The Congressional Budget Office’s announcement Wednesday that 2009’s budget deficit was going to be $1.19 trillion – before a nickel of President-elect Barack Obama’s stimulus plan has been included – raises a crucial question for the U.S. economy: Is there too much stimulus, and what effect would too much stimulus have?

There is certainly more stimulus than in any previous recession. The benchmark Federal Funds rate is essentially at zero, which has never previously been attempted, while inflation is still positive. The money supply has been increased by almost 20% in the last three months, which one would normally expect to lead to higher inflation.

On the fiscal side, the $1.19 trillion deficit forecast by the CBO is 8.3% of gross domestic product (GDP), considerably higher than the previous record of 6% of GDP in the recession-ridden year of 1983. And that deficit calculation doesn’t include President-elect Obama’s stimulus plan, which at $800 billion over two years could add $400 billion to the deficit and push it to more than 10% of GDP.

With both monetary and fiscal stimulus stronger than ever before in peacetime, the government is running the economy absolutely flat-out. Only if you thought the government had no effect at all on economic activity could you believe that recession and deflation would continue.

The initial rationale for all of this stimulus was the unprecedented nature of the housing finance disaster, with drops in market prices and loan-loss levels not seen since the Great Depression. Had the U.S. banking system imploded – as it seemed destined to back in September – the resulting recession could indeed have rivaled the Great Depression.

However the $350 billion from the first tranche of the Troubled Assets Relief Program (TARP), mostly invested directly into bank capital (although a number of banks admittedly used the taxpayer-provided infusion to play “let’s make a deal“), appears to have stabilized matters.

JP Morgan Chase & Co. (JPM), for example, is expected to make losses of around $2 billion in the fourth quarter of 2008 – a nasty result to be sure but by no means unexpected in a quarter when stock markets dropped 20% and illiquidity was at its height. With $25 billion of new capital from Uncle Sam, JP Morgan now has plenty of wiggle-room to survive – even in an extended downturn.

In 2009, further trouble may lurk for the weaker U.S. banks, but strong banks like JPM should gain market share and do quite well.  

With liquidity now largely restored by both the TARP and by federal asset purchases, there would seem no reason why the banks’ corporate lending should be any more restricted than in previous moderate recessions. In those circumstances, the unprecedented fiscal and monetary stimulus should, in the short-term, produce a stock market bounce, an economic recovery, a dramatic run-up in the price of gold, and soaring inflation, in that order.

The conventional wisdom is that the U.S. economy will have a very difficult first half, but that recovery may appear in the second half of 2009.

These things are very difficult to predict, but my money would be on precisely the reverse scenario: The stock market will be strong in the short-term, and economic numbers will turn around quite rapidly, perhaps even producing modest first-quarter GDP growth, and quite robust economic growth in the second quarter.

By late summer, however, the resurgence in inflation and financing difficulties in the U.S. Treasury bond market will cause an increase in long-term interest rates, accompanied by a reassessment of the U.S. Federal Reserve’s 0% short-term interest rate policy.

That will cause the stock market to reverse direction and head downward.

Serious consumer price inflation will take longer to appear. But by the end of the year and in the first half of 2010, prices will be rapidly rising. Accordingly, both the Fed and the Obama administration will have to begin reversing their stimulative policies, raising interest rates and cutting public spending – or even raising taxes. The policy reversal will cause a second economic downturn, but one that’s of a very different nature from the first.

The current downturn has been caused by a collapse in asset prices, and has been reversed by exceptionally strong monetary and fiscal stimulus policies. However, the second downturn will be sparked by a crisis in the long-term bond markets, will be more concentrated on the real economy than on just the financial sector, and is likely to be much more prolonged since fiscal and monetary policies will be forced to be restrictive.

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Monetary policy will have to be tightened to fight surging inflation, while fiscal policy will foster a lengthy battle in the administration and in Congress between the economic necessity of austerity and its hugely unattractive political effects.

Reversing such extreme fiscal and monetary policies will be exceptionally painful, and the second leg of the recession will thus be exceptionally damaging to U.S. corporate profits and to U.S. stock prices. The stock market is likely to take out its November lows by a considerable margin, although at its nadir it will offer patient investors an exceptional long-term bargain – just as it did in 1932, 1949 and 1982, with high real long-term returns for those bold enough to invest.

Currently, the balance of probabilities favors a rising market in the short term – perhaps even rising quite sharply because of the exceptional strength of the current monetary and fiscal stimulus. Gold and gold-mining shares should do particularly well.

Let’s enjoy this projected short-term bull run while it lasts!

