MARKET COMMENTARY

How are Markets Likely to Respond to the 2020 Elections?

07.21.2020 - Douglas Cohen

Key Takeaways:
  • Political views aside, equities have performed best with a Democratic president and a Republican Senate.
  • A blue sweep could lead to significant changes to the economy, with green companies being potential beneficiaries.
  • Possible short-term losers include health insurers, tech giants, big banks, shale producers and some retailers.
  • Investors should consider taking capital gains and reducing concentrations, rebalancing portfolios, emphasizing after-tax income through munis and the merits of a Roth IRA.

Two factors are highly likely to drive the equity market over the balance of the summer: 1) the extent to which the economy emerges from its COVID-19 induced lock-down and 2) any sense that the Federal Reserve is poised to retreat from its unprecedented series of backstops (extremely unlikely), or that Congress will not provide additional large scale relief (also unlikely, but not impossible given ever-increasing political polarization). That last point is a segue to the November elections—an issue that has remained largely in the market's periphery to date.  Election-related positioning is sure to increase though well before the autumn leaves begin to turn. Here is our best objective assessment of the key market-related variables to monitor:

Elections clearly have consequences, but they are rarely paramount

There is a strong likelihood that markets over the next four years will be driven primarily by factors largely unrelated to the election. This is consistent with the notion that equity markets have historically done modestly better under Democratic administrations but that the difference all but disappears when one factors in Republican outperformance in the 12 or so week periods between Election Day and inauguration. Adding congressional control into the mix changes the calculus somewhat though. Despite the oft-heard perception that markets favor gridlock, the equity market has performed best with a Democratic president and a Republican Senate.

Political backdrops and market returns

S&P 500 Index performance under various scenarios

Source: Bloomberg. Time period begins in 1976 with Carter administration. Methodology is based on rebalancing every two years or every election cycle, thus incorporating any changes to Congress resulting from the mid-term elections. 

This is no ordinary election

Despite the points noted above, President Trump is not your typical Republican as evidenced by, for example, his tolerance for budget deficits, protectionism and isolationism.  Similarly, while former Vice President Biden has historically embraced most of the policies supported by centrist Democrats, today's Democratic Party has moved to the left of its predecessors on many social issues and its support for government regulation related to healthcare, the environment, higher minimum wages, etc.

Yes, there is often a stark contrast between the positions embraced by candidates prior to a general election and those that they ultimately embrace. However, this time around we can anticipate that a second Trump Administration would bring more of the same, whereas a Biden Administration is likely to follow the Democratic party’s increasingly progressive base to the left of the Obama Administration's key initiatives. For those reasons, the upcoming presidential election could prove extremely consequential for markets. 

Congressional control is likely to be a key wildcard. At this point, the Democrats are an overwhelming favorite to retain the House. However, the Senate remains very much in play with the Democrat’s needing a net four seat gain to reach 51 although they would have de facto control with a net three seat gain and a Biden win (keep a particularly close eye on Alabama, Arizona, Colorado, Georgia, Iowa, Maine, Montana and North Carolina).  The current PredictIt betting odds point to a roughly 60% chance of a Senate flip to the Democrats—about the same current probability as a Biden win. 

A lot can change over the next four-plus months (think back to what the world was like in mid-February!), but at this point we are very likely looking at either: 1) a Democratic sweep; 2) Biden with a split Congress; or 3) Trump with a split Congress.  We cannot realistically envision a GOP sweep, nor is it likely that Trump ekes out a win with the GOP losing the Senate.  In broad strokes, we think the market would take either scenario 2 or 3 above very much in stride, at least initially. There would surely be some industry-specific winners and losers, but the broader economic landscape probably wouldn't change very much in either scenario until at least the 2022 midterms. 

A Democratic sweep though would likely lead to some profound changes, so we will focus specifically on that possibility.

