US economy faces long struggle out of a deep debt hole

Predicting the US stock market's direction over the next two months may be a simple exercise: Just watch how Republican candidates for the House and Senate are faring in the polls.

At least, much of Wall Street is hoping it's that easy. Every midterm election is about challenging the decisions of the party in power. But the Republican message in 2010 is that the economy can't get better — and will only get worse — unless the Obama administration is stopped in its tracks by a resurgent GOP.

So if investors who buy into that view sense a big Republican victory, they should find a lot more to like about the stock market.

That's the bullish case of the anti-Obama camp, anyway. Meanwhile, the threat of a Republican sweep may be driving the administration to push for new business-focused tax breaks aimed at spurring jobs and keeping the economy from falling back into recession.

For many equity investors that may be a minor comfort, but it's still more likely to boost optimism than feed pessimism in the short term.

When I asked Barry Knapp, head of equity strategy for Barclays Capital in New York, if his well-heeled clients wanted to see the administration essentially neutralised, he answered without hesitation: "Absolutely!"

Bruce Bittles, chief investment strategist at Milwaukee-based brokerage Robert W. Baird & Co., put it a little more politely. "I think the administration has positioned itself as anti-business. It's natural for Wall Street to want to see that changed."

In 2009 Obama and the Democrats had the advantage of a rebounding economy thanks in part to the $787 billion federal fiscal stimulus package.

Sentiment

Whether investors particularly liked the stimulus plan or not, they had to be happy that it helped restart economic growth — the promise of which powered the stock market rally that began in March 2009. As for the financial sector, its bacon was saved by the taxpayer-funded bailout authored by George W. Bush's administration and inherited by Obama.

How could the money men complain? For a while the country seemed to be climbing quickly out of the abyss. Private-sector job growth resumed last November and reached a net 241,000 payroll additions in April, the largest gain since March 2006.

But since April, job creation has dwindled. On Friday, the government said private-sector payrolls added a net 67,000 positions in August, better than expected but still woefully weak.

The expectation is that the White House will focus on new tax cuts for businesses, although they're likely to be modest in scope and impact. And a much bigger tax issue looms: Congress must decide what to do about the Bush tax cuts on wages, capital gains and dividends, all of which expire on December 31.

Extending them in full, without new spending cuts, would assure huge budget deficits for years to come. For their part, Republicans are vowing to slash spending if they are returned to power in Congress.

Americans have heard that promise many times before, from both parties. But with the deficit expected to exceed $1.3 trillion this year alone, the GOP knows that many voters have a visceral fear of the debt-financed spending that exploded with the recession.

Even as more individual investors lost faith in equities last month, the corporate world was signalling the opposite. The global value of announced takeover deals jumped to $286 billion in August, the most for any month in two years, according to data tracker Dealogic.

There is a huge amount of support for the stock market in the near term: double-dip recession worries have eased, takeovers are surging, the Fed is helping on both ends of the interest-rate spectrum, and both political parties are telling the market what it wants to hear.

That doesn't change the fact that the US economy faces a long slog out of a deep hole as it works off the debt binge of the last 25 years. No matter how the November elections turn out, there are no miracle cures.