10/28/20: Market Update by Jack Ablin, Chief Investment Officer at Cresset
With the 2020 election just days away, investors are scrambling to determine what its ultimate outcome could mean for their investment portfolios. Vice President Biden, the candidate with the current polling advantage, has been outspoken about his desire to raise taxes on the rich, vowing to hike the personal income tax rate from 37 per cent to 39.6 per cent on incomes in excess of $400,000. He also plans to, in effect, double the capital gains tax rate and eliminate the step up in cost basis at death.
On the corporate side, Biden hopes to ratchet the corporate income tax rate back up to 25 per cent from the 21 per cent rate established with President Trump’s Tax Cuts and Jobs Act of 2017. Additionally, the anodyne candidate hopes to close a loophole in Trump’s corporate tax act by raising the rate on foreign income, particularly for companies that shifted their intellectual property to tax haven countries.
Near term, however, a massive spending bill is ready to go. Investors anticipate a Biden administration would enact more than $2 trillion in spending to support out-of-work Americans and beleaguered businesses. Longer term, the Congressional Budget Office projects Biden’s tax proposal would raise roughly $3 trillion in tax revenue over 10 years. The candidate plans to channel those proceeds toward infrastructure, health care and alternative energy, among other programs.
Many of these measures rely on the Democrats taking control of the Senate – an outcome that’s far from certain. By combining polling data with political futures markets, we estimate the likelihood of a “blue wave” at about 50 per cent, a Biden victory without congressional control at about 30 per cent, and the status quo at about 20 per cent.
A corporate tax reset would be unwelcome news for sectors like technology and health care, which together comprise more than 40 per cent of the S&P 500. Profitable companies within these sectors sported effective tax rates of 15 per cent and 20 per cent, respectively, last year. Biden’s proposed 25 per cent corporate tax rate would boost their tax liabilities. Additionally, both sectors are heavily invested in intellectual property, much of which is held offshore. Technology companies derived more than half of their revenue offshore last year, while 37 per cent of health care revenue was generated outside the United States. Other sectors with a tax bullseye on their backs are financials, materials and consumer staples.
A doubling of the capital gains tax rate would also inflict pain on sectors with the highest unrealized gains, prompting an acceleration of gain realization. Technology, a sector that has gained more than 180 per cent over the last five years, would be most exposed. Consumer discretionary, which nearly doubled in the interim, would be next. Media reports this week indicate that Trump mega-donor Sheldon Adelson, sensing a Biden victory, is considering selling his Venetian and Palazzo casinos on the Las Vegas Strip to accelerate a capital gain into 2020.
Whether a blue wave or a Biden White House are in store, 2021 would likely mark a secular reversal in economic policy. Ushered in by President Reagan and Federal Reserve Chairman Paul Volcker in the 1980s, monetary policy and supply-side economics held sway in Washington over the last 40 years through a combination of lower interest rates, smaller tax burdens and lighter regulations. The Federal Funds Rate has cascaded from 20 per cent to zero. Corporate taxes as a share of GDP have slid from 2.6 per cent to 1.1 per cent, while the value of the stock market has grown nearly four times faster than the economy. Donald Trump, like Jimmy Carter, is a first-term president who appears powerless to solve a problem beyond his control. In Carter’s case it was the Iran hostage crisis; for Trump, it is the coronavirus. Like Carter, Trump suffers the ignominy of a low approval rating, averaging 40 per cent; Carter’s average was 45 per cent. A Biden victory would likely initiate a shift toward fiscal, demand-side stimulus. Over time, such a result could mean a reversal in inflation, interest rates and the relationship between wages and profits.
We expect near-term stimulus will eventually give way to tax increases and weigh on corporate profits, particularly among the largest names in technology and health care. Municipal bonds, given their tax-exempt status, will become incrementally more attractive in a higher income tax environment. High-yield munis could also benefit from Democrat policymaking should Washington increase its support of cities and states through higher education funding and Medicaid spending.
We expect active management to continue to outpace passive indices as cheaper, smaller and lower-quality names outpace the largest, highest-quality companies in a fiscal-led policy environment. Higher demand would also likely benefit emerging market equities, which are incrementally cheaper than US large caps.
While history has shown that political parties have had little influence on the markets over longer time frames, an economic policy shift could have a profound impact on the markets over time. The good news: we don’t need to react right away. Remember, Reagan’s presidency set a program in motion that took 40 years to play out.
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