A Democratic sweep would likely lead to significantly higher taxes for corporations and high earners

Biden’s tax proposals aim to raise about $4 trillion in incremental revenue over 10 years, with a roughly even split coming from corporations and individuals. One could certainly argue that higher revenue over time is urgently needed as US budget deficits were surging even before the pandemic-induced crisis. The nonpartisan Tax Foundation has concluded that the Biden tax plan would reduce US GDP by 1.51% over the long run though.[1]  At the margin, the combination of lower corporate earnings and lower after-tax incomes from wealthier investors would likely weigh on equity markets in the near-term, in our view. That market impact may well be offset over time by positive COVID-19 related news and a still-dovish Fed, but all else equal we believe the market would prefer either a Trump win with a GOP Senate or a Biden win with a GOP Senate.  

Higher corporate taxes are a near-certainty if there is a dominant blue wave. The 2017 Trump Tax Cuts and Jobs Act reduced the corporate tax from 35% to 21%. Biden has proposed an increase to 28%. While there will likely be a push to revert closer to the former 35% rate from more progressive Democrats, several moderate Democrats were in favor of a lower rate during the Obama years to help level the global tax rate playing field. We would thus be surprised to see anything above 28% and there is a small chance enactment could wait until the economy is on a firmer post-pandemic footing.

There are several other corporate tax-related incentives and deductions that may be tweaked, such as interest expense deductibility, but a move to 28% would likely reduce S&P 500 earnings by 5 to 6% based on our analysis. This assumption does not factor in another Biden proposal that would create a 15% minimum tax on large companies that has enough unintended consequences that we do not envision it being enacted.

The Democratic tax agenda is likely to extend well beyond corporate taxes. Biden has been adamant that he will not raise taxes on those earning under $400,000 per year. He has also eschewed the calls for a wealth tax that were embraced by his most prominent competitors during the primaries. Still, Biden’s self-described guiding principle is “to stop rewarding wealth and start rewarding work a little bit.”

According to the nonpartisan Tax Policy Center, 93% of Biden’s proposed individual tax increases would be paid by the top 20% highest earning households. Of particular note, marginal tax rates for high earners would return to their pre-Trump tax reform levels with a top rate of 39.6% from the current 37.0%. Itemized deductions would again be capped at 28%. Biden would look to significantly increase payroll taxes on those earning over $400,000 per year—the imposition of a 12.4% Social Security tax to be split evenly between employees and employers on those wages would raise nearly $1 trillion over a decade. Long-term capital gains and qualified dividends for those earning more than $1 million would rise to their ordinary tax rate.  To the extent that dividends are already taxed at the corporate level, the cumulative effective tax rate on dividends would be approximately 60%. 

The former Vice President has also proposed ending the step-up provision upon death, a major philosophical change that would increase the tax liability for heirs and could lead to significant selling of shares that might otherwise have been retained. Along similar lines, the 2017 Trump tax cuts roughly doubled the amount that can be given to heirs without being subject to a 40% inheritance tax.  The current lifetime exemption is $11.58 million per individual.  Like most of the 2017 Act’s provisions, the higher threshold is set to expire at the end of 2025, at which point the limit would revert to pre-2017 Act levels, adjusted for inflation.  It is unclear if a Democratic Congress will choose to let the existing provisions simply run their course. 

Biden’s tax plan does offer several potential benefits for low and middle-income workers. Examples include expanded childcare credits, student loan debt forgiveness and tax incentives to promote greater retirement saving.  He has proposed a one-time refundable tax credit of up to $15,000 for new home buyers. Another proposal aimed at affordable housing would enact a new tax credit to reduce rent and utility costs to 30% of income for low-income households. One could also envision the elimination of the 2017 tax law provision that capped state and local tax (SALT) deductions at $10,000 per year—a provision that has angered many blue state residents. There are other proposed taxes (and tax cuts) targeted at specific sectors of the economy, including those summarized further below.