[Editor's Note: As this market analysis underscores, the ongoing global financial crisis has changed the investment game forever. Uncertainty is now the norm and that new reality alone has created a whole set of new rules that will help determine who profits and who loses. Investors who ignore this "New Reality" will struggle, and will find their financial forays to be frustrating and unrewarding. But investors who embrace this change will not only survive - they will thrive. The "Geiger Index," a new service featuring Money Morning Investment Director Keith Fitz-Gerald, has already isolated the new rules that govern this new reality, and has also unlocked the key to what Fitz-Gerald likes to refer to as "The Golden Age of Wealth Creation." The Geiger Index system allows Fitz-Gerald to predict the price movements of broad indexes, or of individual stocks, with a high degree of certainty. And it's particularly well suited to the volatile, uncertain market that we're all facing right now. Check out our latest report on these new rules, and on what investors must do to pursue profits and wealth in this new market environment.]

News and Related Story Links:

• Money Morning Outlook 2009 Series:
  Five Ways to Play Gold’s Rebound to $1,500 an Ounce.
• Money Morning News Analysis:
  Fed Slashes Interest Rates to a 0.0% to 0.25% Target Range … But Now What?
• Money Morning Investigative Report on the Bank Bailouts (Part V):
  U.S. Banks Refuse to Detail How They’re Spending Federal Bailout Money.
• Money Morning Investigative Report on the Bank Bailouts (Part IV):
  Banks That Got $188 Billion in Bailout Money This Year Paid Out $1.6 Billion to Top Execs Last Year.
• Money Morning Investigative Report on the Bank Bailouts (Part III):
  Billions in U.S. Bank Rescue Funds are Fueling Buyouts Worldwide – Instead of Lending at Home.
• Money Morning Investigative Report on the Bank Bailouts (Part II):
  Billions in Bank Rescue Funds are Fueling Buyout Deals, and not the Increase in Loans That Would Help Ease the Financial Crisis.
• Money Morning Investigative Report on the Bank Bailouts (Part I):
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  Troubled Asset Relief Program.
• Money Morning Market Analysis:
  What Shape Will the U.S. Recession Take: U, W or ‘Bloody L?’
• Money Morning Market Analysis:
  Why Fed Policies and Treasury Department Bailouts Will Lead to Inflation Rather Than Deflation.

By Martin Hutchinson
Contributing Editor

No matter who wins the looming presidential election – Barack Obama or John McCain – investors are likely to see a similar outcome: The new president will quickly remove the distortions in the U.S. and world economies that have resulted from this lengthy period of low interest rates, and he’ll do so without eviscerating portfolio values.

But while the outcomes will be similar – as we’ve reported – the routes the candidates will follow to achieve those similar outcomes are decidedly different. This week – in observance of the Democratic National Convention in Denver (see accompanying graphic) – I will look at the potential effect on investors of a Barack Obama presidency, which most experts refer to as “Obamanomics.” Then next week, in observance of the Republican National Convention in Minneapolis-St. Paul, I will examine how a McCain presidency would affect investors.

This exercise in analysis is made all the more worthwhile by the fact that Obama and McCain are now in a dead heat in the latest political poll, according to CNN.

Taxes Will Climb…

The main bad news from an Obama presidency is higher taxes. The Obamanomics platform includes a promise to repeal most of the Bush tax cuts. Obama has also vowed to stop the estate tax from disappearing as was scheduled in 2010, and to increase Social Security taxes on high incomes. He also said last week that both the capital gains tax and the dividend tax should be 20% compared to the current 15%.  At first glance, all those tax increases appear depressing for the stock market itself, as well as for U.S. investors’ pocketbooks directly.

However, the alternative to higher taxes may well be an out-of-control budget deficit, which is far more dangerous in the long run. We already have a deficit of close to $500 billion, without there having been an official recession. What’s more, that figure does not include the full costs of the Iraq War (which are funded by “supplementals”) and does not include the cost of the dual bailouts of Fannie Mae (FNM) and Freddie Mac (FRE), which is certainly a substantial multiple of the $25 billion lowball estimate posed by the Congressional Budget Office (CBO). Given that we’re not electing Calvin Coolidge as president with a promise to make Ebenezer Scrooge the U.S. treasury secretary – meaning that spending is only going to be kept marginally under control, tax increases are pretty well inevitable, anyway.

…as Spending Does, Too

On the spending side, Obama is pretty much a standard-issue Democrat. He will introduce a new healthcare plan, which will be expensive, though not as expensive as Hillary Rodham Clinton’s would have been (because it will not include a “universal mandate” forcing everyone to participate). He will wind down the Iraq War and is fairly unlikely to engage in further adventures that turn out to be expensive (though one can never tell here, particularly with Vladimir Putin on the prowl). He may take a bit of an ax to corporate welfare, farm subsidies and ethanol subsidies, none of which are important to the major Democratic constituencies. Thus, overall spending under Obama is likely to be higher than under McCain, but not by much.

