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Analysis: The U.S. elections: Time for investors to worry

By Steven C. Johnson

NEW YORK (Reuters) - Investors have yet to break a sweat over November's U.S. elections. That's likely to change soon.

Investment strategists say the contests are among the most important in recent memory: a new government will need to tackle the deficit and start containing the national debt or the United States risks further credit rating downgrades that could erode the dominance of the dollar in global financial markets.

That will mean tough decisions on spending cuts and tax reform at a time when a few missteps could easily derail a fragile recovery in an economy that has only just escaped from the worst of the post-financial crisis torpor.

So, what should investors do? What would a second Obama administration mean for tax policy? Would a Republican or even Democratic sweep be best, or can a divided White House and Congress learn how to work together again? Here's a look at how to navigate four possible scenarios.

OBAMA RE-ELECTED WITH DIVIDED OR REPUBLICAN CONGRESS

If the elections yield the same political gridlock that brought the country within hours of default in 2011, financial markets could slide.

"If people dig in, the polarization will get worse, and that could be the worst outcome for markets," said Eric Stein, vice president and portfolio manager at Eaton Vance in Boston.

Most economists argue the only option for long-term fiscal health is for the U.S. to trim its deficit, which was at $1.3 trillion in the year ended September 2011.

A fix can be delayed a little if the economy is weak but the U.S. government would be on borrowed time. At the very least, a credible longer-term plan has to be put in place to keep markets calm.

Without one, not only will Moody's and Fitch almost certainly join Standard & Poor's in stripping the United States of its AAA rating, but all three may consider cutting the rating again. That could push borrowing costs higher, which in turn could choke off growth.

In the past, markets often welcomed divided government, reasoning it would stop Washington from meddling too much in business.

But if nothing happens this time, $1.2 trillion in automatic spending cuts would start to kick in next year, while temporary Bush-era tax cuts on income, dividends, estates and capital gains would expire, meaning higher taxes for many.

"If you get a Congress that won't compromise, won't solve the deficit problem or even address it, that will hurt the dollar, which will hurt internationals and multinationals," said Marc Pado, U.S. strategist at investment advisor DowBull.com.

Some worry the uncertainty could spark a broader stock market retreat this year, particularly if investors decide to book profits instead of risking paying a much higher tax on any capital gains or on dividends in 2013.

"It's a huge dark cloud for the markets," said Greg Valliere, chief political strategist at Potomac Research Group in Washington, who said investors "might want to lighten up on stocks that have high dividend yields" if higher taxes looked likely.

But paralysis should not be assumed. Obama would not have to worry about re-election, which could increase his flexibility to deal with the Republicans, who themselves will want to avoid being blamed for failure to deal with the deficit.

For Obama, re-election would be a chance to show "he can deliver for the American people," said Alan Wilde, head of fixed income and currency at Baring Asset Management in London, with $50 billion in assets. "This must mean swift progress on fiscal consolidation and working with Congress in a constructive way."

WINNERS AND LOSERS: Treasury bonds and the U.S. dollar would carry high risks. Stocks would also be highly vulnerable, though health care stocks would benefit from an Obama win. Luxury store groups such as Tiffany could be hit by higher taxes.

REPUBLICAN WHITE HOUSE, DIVIDED CONGRESS

This outcome also worries those who fear gridlock. Even if they lose the White House, Democrats may block initiatives of a new Republican President if they hold the Senate.

Major investors and ratings agencies say there needs to be some attempt to address government welfare, pension and medical spending.

Republicans are more willing to cut benefits in order to lower taxes. But cuts in what is widely regarded as "entitlement" programs are not popular, and Democrats would resist anything drastic.

Wilde of Baring noted that credible fiscal reform in the UK has bought that nation's government time and the U.S. would have a similar opportunity.

If the two sides show a reasonable level of cooperation, there would be a greater chance of tax cuts for corporations and less chance of tax hikes for the rich, which should help stocks.

There would probably be a reduction in tax loopholes to help pay for this, though, and spending cuts could threaten growth.

The danger would be if any tax cuts don't ignite animal spirits in the business world and the economy slips back into recession thanks to austerity policies.

WINNERS AND LOSERS: Investors would be in much the same position they'd be with Obama and a divided Congress: treat Treasuries with caution until it is clear the deficit is going to be tackled, hedge against a dollar decline and be careful on high-beta growth stocks such as technology shares. It might be better to hide in defensive areas such as companies making and selling essential consumer goods.

Pado said a Mitt Romney administration would probably be good news for defense shares such as Lockheed Martin as it would be more likely to try to shield the sector from draconian cuts. Republican hostility to the Obama health care reforms might hurt some health-care stocks.