We would point out that, while clients are always encouraged to consult with their tax advisors regarding specific tax-related strategies best suited to their unique circumstances, investors may want to consider the following tactics by year end: taking capital gains and reducing concentrated holdings, rebalancing portfolios before possible tax changes occur and increasing their emphasis on municipal bonds despite the overall low-yield environment. Other potentially time-sensitive actions may include utilizing the expanded lifetime gift-tax exemption while it remains in place and converting traditional IRAs to a Roth IRA at current tax rates.

There will likely be at least a handful of industry-specific winners and losers

Again, we will focus primarily on the implications of a blue sweep, the scenario likely to lead to the most significant changes. Green energy companies stand to be among the biggest beneficiaries of a return to programs that seek to combat climate change.  Significant tax-incentives for renewable energy providers and products such as electric cars are likely (this is one area where Biden could make some inroads even with a narrow Republican Senate majority as there are at least a handful of Republicans who have indicated support for green-oriented policies).  While Biden and a Democratic Congress are unlikely to ban fracking outright, they are likely to limit both on-shore and off-shore oil and gas growth. This may contribute to higher fuel prices over time, but the near-term implication would be to exacerbate the existing pressures on many American shale producers and the states that have become increasingly tied to the fossil fuel industry.

Much like the days before and after Obamacare was implemented, the outlook for healthcare stocks is … complicated. Biden hopes to build on the core elements of Obamacare and add a stronger public option. Pharma stocks (including biotechs) are likely to be in the crosshairs no matter who wins the election, but Democrats have historically been more disposed to drug price controls and more open to drug reimportation. The COVID-19 crisis has generated some collective appreciation for the importance of a thriving drug industry, but we wouldn’t count on that goodwill lasting very long with or without major virus breakthroughs.  While providing more Americans with health coverage should increase overall healthcare spending and benefit some providers, including hospitals, an expanded public option is likely a greater threat to the business models of many health insurance companies than what transpired with Obamacare.

Other industries that could face pressure include the big technology giants, primarily due to strong antitrust sentiment within much of the Democratic party.  That sentiment, exemplified in the policies proposed by Senator Elizabeth Warren, also extends to the largest banks.

Speaking of the banks, Federal Reserve Chairman Powell’s term expires in 2022.  Long the target of unprecedented public criticism from President Trump, Powell’s seemingly strong response to the COVID-19 crisis could get him another four years under either administration.  We wouldn’t count on it though.  Trump would likely embrace a more bona fide dove. Conversely, a more hawkish Fed leader could pose a threat to the broader equity market, at least in the near term even as, all else equal, higher rates would likely benefit the bank stocks.  While there are niche industries that could benefit (e.g., building materials, marijuana) or suffer (private prisons, for-profit colleges) from a Democratic sweep, increased support for a sharply higher federal minimum wage and general support for labor unions could pressure many of the retailers that are currently struggling to maintain operating margins during the COVID-19 era.    

Elections and policy changes oftentimes may move markets and stocks in the short to medium term, however, long term investing requires deeper fundamental analysis of many other factors, including how consumers, companies and industries adapt to changes.  Many folks have strong political opinions and we have tried to avoid any partisan jabs. We are well aware though that we have only scratched the surface of what a change in administrations might entail as there are many implications that transcend the capital markets directly ranging from foreign policy to the composition of the judicial branch to many social priorities.  Our only intentional political guidance is as follows: research the issues and the candidates the best that you can—and vote!

[1] “Details and Analysis of Former Vice President Biden’s Tax Proposals”, Li, Huaquin, Garret Wilson and Taylor LaJoie, Tax Foundation, 4/29/20.




The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

MARKET COMMENTARY

Initial Jobless Claims Continue to Fall, But Remain at Elevated Levels

08.13.2020 Jon Heckscher

NEXT POST

MARKET COMMENTARY

Emerging Themes in a Post-Pandemic World

07.14.2020 Carin L. Pai, CFA

PREVIOUS POST