Over the past several months, we’ve delivered a number of webinars regarding markets and the upcoming elections. As we typically do with our events, we engage in a healthy Q&A afterwards to answer clients’ questions. In light of next week’s election, we wanted to share with you our thoughts regarding the most common concerns raised by clients.
Market reaction to election outcome
The options market—the closest thing we have to a crystal ball in financial markets—presently predicts a move of about 4% in the S&P 500 between now and election day; it also predicts volatility will peak sometime around November 18. To add some context, these are slightly elevated levels of volatility—higher than average but far from crisis levels. The options market isn’t predicting which direction the market will move—at the moment, contracts are almost perfectly balanced on which direction the market will move.
While an increase in volatility can have any number of catalysts, we can say with confidence that whatever it is that might move markets in November, it’s likely unknown to us today. This seems counterintuitive to us given our collective fixation with the election, but if it were fully expected (or predictable), markets would rapidly price it in. Market volatility is, after all, the process through which markets price in new information, and the best time-tested approach to managing volatility is through high quality diversification. In times like these, it’s more important than ever to take the long view—we have constitutional mechanisms for resolving contested elections. Our democracy, despite its flaws, remains robust and strong; over 75 million Americans have already cast their votes and political scientists are predicting record turnout this year, with millions of new and young voters participating. And, finally, market volatility rarely lasts very long. When we look deeper into our crystal ball, we see the options market presently predicts a return to more normal levels of volatility by December and January. All things pass with time.
The true impact of taxes
Vice President Joe Biden has been clear (and Trump’s campaign commercials continue to remind us), that the former Vice President intends to raise taxes on those earning over $400,000 per year. He’s calling for a repeal of tax cuts (TCJA) signed by President Trump that would raise (or bring back) the highest marginal bracket to 39.6%, up from its current rate of 37%. Biden has also called for an increase in the highest marginal capital gains tax to 39.6% on households with income greater than $1 million, a move that would essentially tax capital gains as income. This would represent nearly a 100% increase in the capital gains tax (from its current rate of 20% to 39.6%). Biden has also proposed increasing corporate tax rates from 21% to 28%. In contrast, Trump has advocated for more tax cuts, including cuts to payroll taxes that fund Social Security and Medicare.
While higher taxes tend to result in lower stock prices, many factors can positively or negatively influence asset prices. Tax policy, although an important one, is just one of those factors and there are sure to be others that may have a neutralizing impact on any prospective increases in taxes. For example, any increase in taxes by a prospective Biden administration would quite likely be accompanied by increased government spending, which stimulates the economy and can raise asset prices for stocks and real estate. Subsequently, it’s likely that any headwinds stocks were to face from higher taxes would be offset by tailwinds from other factors, such as increased government spending. Economists at Goldman Sachs said as much several weeks ago.1 And it’s also possible that markets have already priced in the prospect of higher taxes; JP Morgan came out with a statement several weeks ago stating that, in their view, the market had already priced in a “blue wave”, implying that stock prices have already digested a likely increase in taxes.2
Our growing debt and deficits
It’s a bit contradictory to be in favor of tax cuts or increased government spending while at the same time claiming to have concerns about our growing debt and deficits. Cutting taxes results in funding government through debt rather than income. And more government spending, at a time when we’re already running a $3 trillion deficit, will only add more red ink. While interest rates are certainly low, debt still isn’t free. The only way we can reduce our debt and deficits is through reductions in government spending that exceed reductions in tax collections; or to raise taxes at a rate greater than government spending, and neither party is seriously committed to doing either.
In addition to combating a crippling pandemic, the United States faces real infrastructure challenges: an educational system in need of reform and better funding, a healthcare system unprepared for millions of new retirees, and a military that’s arguably unprepared for the challenges posed by a changing global order. Regardless of where one sits on the political spectrum, the demands on government in the years ahead will only magnify. For these reasons alone, it’s our view that higher taxes (and still more deficit spending) are coming sooner or later, regardless of who occupies the White House, the Senate, or the House of Representatives.
Debt and economic growth
A related concern is that rising government debt will become a drag on future economic growth. This is a common discussion topic among academics, but there’s little consensus. Greater debt typically means more dollars going out the door to fund interest payments (unless rates fall significantly). Currently, the budget includes $338 billion in interest payments on debt incurred to finance past government spending. Let that sink in for a moment—the debt represents the sum total of accumulated prior years’ deficits. We’re paying $338 billion in interest for spending that incurred in prior years. That’s up from $248 billion in 2016 (an increase of 36% in just three years). And, in theory, every dollar that goes towards interest payments is a dollar unavailable to fund other programs.
Outside of the academic world, it’s unclear that the U.S. federal debt burden poses any real threat to U.S. economic growth for several reasons:
- The economy has what economists call “excess productive capacity”. This means the economy’s capital stock—workers and plants, property, and equipment—aren’t presently utilized to their full capacity. We see this manifest itself through unemployment, underemployment, and low interest rates. This is one of the reasons why we’ve failed to see any meaningful inflation for over a decade, despite repeated increases in government spending and massive quantitative easing from the U.S. central bank.
- Inflation isn’t a concern presently—in fact, economists and central bankers have been more concerned about deflation over the past decade; the economy has lots of room for greater fiscal and monetary stimulus (the later comes from the central bank, the former comes from government spending). Despite an increase in government debt of over 115% since 2010 and a $4.5 trillion increase in the Fed’s balance sheet, inflation has fallen significantly from around 3.4% in 2000 to less than 2% in 2020. As a result,, there’s likely room for more deficit spending and quantitative easing without spurring runaway inflation.
- Unlike nearly every other borrower on Earth, the U.S. government borrows in its own currency. And since the U.S. government has a monopoly on the printing of U.S. dollars, it can never default on its debt. While the government can elect to default on its debt, that would be a political decision, not one forced upon it by credit markets. Because inflation is anemic at best, any issuance of new dollars isn’t likely to spur much inflation.
Three key take-aways
The takeaways for investors are threefold.
- First, the economy is far from overheating; inflation simply isn’t a concern and likely won’t be for quite some time. And the debt, for a number of reasons, appears quite manageable at the moment. Besides, given all that ails us, now isn’t the time to suddenly embrace fiscal austerity.
- Second, markets are quick to price in new information and expectations about the future; if JP Morgan is right, the market has already priced in higher taxes due to a “blue wave”. Subsequently, investors should continue to stick with a well-diversified, long-term investment strategy. Any attempts to time markets based on election wins or losses will likely just result in disappointment, unnecessary capital gains taxes, and a portfolio that’s unaligned with one’s financial plans and objectives.
- Finally, we should eschew buying into simplistic policy proposals or soundbites offered up by politicians. The challenges we face are complex and many and they require a measured, intelligent approach if we’re to succeed in overcoming them; neither party has a monopoly on intelligence or good ideas.
All of us at Mercer Advisors thank you for your trust and confidence. We remain fully committed to partnering with you and your family on your journey to economic freedom.
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1 Roberts, Jeff John, “Biden ‘blue wave’ would boost economy, says Goldman Sachs”, Fortune, October 5, 2020
2 Ausenbaugh, Elyse, “Markets Spot a Blue Wave”, JP Morgan Private Bank, October 14, 2020.
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