Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Trump, Biden, and Markets
There is always risk around election season, but perhaps never as great as the risks in front of the 2020 Presidential election. The markets seem now to have turned a bit of attention from COVID-19 to this year’s November elections. No matter who wins, it seems clear that there is risk – both market and socioeconomic volatility. The press on both sides of the aisle seems intent on stirring up discord. We are not here to editorialize. Rather than taking sides and contributing to the cacophony of political polarity, we are considering the risks as they pertain to capital markets and client portfolios, and making thoughtful, informed decisions.
It is fair to assume that in terms of fiscal policy, a Trump presidency is likely to largely represent maintenance of the status quo. President Trump has talked about additional corporate and individual tax-cuts in his second term after having gotten the Tax Cuts and Jobs Act (TCJA) over the goal line. That act took the corporate tax rate to 21 percent, an obvious windfall to corporate profits and earnings. We can probably also assume that a re-election of Trump will result in continuity at the Fed and existing monetary policy. These policies, in a vacuum, would be market positive at the margin. However, nothing happens in a vacuum, and we believe it prudent to explore other market implications.
A Trump victory is likely to have significant social consequences. It is easy to envision a scenario where a second Trump term will cause another round of significant social unrest similar to what we have seen this year in America. This could be particularly true if the election is in any way contested, or if he loses the popular vote by a significant margin and still garners 270 electoral votes in an electoral college win. In that scenario, we might not have an actual outcome of the election for weeks. We look to the 2000 Presidential Election recount (remember hanging chads?) for Bush as a framework for our thinking here. A nation waiting on the outcome of a Presidential election at that time was a recipe for market volatility, as the possibility of a drawn-out court fight emerged. The NASDAQ lost 12.2 percent of its value that week.
At the time, it was clear that the frothy tech-led bull market was already unwinding, but the lack of election outcome was something of a contributor. We see something of an analog in the current market environment. The worries around the sustainability of earnings growth were at issue at that time as well, although currently tech stocks are broadly at new highs. At a minimum, much like we saw in 2016, a Trump re-election may lead to initial market volatility, perhaps given concerns around what tax cuts and other fiscal policy measures will do to budget deficits.
We now turn our analysis to the possibility of a Biden presidency and the implications for fiscal and monetary policy, and possible outcomes for the capital markets. Joe Biden has been clear that he would roll back the TCJA and raise the corporate tax rate from its current 21 percent to 28 percent. According to Bloomberg, 2021 S&P 500 operating income is estimated to be 210.24 billion, and earnings are estimated to be 166.09 billion. That works out to exactly a 21 percent effective tax rate. If corporate tax rates go from 21 to 28 percent, it stands to reason that forward estimates would decline by 9.7 percent to 151.37 billion.
Obviously, this analysis is imperfect because some analysts may have already factored in a tax regime change and the fact that companies will manage earnings to pay as low a tax rate as possible. However, it is clear that such a rise in the tax rate will have a significant adverse effect on earnings. The S&P forward multiple is already at levels we’ve not seen in over a decade. Ed Yardeni has a good chart book you can access here, with forward multiples for various market indexes. In order for stocks to remain where they are or go higher, at least in aggregate, we’d need to see either multiple expansion from today’s extreme levels or a market decline. Biden has also suggested that those with over a million dollars a year in income should pay the same tax rate on investment income, capital gains, and ordinary income. This would also mean that capital gains would likely be harvested in front of a policy change.
In terms of monetary policy, Biden has proposed that the Federal Reserve incorporate race into its analysis and policy goals, and that the Fed should “aggressively enhance its surveillance and targeting of persistent racial gaps in jobs, wages, and wealth.” We are unsure how monetary policy could achieve that specific end given the tools available to the Fed. Declining interest rates help all of those looking to borrow. The Fed also engages in inflation targeting, and here is where the analysis becomes interesting. If inflation is “always and everywhere a monetary phenomenon,” and is a general decline in purchasing power, those who use the greatest percentage of their income for staples are impacted the most. This is more of an exercise in thought, as we do not see the Fed in any scenario taking the liquidity punchbowl away. We believe interest rates will remain lower for longer, but exploring the effect of Fed policy on those who can least afford to have purchasing power inflated away is a worthwhile rabbit hole to go down.
We do not know if the polls are as wrong today as they were in 2016, but we do look at them with a healthy dose of skepticism. We have no way to really understand what inherent sampling bias might exist. Taken together, it is hard to conclude anything but that the risk/reward is exceedingly poor in front of this election, particularly given valuation extremes. Ultimately, however, as we have seen historically – most recently with COVID, the markets can tend to have issue fatigue. No matter how big the issue is, focus will eventually turn to something else. Of course, as with everything in life, “this too shall pass,” and that is the opportunity.
Chief Executive Officer