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It’s in vogue these days to assume that Republican victories in the upcoming mid-term elections will boost the market. With the Dow Jones Industrial Average breaking above 10,700 again and seemingly within reach of 11,000, some of that sentiment may already be priced in to equity prices. But even if the political winds shift markedly to the right, seating a new crop of “pro-business” branded legislators, there are good reasons to think that the market won’t be that predictable.

High among them is that one of the more grisly post-election issues Congress must face is whether to further extend federal unemployment benefits for long-term unemployed workers that were last extended in July and expire on November 30.

There’s a big debate among economists about whether the extensions are good policy. A long held tenet of U.S. Government policy in the modern era is that the government needs to maintain benefits to provide for basic needs while families wait for jobs to return. But a perspective that’s gaining more traction is that too many people are milking the system, using benefits to hold out and decline job opportunities until they find a job comparable to the one they lost, which in today’s economy may never come.

Proponents of cutting benefits buttress their arguments against further extensions on Germany’s arguably successful experience of reducing unemployment by slashing job loss benefits. Unemployment in Germany initially spiked after reform measures — then called Agenda 2010 – were implemented in 2003-2005, though subsequent improvement was so strong that by the end of 2009 German unemployment figures were still better than before the reforms began. Reasonable people can differ on the policy issue, though policymakers should act with compassion for those who want to work and need benefits to keep food on the table while they pound the pavement.

But regardless of ones perspective on the debate, what it means for investors is turbulence. Right now it’s easy to underestimate the depth of conviction conservatives who support cutting benefits hold. A platform to cut unemployment benefits doesn’t win votes from the large proportion of the electorate affected by job loss, but once those votes are cast the game changes.

And to boot, the issue is likely to pop up again and again like a jack-in-the-box over the coming winter. Consider this scenario: Following Republican victories in November, a “lame duck” Congress passes a watered-down extension of benefits through January 2011, when newly elected legislators take office. Then a rebalanced Congress publicly debates how far to go in cutting benefits and votes again, aggravating economic fears.

Even if Congress does cut the benefits and that eventually works akin to the German example, it will take many months if not years to see the signs. Long before that, when the debate itself becomes a big story, shock waves on aggravating unemployment and shattering a delicate recovery may shake the markets.

So as election fever heats up, take cover.



Disclosure: No stocks mentioned in this post.

Source: Will Extending Unemployment Benefits Dampen Market Gains?