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Markets Expect Political Gridlock But Are Worried About Taxes

Stocks are pricing in political gridlock, and any upset to the view that Republicans take the House in midterm Congressional elections next week could tilt the market either way.

Alexandra Grablewski | Riser | Getty Images

So far, analysts agree the markets are pricing in a new era of Republican control of the House of Representatives, and that Democrats will continue to hold the majority in the Senate. After Tuesday's vote, the markets should then quickly shift focus to the fate of the Bush tax cuts, expected to be dealt with by the lame duck Congress in the weeks after the election.

"I would argue the fate of the Bush tax cuts is the bigger story, compared to the election. I think the election is pretty much factored in, but nobody can be sure on what's going to happen on the Bush tax cuts," said Greg Valliere, chief political strategist at Potomac Research.

Dan Clifton, Strategas head of policy research, believes though that a big surprise from Republicans could send the market higher, and a Democratic victory in both houses would be a negative.

"I think investors have fully baked in that the Republicans are going to take over the House, and they'll pick up about 55 seats. They need 39 to take over the majority," said Clifton. "Investors don't believe Republicans will take over the Senate. They think they'll pick up seven seats."

"If that's fully priced in at this point, then you just get a relief rally," said Clifton.

Analysts say the market typically performs well during gridlock, but there is also a fear that it could impair the ability of Congress to take needed action.

"Gridlock is generally good for the market. I could spin a story that says gridlock is not as good as people say. If you want to get anything done on Freddie or Fannie and immigration reform, it could be counterproductive," said Valliere.

Taxes will be the hottest topic after Tuesday's election, and the question is how will the lame duck Congress deal with the expiring Bush tax cuts.

Valliere sees a 70 percent chance that the tax cuts get extended in their entirety. The Obama administration proposes extending tax cuts for most people, but not the wealthiest Americans.

For investors, if the tax cuts are not extended, the dividend tax rate would go from 15 percent to as much as 39.6 percent for those in the newly raised upper tax bracket, and the top capital gains tax will automatically go to 20 percent from 15 percent.

If the dividend tax rate and capital gains rates do look set to rise, Knight Equities managing director Peter Kenny expects to see investors take some profits from the stock market but not eliminate core equities positions. "I don't think it's the worst thing for the markets. I do think it does address some sense of fiscal responsibility," he said. Kenny does not expect to see the tax cuts extended.

But Clifton also believes Congress could retain all the tax cuts, after an ugly post-election battle.

"What changed my view is there's now nine Senate Democrats who are saying they're not going to vote for the middle class tax cut unless they get all the tax cuts extended. The reason is they're up for election in 2012, not 2010. It's those Democrats that are going to lead the way forward," he said.

Some Republicans, meanwhile have said privately that the tax vote could be put off until January, when they will put together a passable proposal, said Valliere. He said that course would be very disruptive.

"This could then go from January to February to March before they fix it, and then Obama still has a veto," he said. Meanwhile, companies would be forced to handle withholding as if all the cuts had expired, creating an accounting mess if the cuts are reinstated.

"You're at least going to get a one-year extension (of the tax cuts), and you're going to get it in the last week of November, first week of December...there's so many tax cuts that are going to expire if they don't get extended," Clifton said. He also said another 27 million Americans would be impacted by the AMT, and it is unlikely President Obama would allow that to happen.

"If it's not patched before the end of the calendar year that means when taxpayers go to pay their taxes in March or April for this calendar year, 27 million will have to pay the alternative minimum tax this spring...it is going to be a tax revolt at a level we've never seen. The administration absolutely needs to get that done," he said.

Valliere said he does not expect the issue to be resolved until the very end of December.

"The clouds over the market on the Bush tax cuts extension is not going to clear until December 20 or 21," he said.

Economists are also watching the tax developments with interest.

"The big story here is that within a month's time, Congress has the ability to pass on $300 billion in tax increases or nothing...if they don't take a vote it's $300 billion automatically. Those are two extremes," said Citigroup economist Steven Wieting. He said his baseline case is that the Obama administration gets close to the amount of tightening it wants.

"If you look at it, it has more impact on the economy than QE," Wieting added. "This is a big issue and they have tremendous potential to influence the economy next year, and we should start to get answers in the end of November."

Winners and Losers

Valliere said a big theme in the new Congress will be austerity. "I think we'll see a defacto freeze on spending for the next two years...my personal view is you could not pick a worse time for austerity. You've got an ailing patient and let's put some leaches on the problem, but that's what the public wants," he said.

"I think much of the defense budget will be frozen. Anything that relies on Washington is going to get a hair cut," he said.

Managed care companies could see a minor benefit from a Republican win in the House, but the GOP would have to take both Houses for gains to stick, Clifton said. He expects a Republican House would try to roll back health care reform, but the effort would end there.

"You get a rally in managed care, but it's temporary. Energy has real issues...if the Republicans win the Senate, then that really changes the game," he said. In addition to working up new regulations on offshore drilling, Strategas points out the EPA is studying fracking with the goal of taking regulatory authority over the process, and the GOP is more likely to favor the current state run regulatory structure.

Energy companies could be among the biggest winners if Republicans increase their numbers as expected. For one thing, the House Natural Resources committee would be chaired by Rep. Doc Hastings of Washington. Hastings was against the moratorium on new drilling and tried to stop a bill that would impose new safety standards on offshore drilling.

"There's a lot in the air for energy in this election," said Clifton. Republicans would also have a more favorable industry view on issues of cap and trade, taxation, and Environmental Protection Agency oversight.

On the outside chance Democrats hold onto the majority in the House, Clifton sees municipal bonds, dividend paying stocks, infrastructure companies, clean energy firms and communications companies as better bets.

- Follow me on Twitter @pattidomm.

Questions? Comments? Email us at marketinsider@cnbc.com

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