by Erik Ristuben, Russell Investments
Itās no secret that uncertainty is public enemy number one to the stock market. Above all else, markets detest the unknown. Not convinced? Look no further than this past March, when the S&P 500Ā® Index tumbled nearly 35% in just over a month as one of the most unpredictable events of our lifetimesāthe coronavirus pandemic1āquickly engulfed the U.S. and Europe.
Itās hardly a surprise, then, that with less than two months to go until Election Day in the U.S., the nation is abuzz about the possibility of renewed market uncertainty come Novemberāespecially if the Democratic party wins control of both Congress and the White House. And, in normal times, these concerns wouldnāt be unfounded.
After all, a win by Joe Biden over Donald Trump, coupled with a Democratic majority in both the Senate and the House of Representativesāboth plausible scenarios2āwould make for a very different political landscape in Washington, D.C., next year. A different political landscape, of course, typically means different policies and priorities from government leadersāand in the eyes of the market, different means uncertainty. Uncertainty over what current policies might be unwound, uncertainty over what new reforms might be enacted, uncertainty over the degree of change coming down the pike. Regardless of whether the Democratic or Republican party is in control, market uncertainty is typically sky-high during this time.
But these are not normal times. The coronavirus pandemic has upended daily life as we know it, and despite the swift rebound in markets, the economy has a very long way to go in its recovery. Of the 22 million jobs lost due to widespread lockdowns in the spring, the U.S. has recovered only about half.3Ā Unemployment remains stubbornly high at 8.4%āmore than double Februaryās 3.5% reading. Most schools remain closed to in-person learning, and approximately 24% of the U.S. workforce is still working from home.4Ā In addition, even in a best-case scenario, a vaccine is probably still a few months away.
The long and short of all this? Over the next 12 months, we believe that the U.S. economy will be influenced far more by the outcome of the COVID-19 crisis than by any new policies or proposals. Put another way, we think that COVID-19 will likely lead to increased policy stability in the U.S. through much of 2021, regardless of any changes to the political makeup in Washington.
To fully understand why, letās dig under the covers a bit.
A politicianās priority: To get re-elected
Thereās a simple truth inherent in politics: Whether a first-term senator, a long-serving member of the House or the Oval Office incumbent, a politicianās number-one job is almost always to get re-elected. Simply put, politicians donāt get re-elected by negatively impacting the economy. And, at a time when the American economy is in an extremely vulnerable state, the risks of pushing bold, sweeping proposals through Congress are simply too high for most politicians to get behind.
Sure, a politician may believe that a drastic new policy will supercharge the nationās economic recoveryābut what if this new policy were to backfire and inflict additional economic carnage instead? The politicianāand others who helped pass the dramatic new lawāwouldnāt get re-elected, plain and simple.
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This is precisely why we donāt expect any radical policy changes come January, even if a unified Democratic government takes control in Washington. Until the COVID-19 crisis has passed, the political liabilities of supporting bold, dramatic reforms are too great.
In addition, the economic uncertainty stemming from the pandemic further limits the political wiggle room among members of Congress. Why? We believe that the economic fallout from this crisis is likely to persist for another 12 months, regardless of whether thereās a vaccine by year-end or not. Bear in mind that even if a vaccine is approved by then, it will still need to be manufactured, distributed and administered to approximately 328 million Americansāan immense undertaking unprecedented in our nationās history.
If weāre right, this would leave just 12 remaining months for three-quarters of those elected to Congressāthat is, all of the members of the House of Representatives, whose terms last just two yearsāto focus on other priorities before facing re-election. Thatās a seriously compressed timeline in which to enact meaningful change.
The politics of a thin majority often leads to inaction
Itās important to understand that a Democratic takeover of Congress, if it were to occur, would likely be by fairly narrow margins. Republicans currently hold a three-seat advantage (53-47) in the Senate, and we believe itās unlikely that the Democrats will flip more than five seats in November. This means that, if the party were to assume control of the Senate, it would have anywhere from a 52-48 edge to a 50-50 tieāin which case a Biden win would be required in order for Kamala Harris to cast the tiebreaking vote for the Democrats. In other words, if the Democrats do take the Senate, it will be by a razor-thin majority, no matter how you slice it.
Itās also vital to keep in mind that any seats the Democrats do pick up are likely to be highly contested seats from states typically not considered very progressiveāsuch as Arizona, Colorado, North Carolina, Iowa and Montana. This means that any newly minted Democratic senator would likely be more centrist in natureāand therefore much less apt to support any dramatic new legislation.
Unsurprisingly, the politics of a thin majority often yields little in the way of change. As proof, look no further than the 115th Congress, where the Republican party controlled both the Senate and the House during the first two years of President Trumpās term. After pressing for a repeal of Obamacare for years, the party was unable to overturn the former presidentās signature healthcare act, despite two years of a unified government. As is often the case, the headwinds of a fragile governing majority proved to be too much to overcome.
Bidenās tax proposals: Mostly moderate in scope?
Itās worth pointing out that most of the initial tax proposals put forth by Biden are fairly moderate in scope. For instance, the Democratic presidential nomineeās plan calls for raising the corporate income tax to 28%5āup from todayās rate of 21%, but still significantly lower than the 35% rate that existed prior to the Tax Cuts and Jobs Act (TCJA) of 2017. Itās also important to note that the 28% figure is Bidenās opening bidāand in politics, you usually donāt get your opening bid. We expect that number to be negotiated down further should Biden win the presidency. Keep in mind that if the economy still appears to be highly vulnerable in early 2021, thereās a chance Biden will not even push for changes at all. While this is not our base-case scenario, itās also not out of the question.
While Bidenās plan also calls for an increase in the individual income tax rate, that increaseāfrom 37% to 39.6%āwould only apply to individuals making over $400,000 a year.6Ā Importantly, the proposed 39.6% rate would be the same rate that applied to top income earners prior to the passage of the TCJA.
The one major proposal by Biden in this arena involves the capital gains tax. If elected, the former vice presidentās plan calls for taxing long-term capital gains at a rate of 39.6%āthe same rate that he would tax ordinary incomeāfor individuals with incomes over $1 million.7Ā Currently, the top capital gains tax rate is 23.8%, so this would equate to a massive increase. However, the consensus among tax experts is that this increase would lead to just a 0.1% drop in future U.S. GDP (gross domestic product) growthāin other words, not a substantial hit by any means.
The bottom line
As the countdown to Election Day intensifies, thereās little doubt that investors will continue to be buffeted by unnerving headlines from both sides of the political spectrum. But the basic reality is this: The U.S. government is purposively designed to make it difficult to get big things done. Even a unified political party only has two years to enact meaningful changeāand thatās in normal times. Trying to pass bold, drastic reforms amid a once-in-a-century pandemic?
Forget about it.
1 Source: https://www.cnbc.com/2020/08/17/stock-market-futures-open-to-close-news.html
2 Source: https://projects.fivethirtyeight.com/polls/president-general/
3 Source: https://www.marketwatch.com/story/us-regains-14-million-jobs-in-august-and-unemployment-drops-to-84-as-economic-recovery-shows-resilience-2020-09-04
4Ā Source: https://www.bls.gov/news.release/pdf/empsit.pdf
5 Source: https://www.wsj.com/articles/biden-tax-plan-targets-profitable-companies-that-pay-almost-nothing-11595848477
6Ā Source: https://taxfoundation.org/joe-biden-tax-plan-2020/
7Ā Source: https://www.wsj.com/articles/capital-gains-tax-rate-chasm-separates-trump-biden-11597409062
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