REPUBLICANS WIN WHITE HOUSE AND CONTROL CONGRESS

Initially, markets might see a Republican sweep as by far the most pro-business result. U.S. stocks and the dollar could rally.

A Republican president, whether Mitt Romney or Rick Santorum, would have a winning chance of curbing government spending with Congressional support. That would win plaudits with ratings agencies and investors.

There would be less concern a Republican administration would raise taxes on dividends and other capital gains or target the rich for higher taxes, though some loopholes would probably be eliminated.

And there would be expectations of a reduction in regulation including a rolling back of major parts of Obama's health and financial industry reforms.

"For the economy to hum, you need a number of ingredients. One is low spending. Another is low taxation. And third is certainty of policy," said Dan Ripp of Bradley Woods, a private firm that interprets Washington for institutional investors.

The initial euphoria on Wall Street would be tempered by concerns a Republican-dominated Washington would cut spending too far, too fast and tax reductions wouldn't lead to enough of an economic boost to offset that impact on the economy. The worst-case scenario: A deep new recession and a worsening deficit and debt problem.

"In the short-term, markets would respond positively" to a Republican sweep, said Ron Florance, head of investment strategy at Wells Fargo Private Bank. "But in the long run, it still comes down to how prudent the policies are," he said. "And the reality is, whether it's one party or split-party government, if the markets don't think there's a trajectory for getting our debt problem under control, expect serious pain in the fixed income market."

The non-partisan Committee for a Responsible Federal Budget has said the tax-cut plans floated by the three top Republican candidates would all increase the national debt.

Extending the Bush tax cuts probably would, too.

"Unfortunately, the right answer is to reverse all the Bush tax cuts," said Pado. "It's not the answer anyone wants, but it's the right answer."

A Republican sweep could also raise questions over the future of Fed Chairman Ben Bernanke. His term is due to end in 2014, but he could leave sooner because of lack of support from a Republican administration.

With or without him, the central bank may also have less room for maneuver. A recent Republican proposal in the House aimed to limit the Fed to fighting inflation, rather than its current dual mandate of fighting inflation and pursuing maximum employment.

If the Fed is less able to stimulate the economy, it would take a vital crutch away - a crutch that has helped the United States recover from the worst of the financial crisis.

Meanwhile, hopes that Republicans would attack long-term spending may be misplaced. "It's hard for me to imagine a party will sweep into power and immediately want to take away benefits from the elderly," said Sean West, director of political risk coverage at Eurasia Group. "They would probably lose Congress two years later if they did that."

Which Republican wins also matters. Analysts expect Romney would move more gradually towards deficit reduction but Santorum says he plans to slash $5 trillion from the budget over the next five years, which increases the risk of an austerity-driven recession.

WINNERS AND LOSERS: Initially, the dollar and stocks could rally on the hope of tax cuts and lighter-touch regulation. The question is whether the gains will be sustainable. Winning sectors could be defense, banks and other financial companies, and high-end retailers. Steer clear of health-care stocks.

OBAMA RE-ELECTED, DEMOCRATS CONTROL CONGRESS

This is probably the least likely scenario given the hurdles for the Democrats to regain control of the House. But just as a Republican sweep could rely too heavily on spending cuts, analysts fear this may lead to higher taxes and more regulation.

A Democratic sweep may well mean higher taxes on dividends, higher tax rates for partners of private equity firms, and the end of tax loopholes for many businesses. That could lead to a sell-off in stocks before the new administration took power.

A lot may depend on whether the so-called "bond vigilantes" frighten the Obama team by triggering a sell-off of U.S. Treasuries, which would also add to concerns about credit rating downgrades.

But if bond yields remain low, it will take the pressure off of Washington to cut spending and tackle the deficit. "Why would people want to impose this kind of pain when they have not received a nasty message from the bond market," said Potomac Research Group's Valliere.

Florance doesn't think the United States will get off so easily this time. "Global capital markets will demand those interest rates adjust to reflect the real risk investors face from both a credit and inflation standpoint," he said. "Treasuries are not immunizing investors against either."

WINNERS AND LOSERS: Treasuries and the dollar get hit if genuine concern about the deficit takes hold. Stocks could also suffer because of higher taxes.

The health care and alternative energy sectors may be relative outperformers, with investors betting the latter may be in for tax benefits and further subsidies. But luxury retailers might struggle if taxes rise; discount chains such as Wal-Mart could outperform.

(Reporting by Steven C. Johnson, Walter Brandimarte and Daniel Bases; editing by Martin Howell and Andrew Hay)

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