With the U.S. Presidential election fast approaching, and two very different candidates on the ballot, market investors are beginning to look at how politics may affect the economy, capital markets and prospective investment returns.
First some caveats:
- Significantly factoring politics into long-term strategic investment decision-making is a very risky proposition. Politics, by its very nature, is laden with emotion, and emotion can be a very detrimental factor in making investment decisions.
- Furthermore, correlating broad stock market historical returns with political party affiliation is meaningless given the dramatic changes that occur in the economy and capital markets over long periods of time, not to mention the dramatic changes that occur over time to the demographic characteristics and policy priorities of the two dominant political parties.
The past 12 years provides a good example of the intersection of politics and market performance. Looking at overall market returns during the tenures of the past two American presidents is quite instructive, particularly given the enormous difference in both policy initiatives and leadership style of these two administrations.
Under President Obama, the S&P 500® was up approximately 14.5% per year on an annualized basis over his eight years in office. Under President Trump the S&P 500 was up approximately 13.7% per year on an annualized basis over his shorter, four years in office. An investor would be quite happy with either of these performance results for the overall market.
The controlling party affiliation of both the U.S. Senate and the U.S. House of Representatives, and how that aligns with the party affiliation of the president is very important. This alignment, or lack thereof, needs to also be considered when looking at market returns over presidential cycles. Both presidents experienced changes in this dynamic during their tenures.
Fed policy also contributes
It is also extremely important to note that during both administrations, Federal Reserve (Fed) policy was incredibly supportive to the market.
Coincidently, yields declined about 1.5% on 10-year treasury bonds during the tenure of both presidents. During the Obama administration the bond yield declined from approximately 3.5% to 1.9%. During the Trump administration the bond yield declined from 2.0% to 0.6%.
Falling interest rates are a powerful force in driving stock prices higher. It is even more powerful when there is divided political power between the executive branch and Congress. It could be argued that Fed policy, driven by its chairman, is equally, if not more important, than the president in terms of market performance.
Politics – and more importantly policies targeting taxes, spending and regulation – can have a profound impact from a shorter-term tactical standpoint, and can influence relative performance differences between key sectors and industries.
As an example, the significant tax law changes of 2017 led to a very strong stock market rally, led by the more cyclical sectors of the market.
Here are some hypothetical election outcomes and potential policy initiatives that investors may be compelled to consider.
Current national polls show Joe Biden with a meaningful lead. The size of this lead, if history is a guide, would also indicate an increasing possibility of a Democratic sweep, thus increasing the odds of specific policy initiatives, especially as they pertain to taxes.
Key tax policy prescriptions that the Biden campaign have articulated include:
- Bringing the highest income tax rate back to 39.6%, where it was in 2017. This would affect individuals earning over $400,000 per year.
- Taxing capital gains at the same rate as ordinary income with a top rate of 39.6% for individuals earning over $1 million. This would be a significant jump from the current capital gains rate of 20%.
- Eliminating the stepped-up cost basis rule on inherited assets. Specific rules around this proposal have not been specified, but if enacted would have major estate planning ramifications. Also, the current top estate tax rate of 40% could be increased.
- Raising the maximum corporate tax rate from 21% to 28%. This tax rate may be set at a higher level than 28%, particularly due to exploding budget deficits, but would remain below the very high 35% that was in place for many years.
There are many Biden campaign proposals which are not tax related that would have implications for various industries and market sectors. These include significant federal support for “green” initiatives to combat climate change, revisiting “Obamacare” legislation including healthcare service delivery and funding, trade policy, and technology company regulation.
Potential market implications to consider under this election result include:
- Some degree of decline in stock market performance, due to the market pricing in the cost of higher corporate and capital gains taxes, seems likely. Recall stocks quickly rose about 10% after corporate tax rates were lowered in 2017. A similar percentage decline could occur if this tax policy were reversed. The element of proposed tax policy that may have more market impact though, is a dramatic change in capital gains treatment. Investors would be incented to sell appreciated assets, thus paying prevailing lower capital gains taxes.
- Larger companies may be impacted less from increasing tax costs than smaller companies – or may have more resources to respond. This could continue the long running performance advantage of large cap stocks relative to small cap stocks.
- Industries and or companies that have more “sustainable” characteristics could outperform in this election result. Stocks of the “legacy” energy companies may continue to underperform, while stocks of alternative energy industries may benefit. Incorporating ESG factors (environmental, social and corporate governance) to manage risk in portfolios will become even more important.
- Technology stocks, particularly mega-tech, which are currently dominating market returns, may have their earnings negatively impacted. However, they remain in a strong secular growth mode and should thus be able to better weather this challenge. All bets are off for this sector if either a Democratic or Republican administration believes these large tech leaders have become too powerful and need to have their market power checked.
Although Biden currently has a healthy lead in the polls, the electoral college may ultimately be a much tighter race due to a handful of “swing states.” Also, current political betting sites show the race much closer than the national polls. If President Trump were to be re-elected, it appears likely that Congress would remain divided, leading to expectations of a somewhat status quo impact on policy and the markets.
However, the following might occur in a Trump second term:
- A strong push for an infrastructure bill, which could get bi-partisan support, may benefit certain cyclical industries, including “legacy” energy and materials.
- A push for additional tax cuts, particularly payroll taxes, may be pursued. Although there is a low probability of this passing both houses of Congress, it would provide more fiscal stimulus and drive more consumer spending, thus helping consumer non-discretionary industries and housing.
- The tax cuts that were enacted in 2017 expire in 2025. It is likely that a second term Trump administration would look to extend, or make permanent, this tax legislation later in the term.
Financial and estate planning may have added importance under these potential scenarios – especially regarding policy changes emanating from a Biden administration.
Tax policy changes that have been outlined by a new administration would have implications not only for market returns, but more importantly for individuals as they navigate the complexities that changing tax policy may have on their portfolios. Where to hold assets (qualified or non-qualified accounts), sell and/or gift assets and how to generate income or cash flow in an optimized manner will require careful planning.
A lot will happen over the next few months up to election day. In addition to factoring in possible political outcomes and their consequences, the markets will remain influenced by trends in the Coronavirus infection rate, vaccine development, a potential fourth phase of fiscal stimulus, social unrest and global trade developments.
Finally, although it is not even a “back burner” political issue now, the nation’s large and rapidly growing deficit will eventually become a political issue once again.
As of now the Fed is effectively financing these deficits with its asset purchase program. This has been an effective and proper strategy, particularly given the crisis environment and the ability of the Fed to pursue this policy without triggering inflation or currency fears. Longer term, this is unsustainable and needs to be addressed by whoever is occupying the White House.