US money spinners fear fiscal gridlock

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Jim Black is a dyed-in-the-wool Republican who is worried. In the aftermath of the US midterm elections, he and his largely Republican colleagues are seated round a conference table in West Los Angeles, trying to make sense of the dramatic Republi can victories.

They voice fears that too much change and uncertainty will wreak havoc on the economy. The setting is very up-market, reflecting the positions of these money managers who represent many of the largest US financial houses. But instead of being jubilant over their party's return to legislative power, most are depressingly downbeat. What they forsee for the next two years is divisive domestic politics, divisive external struggles over security and trade issues, and divisive internal class struggles based on a deepening spread of income distribution.

As a result, the majority of these big institutional investors are bearish, with most holding large cash positions as they wait for markets to turn. Some believe the "turn" when it comes will be very big and prolonged, rivaling prior bear markets that are not even a memory to the yuppie generation of the 1980s.

One need only read California's newspapers to see what is fuelling such bleak forecasts. Orange County's disastrous experiments with leverage and derivatives have sent shockwaves through the state and the huge munipical bond community. Losses to the county's $7.5bn investment fund may have been underestimated at $1.5bn.

These losses will affect not only big county projects, such as a planned $3bn expansion of Disneyland, but also the fortunes of the 180 municipalities and government agencies that invested in the fund. Moreover, big losses on Wall Street and a possible lawsuit against Merrill Lynch, which played a central role in the county's investment strategy, are expected fallouts.

In the meantime, government officials are attempting to halt panicked selloffs in the municipal bond markets, and the Securities & Exchange Commission is promising a full-scale investigation. The scandal in Orange County, plus Bankers Trust's continuing difficulties with derivatives and word that the Fidelity Magellan mutual fund has somehow lost track of a $1.4bn loss, are shaking public confidence in the competence of the financial community. But the money managers agree that these unrelated problems are temporary setbacks that will soon fade from memory.

More worrying is the prospect of bitter politics over the next two years. Despite pledges of bipartisan agendas by both parties, none of the money managers believes this will be the result. They expect Republicans to try and lock in their power, and Democrats, in their unfamiliar minority role, to fight them every step of the way.

They also expect a weakened President Clinton to be further weakened by challenges from within his party and by a reinvigorated Whitewater investigation led by Republicans. Some fear the legal battles will become so time consuming and contentious that MrClinton may be forced to stand down. With the ultimate prize of the presidency "out there dangling," said one veteran money manager, "you know the politics are going to be nasty."

None of this bodes well for business or public confidence. These sophisticated professionals are betting on political gridlock and more upheavals. Most in this crowd are "hawks" on deficit-reduction but do not expect much progress on that front. Armed with copies of memos obtained from a bipartisan deficit-reduction commission in Washington, the managers shake their heads and predict that none of the recommendations will be adopted.

The Entitlement and Tax Reform Commission, co-chaired by Senator Bob Kerrey, a Democrat, and Senator John Danforth, a Republican, met last week to review the options it will present to the President Among them are controversial proposals to raise the eligibility age for Social Security benefits to 70, to cut Medicare benefits to those above specified income levels, and to reduce tax deductions for wealthier taxpayers.

In a joint letter to commission members, the co-chairmen said that without prompt action to reduce costs of these entitlement programmes, the US economy will remain mired in severe budgetary constraints for the forseeable future. There will be no money for public works, education and crime control projects. Social Security, Medicare and other programmes, when added to interest payments on the national debt, now account for 60 per cent of government spending. Without action in these entitlement areas, all other efforts to reduce the budget are relatively meaningless.

However, as the money managers predicted, there is little support in Congress from either side. One Republican commission member said deliberations, on the eve of presenting recommendations to the President, were close to "meltdown", and Martin Sabo, outgoing Democratic chairman of the House Budget Committee, said support for such tough action was unlikely. So far, the money managers have called it right.