Will December 2012 be August 2011’s Encore?

We’re attending the InvestmentNews Retirement Income Summit this week, learning more about how to better meet the needs of those nearing retirement or in the throes, and those who advise them. We had the pleasure of sitting in on a presentation from James M. Delaplane of Vanguard on the current political and regulatory climate, and how it may impact investors moving forward. Unfortunately, the news isn’t great. He highlighted a couple of elements in what appears to the brewing of a perfect storm, including a political action freeze, the not-so-lame impending “lame duck” period, and election variables that will take us down to the wire.

Initially, Delaplane noted that we’re facing a wide variety of financial and regulatory concerns that need to be addressed, ranging from tax reform to deficit reduction to standard of care. The proposals from both sides of the aisle across the entire spectrum of issues are incredibly diverse, with little room for compromise. The diverging perspectives, paired with a fast approaching election date, has put us into what may be the eye of the storm, with little action likely before November unless a deadline demands it (for instance, the student loan rate debate that’s currently taking place).

The freeze would likely be of little consequence if it weren’t for the fact that the thawing period will be met with an onslaught of additional deadlines that carry with them the ability to incite even more extreme partisan politics than an election, setting us up for the least lame “lame duck” period ever. On the last day of 2012, we are set to see the expiration of the ’01 and ’03 Bush tax cuts, along with the expiration of the recently extended payroll tax deductions. On top of this, the first day of 2013 will see the Obama Health Reform Act taxes kicking into gear, alongside the $1.2 trillion in spending cuts that were triggered by the failure of the Super Committee. Just in case that’s not enough drama for you, due to the extension of the Payroll Tax reduction earlier this year, the debt ceiling debate that we’d penciled in for February of next year will likely be playing out at the same time that the rest of these issues take center stage. These are hurdles that the outgoing Congress and President Obama, regardless of whether or not he wins re-election, will have to tackle, and given their long history of playing nice (sarcasm here, in case you missed it), fireworks will be hard to avoid.

But what about after the lame duck period pyrotechnics fade, and the newly elected officials take hold of the wheel? Even then, uncertainty abounds. According to Delaplane, scenario A features a united Republican government. He argues that Republicans will likely retain control of the House, potentially losing ten seats in the process, but without a significant enough shift to shake their power. In the Senate, with 23 Democrats forced to defend their seats, versus only 10 Republican seats up for election, there is the chance for a power flip, but if it were to happen, it would be done with around a 52 seat majority. The problem is that pushing through legislation efficiently is going to require more than that. The Presidential race is a hard call, but in a world where Romney ekes out the win, Delaplane sees many of the regulatory endeavors currently being debated hitting the sideline. For instance, the highly contested ERISA fiduciary definition would probably never again see the light of day in a Romney administration, nor would the idea of appointing an SRO for advisers get much traction.

However, Delaplane also points out that scenario B, a divided government, in one capacity or another, is far more likely, which is where, historically, things get interesting. In the past, years of divided government for both Reagan and Clinton fostered an environment of productive bipartisan cooperation. After the 2010 election, divided government became more partisan in nature, giving us a Congress with 9% approval ratings and the “Do Nothing Congress” moniker. What’s the difference? Delaplane pointed to last August’s debt negotiations as the most illustrative example. There was a chance that a “grand compromise” of sorts could have been reached between Speaker of the House John Boehner and President Obama, and that such a compromise could have squeaked through Congress, had Obama been able to rally the Democrats behind it. The problem at the time was that the Republican base in the House was controlled by an 87-strong freshman core of Republicans, many of whom had been ushered into power on the wave of Tea Party sentiment that had fueled the 2010 midterms. The freshman core was largely unwilling to compromise, which functionally gutted Boehner’s ability to negotiate any kind of deal that Democrats would have signed onto.

Why does this example matter in the context of peering into a divided government future? In a world where the divided government brings in a strong crop of Representatives and Senators from either side of the aisle that embrace a philosophical bias similar to that freshman 87 during the debt ceiling negotiations, we may be in for even more of the partisan brinkmanship that 2011 played host to. While we can hope that cooler heads and forward thinking minds prevail, it’s certainly a risk worth contemplating that the opposite will occur.

But what about overarching tax reform? Why not just get it right? Delaplane argues that there are some who are advocating for the expiration of the Bush tax cuts as a means of driving momentum towards this kind of policy development. With the amount of tension existing between a desire for a simpler tax code and the drive to retain some forms of tax incentives, momentum will have to be derived from somewhere to get the ball rolling on such reforms. But most importantly, Delaplane stated, Presidential leadership will have to play a central role, and whoever may reside in the White House will need to spend significant political capital to get the necessary reforms in place.

Bottom line? The end of this year should bring about some interesting politically-fueled volatility. For us, the question now is whether or not managed futures will be able to capitalize on the volatility this time around.