

Extension, -303.3

Payroll Tax, UI-92.7

Defense Sequester

-55.0

Fiscal Drag Is Twice The Size Of The Largest Post WWII Tax Increase

Size of Federal Tax Increases, Pct of GDP

1.7%

0.4% 0.4%

1.1%

0.2%

0.6%0.4%

0.6%

3.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

'68 '69 '80 '82 '84 '86 '90 '93 '13

The coming fiscal drag dwarfs the size of any previous tax increase

Two Catalysts For A Lame Duck Tax Bill: Debt Ceiling & AMT

Federal Debt Outstanding (Monthly, $TN)

7

8

9

10

11

12

13

14

15

16

17

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Total Public Debt Subject to Limit

Debt Limit

Last Click: $15.5TN

Taxpayers Affected By AMT Under Various Scenarios

(JCT, Millions)

0

10

20

30

40

50

60

70

'10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22

Bush Tax Cuts Extended with AMT Patched

Bush Tax Cuts Extended Without AMT Patched

Current Law

Three Lame Duck Scenarios

• Consensus Election Result: Obama Pushes Bowles Simpson, Republicans Object. GOP accepts short-term tax cut extension for debt ceiling increase.

• Status Quo Election Result: Who has the mandate? Fight over high income tax cuts? Temporary debt ceiling extension?

• Republican Sweep: How does Obama handle this? Do Republicans wait?

2013 Fiscal Deal?

One Party Controlling Congress Gives Greater Fiscal Flexibility

Reconciliation Background• Legislative process established in

Congressional Budget Act of 1974 • Allows Senate to pass reconciliation

bill with simple majority, rather than 60 votes

• Eliminates a Senate filibuster• Debate limited to 20 hours• Requires House and Senate passed

budget resolution in place• Designed to speed passage of laws

impacting spending and taxes• Takes about six months to pass the

legislation into law.• In recent years, is used to pass fiscal

legislation lacking bi-partisan support such as the Bush tax cuts and Obama healthcare.

# of Votes for PassageRecent Reconciliation Bills

78

85

58

50

5456

40

45

50

55

60

65

70

75

80

85

90

'96 WelfareReform

'97 CapGains

'01 TaxCuts

'03 TaxCuts

'05 TaxCuts

'10 HealthCare

Supreme Court Ruling On Healthcare Could Be A Catalyst

Intrade: SCOTUS Finds Individual Mandate Unconstitutional

20

30

40

50

60

70

11/ 1/ 11 1/ 1/ 12 3/ 1/ 12

Affordable Care Act Tax Provisions In Place in CY 2013

(JCT, $BN)

1.52.9

1.80.4 0.4 0.1

20.5

5.5

0

5

10

15

20

25

FSA

Phar

ma

Devi

ces

Part

DSu

bsid

y

7.5%

AGI

HC

Dedu

ctio

n

Med

icare

Tax

Cellu

losic

Projected Healthcare Spending Looks Unsustainable

Healthcare Spending & Net Interest Costs As Pct. Of Total Federal Spending

0%

10%

20%

30%

40%

50%

'62 '68 '74 '80 '86 '92 '98 '04 '10 '16

Net Interest As Pct of Federal Spending

Healthcare Spending As Pct of Federal Spending

Healthcare & Interest Will Be 43% of Federal Spending in 2017

2010 Healthcare Legislation Spending Estimate, $BN

0

50

100

150

200

250

'10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22

March 2010: Original $900bn, 10-Year Estimate Was Based On Six Years of

Implementation

March 2012: $1.7tn Estimate Based On 9

Years Of Implementation

2012 -2021 Forecast , Congressional Budget Office, Office of Management and Budget

Tax Reform Is The Best Way To Deal With The Fiscal Cliff But Challenging

Federal Tax Revenues,Pct of GDP

12

13

14

15

16

17

18

19

20

21

22

'46 '54 '62 '70 '78 '86 '94 '02 '10 '18

Sustained Tax Revenue Over 20 pct of GDP Seems Unlikely Given History

2012 -2021 Forecast , Congressional Budget Office

Top Individual Tax Breaks for FY2014 With Expiring Provisions Extended

51.6

51.7

51.9

54

58.4

71.4

76.2

99.8

162.7

164.2

0 50 100 150 200

Charitable Contributions

Child Credit

Tax Breaks for Estate Assets

Deduction of Income Taxes

Earned Income Credit

Capital Gains Rates

Excl. of Medicare

Mortgage-Interest Deduction

Excl. of Employer Pensions

Excl. of Employer Health Ins.