On monetary policy, Obama is advised by former U.S. Federal Reserve Chairman Paul Volcker, a believer in fighting inflation through high interest rates – a strategy he successfully employed in the early 1980s. Further, current Fed Chairman Ben S. Bernanke is a Republican appointee whose term expires in January 2010. And since former Fed chief Alan Greenspan served throughout the Clinton years, there has not been a Democrat-appointed Fed chairman since Volcker himself in 1979.  It is thus very probable that Obama will replace Bernanke, and quite possible that he will replace him with a monetary “hawk” who will push interest rates higher. This will make Wall Street squawk, and will likely cause a temporary crash in stock prices, but will end up being very much to the long-term benefit of the U.S. economy. Enough with the financial bubbles that we’ve seen!

Key Obama Policies Will Create Investment Opportunities

Obama’s other major initiative is to combat global warming by instituting a system of carbon emissions permits that – unlike Sen. McCain’s equivalent permits – would be sold, rather than given, to the major emitters. This is a much less efficient way of reducing carbon emissions than a carbon tax, and involves government more deeply in the details of how emissions are reduced (for example, government gets to decide how many permits to sell). The additional revenue from the permits may help balance the budget, although Obama has plans for a $150 billion government investment in clean energy technology over the next decade.

Internationally, Obama is likely to pursue a more multilateral foreign policy than current U.S. President George W. Bush or McCain. He appears reasonably committed to international trade, and may indeed through his charisma have the ability to make progress on the Doha round of international trade talks, stalled since 2003.  That would increase investment opportunities in such emerging markets as India and China – particularly when patents or other intellectual property are involved.

In terms of sectors that investors should either consider or avoid altogether, an Obama presidency is likely to be bad news for the pharmaceutical majors producing patented drugs. Prescription drug costs are one of the key catalysts behind soaring medical costs, and any kind of public sector healthcare scheme is likely to attack this area, viewing it as a major opportunity for cutting costs. The medical sector in general might also suffer, not so much because of Obama’s policies as because of the greater license a Democratic administration would give to the trial lawyers.

The major beneficiaries of a policy of higher interest rates will be companies with large piles of cash, who will earn better returns on that money and have cheaper opportunities to deploy it as the share prices of their highly leveraged rivals crash to earth.

Finally, you might look for a new energy company that could benefit from Obama’s afore-mentioned $150 billion alternative-energy fund.

[Editor’s Note: Money Morning Contributing Editor Martin Hutchinson has personally interviewed the economic advisors for candidates McCain, Obama and Edwards, and very early on concluded that Obama and McCain would be the best candidates for investors. For a full report on the "presidential profit plays," please click here. The report is free of charge.]

News and Related Story Links:

• Money Morning Economic Analysis:
  Doha Discussions Could Take Another Seven Years .

• Democratic National Convention:
  Event Web Site.

• Republican National Convention:
  Event Web Site.

• Whitehouse.gov:
  The Bush Tax Cuts.

• Money Morning Special Investment Research Report:
  Special Report: Hit the BRICs for a Global-Investing Double Play.

• Wikipedia:
  
  Estate Taxes.

• Whitehouse.gov:
  President George W. Bush.

• Wikipedia:
  IOUSA – the Movie.

• Congressional Budget Office:
  Web Site.

• Wikipedia:
  
  Calvin Coolidge.

• Wikipedia:
  Ebenezer Scrooge.

• Environmental Economics:
  Obama versus McCain on climate.

• Wikipedia:
  
  Iraq War.

• CNN.com:
  
  Poll: Race for White House tied.

• Wikipedia:
  Hillary Rodham Clinton.

• Money Morning Investment Research Report:
  
  Profit Opportunities From the New Cold War.

• Wikipedia:
  Paul Volcker.

• Wikipedia:
  
  Emissions Trading.

• Money Morning Election Series:
  
  Election 2008: Obama or McCain – U.S. May Suffer Either Way.

• Money Morning Election Series:
  
  Election 2008: The Achilles’ Heel of Obamanomics.

• Money Morning Election Series:
  
  Election 2008: Why Poor Presidential Approval Ratings Make For Great Stock Markets.

• Money Morning Election Series:
  
  Election 2008: As Democratic Primary Hits a New Pinnacle Today, Obamanomics Emerges as Clear Front-Runner for Investors.

• Money Morning Election Series:
  The Six Profit Plays to Consider as “Super Tuesday” Plays Out.