A Pandemic, Politics, and a Biden vs. Trump Administration’s Effect on the Market
“When you don’t know that you don’t know, it’s a lot different than when you do know that you don’t know.” -Bill Parcells
Approaching an Uncertain Market
The market can handle good news. The market can handle bad news. What the market cannot handle is uncertainty. As we’ve been living in a period of economic and political uncertainty for most of 2020, investors need to be bracing for the possibility that the worst has yet to come. There is an increasingly real chance we wake up November 4th with the election in TBD mode – a scenario where both sides are claiming victory and it takes several weeks and court rulings before we arrive at a winner.
In times like these, it is critical to recognize that personal attitudes are not necessarily shared by the market. There are billions of participants in global financial markets each investing for different reasons and with different expectations about economies. Based on your party affiliation, worldview, or attitude toward the candidates themselves, it may seem to make sense that if <Trump/Biden> wins the election, markets will <rise/fall>. However, in practice, things rarely play out so cleanly.
What has driven markets in 2020? Easy – COVID. Global pandemic wasn’t on anyone’s radar at this time last year. We were going to football games and weddings and concerts – then everything changed. The “unknown-unknowns” are what truly drive surprising market results and, by their very definition, they cannot be planned for or predicted.
Looking beyond the outcome of the election, some of the more prescient questions for investors to consider:
- When will a COVID vaccine become available?
- How is Brexit going to affect European and Global economies?
- What will China do next?
- How will the world adapt to climate change?
- How will expensive growth stocks perform at elevated valuations?
- What other big events will occur that no one will see coming?
Now that we’ve accepted that “we don’t know what we don’t know,” let’s take a closer look at what we do know; how each administration has said it would approach the individual tax code.
Individual Tax Rates
President Trump has proposed to make permanent the individual tax provisions enacted under the 2017 federal tax reform legislation, which lowered the highest individual income tax rate from 39.6% to 37%. The 2017 tax reform act was enacted under the budget reconciliation process, which requires only a simple majority in the US Senate, not a 60-vote supermajority.
Former Vice President Biden has proposed to return to the pre-2017 federal tax reform rates for taxpayers earning more than $400,000, which would include restoring the highest individual rate to 39.6%.
Capital Gains Tax Rates
President Trump hasn’t officially proposed any changes to current capital gains tax rates but recently has expressed interest in possibly lowering the current 20% maximum individual capital gains tax rate to 15%. He also has expressed support in the past in indexing capital gains tax rules for inflation.
Former Vice President Biden has proposed taxing long-term capital gains and qualified dividends at ordinary rates for taxpayers with taxable income above $1 million – meaning long-term capital gains and qualified dividends would be taxed in the same manner as short-term capital gains and ordinary dividends. Biden is also proposing that unrealized capital gains above $100,000 be taxed at death or upon gift, as opposed to waiting until the sale or exchange of the asset. This exclusion would likely be on a per-individual basis, and exceptions would include assets passing to the taxpayer’s spouse or charity.
Itemized Tax Deductions
Some changes made to itemized deductions under the 2017 federal tax reform legislation are scheduled to sunset in 2025, along with the other individual tax provisions. Other individual tax provisions President Trump is proposing to make permanent include:
- Repealing the Pease limitation, which limited the deduction for home mortgage interest, state and local taxes, charitable contributions and miscellaneous deductions
- Limiting the home mortgage interest deduction on new mortgages to principal of $750,000 (instead of $1 million)
- Capping the state and local tax deduction at $10,000
- Suspending the miscellaneous deductions subject to the 2% floor
- Increasing the charitable contribution limitation to 60% of AGI
Former Vice President Biden has proposed to cap the value of itemized deductions at 28% for taxpayers earning more than $400,000, but his official campaign policy statements do not address all of the specific individual tax deductions that were modified by the 2017 tax reform act. Biden has expressed support for restoring the itemized deduction for state and local taxes, according to some reports.
So now that we have an idea of potential tax changes over the next administration, where should thoughtful investors be looking to deploy capital?
Considering Illiquid Alternatives
Given their longer investment periods and lack of correlation to broader market forces, illiquid alternatives should be at the forefront of accredited investors’ actionable investment list. In the short-term, an economic pullback (or even recession) would impact private businesses along with their public peers. Additionally, valuations are driven less by technical factors exhibited in public markets, as the majority of investors plan to hold positions over multiple years, rather than looking for a short-term gain. This allows forward-thinking managers the opportunity to drive fundamental value creation during longer holding periods. Obviously, cyclically sensitive businesses will be the most impacted during any down period, but this can also create opportunity for funds and sponsors currently raising capital to deploy over the life of a deal, and thus should be considered based on the long-term strategy’s fundamental merits, rather than the current political tone. Over an investment cycle, private equity investments should generate materially stronger returns over public markets in exchange for longer holding periods.
The bottom line is this: market movement favoring one candidate over the other likely doesn’t exist at this stage of the election, and at most it’s negligible. What’s most essential is to know there is a winner and who the winner is. Once that result is accepted, the market will let go of some anxiety and even out. Regardless of who wins the 2020 presidential election, sharpened investors can avoid the noise and stay the course.
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