Buffett Rule Is About Raising Capital Gains & Dividend Taxes

Buffett Rule Revenues & President's Budget Projected Spending

($ TN, 10-Year Estimate)46.96

0.050

5

10

15

20

25

30

35

40

45

50

Buffett Rule Revenue Obama's Projected Spending

Dividend Tax Rates Set To Triple Without Congressional Action

Annual Change In The Number of S&P 500 Companies Paying A Dividend

-40

-30

-20

-10

0

10

20

30

'81 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11

1986 Tax Reform Act equalized capital gains until the late 1990 income tax increase

Cap Gains & Dividends

@ 15%

Cap gains tax rate was half of dividends, leading to a shedding of dividend payments in the late 90's.

Dividend Tax Increase

Cap Gains Cut

Financial Crisis

Companies Are Pushing For Corporate Tax Reform

Effective Corporate Tax RateBy Industry, 2007-2008

0%

5%

10%

15%

20%

25%

30%

35%

Utili

ties

Min

ing

Leas

ing

Tran

spor

t

Agric

ultu

re

Real

Est

ate

Info

Tec

h

Insu

ranc

e

Man

ufac

turin

g

Avg.

Eff.

Tax

Rate

Fina

nce

Cons

truc

tion

Who

le &

Reta

ilTr

ade

Spread Between Statutory Corporate Tax Rate And Effective Average Tax Rate

0% 2% 4% 6% 8% 10% 12%

Turkey

Canada

Spain

Korea

Mexico

Italy

France

United Kingdom

Germany

Japan

United States

Cannot Do Corporate Tax Reform Without Individual Tax Reform

Net Income By Business Entity(IRS, Statistics Of Income, Billions Of 2009 Dollars)

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

'80 '84 '88 '92 '96 '00 '04 '08

Sole Props, S-Corp, Partnerships

C-Corp

The Fed Is HurtingSocial Security

Social Security Fund's Actuarial Nominal Interest Rate Assumptions

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

'09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20

Top 10 Federal Spending Programs Exceed Tax Revenues

Top 10 Federal Spending Programs & Tax Revenues, $BN, FY 2011

0

500

1000

1500

2000

2500

3000

3500

1 2

Social Security

Defense

Medicare

Interest

Healthcare

Veterans

Fed EmployeesUnemploy

TransportNutrition

Tax Revenues

$3,099

$2,305

Despite Catalysts, High Turnover Could Make Reform Difficult

Number of Freshmen in Congress By Election Year

0

20

40

60

80

100

120

140

'82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12

Consensus Scenario

• Obama wins presidency

• GOP controls both houses of Congress

• Lame duck bill extends some, but not all tax cuts

• Contentious 2013 fiscal deal could get done

• Obama would need to sacrifice some HC measures to get GOP to increase taxes

• No deal = rolling debt ceiling increases

• Obama uses his regulatory levers

Out of Consensus Scenario

• Romney wins presidency• GOP controls both houses of Congress• All tax cuts get temporarily extended• Republicans complete a fiscal package of

tax and entitlement reform• Green light on energy development• Healthcare bill changed• Small changes to Dodd-Frank

What To Watch For• President Obama’s approval rating• Real per capita disposable income• Congressional generic ballot test• Supreme Court ruling on healthcare• Fed policy: Operation Twist continues?• Fiscal cliff negotiations• Iran negotiations• Social unrest in the U.S.