By Peter Mallouk
3 Ring Circus
Stuck in the Middle With You
The current race for the White House is one for the ages. While the candidates jab at one another, the real battle has not started yet. There is little doubt many eyes will roll, jaws will drop and possibly (more) punches will be thrown. Anderson Cooper, Megyn Kelly and Rachel Maddow will see record ratings, as will their cable news networks.
“For all the rhetoric around taxes, the truth is, in the real world people do not change their behavior when tax rates move a few points either way.”
Then there are the implications. While there are certainly very real differences between Republicans and Democrats when it comes to major social issues, the differences when it comes to economics have been far more muted than most people realize. Presidents from both parties have initiated massive social programs. President Bush passed the Medicare Prescription Drug program, at the time the largest entitlement program since FDR’s presidency. President Obama quickly broke that record, passing the Affordable Care Act. President Bush cut taxes a few percentage points and President Obama raised taxes a few percentage points. While this is certainly a different point of view, neither advocated for or took actions that were as radical as what is on the table today, including tax rate cuts in the double digits or tax rate increases in the double digits. Republicans argue that if taxes are cut, then consumers will spend more money and invigorate the economy. This results in more jobs, higher incomes and more taxes collected to pay for all the stuff the country needs to pay for, like defense spending, entitlement programs and debt payments. Democrats argue that higher tax rates are the only way to pay for programs and that supply-side economics (or trickle-down theory) does not work.
To be clear, there is no question that major tax changes do change behavior. For example, California residents that make a good living now pay more than 50% of their income to the federal and state governments. This has changed behavior as residents and companies have begun to pack up and head to other places like Texas and Nevada. No one can argue that a big shift from present rates would not change behavior. If California raised taxes again so the effective rate headed into the 60%+ range, then the highways would be backed-up with cars heading east. If California lowered their rate by 10%, it would likely stop the exodus.
For all the rhetoric around taxes, the truth is, in the real world people do not change their behavior when tax rates move a few points either way. If your taxes go up or down two or three percent, are you going to quit your job or stop investing? Of course not. If Democratic candidate Bernie Sanders somehow wins (are you still a candidate if you are mathematically eliminated?), then one could expect a real change in behavior.
Many folks are willing to go to work and keep 60% of what they earn. Not too many people are willing to go to work and keep less than half of what they earn. Now that Clinton has clinched the majority of pledged delegates, the threat of a significant tax increase under Sanders has diminished, but has not completely disappeared. If Hillary is disqualified from running (choose your scenario or conspiracy theory and plug it in here), then Sanders and his tax policies are back in the game, and that is certainly a possibility, albeit a very small one.
Recent polling shows Wall Street, believe it or not, modestly favors Hillary Clinton. The reasons are straightforward. First, the markets do not care about social issues, so you can toss all that out the window for these purposes. While Democrats are blue and Republicans are red, Wall Street is emphatically green.
“While Democrats are blue and Republicans are red, Wall Street is emphatically green.”
At first glance, it would seem Wall Street would favor Trump. If Wall Street is “all about the money,” then what is not to like about a candidate promising to lower taxes and make trade more “fair”? The main issue has to do with Wall Street sorting out the salesmanship from the true intentions. We all know about the wall (the “really big wall, beautiful wall!”) that Trump wants to build on the border with Mexico. We also know about Trump’s promises (or threats?) to pull back trade agreements with China and possibly not even make our debt payments on Treasuries that China owns. Are these statements really his intentions, or is he simply positioning himself for future negotiations and a more moderate outcome?
“While a Republican candidate traditionally espouses principles the markets favor, the markets will take slightly higher taxes and the status quo over a largely unpredictable outcome.”
First, there is not an economist on the left or right that thinks defaulting on a Treasury payment is a good idea. It would have an immediate and devastating impact on the US and global economy. Right now, the world views a US Treasury as the safest investment in the world. That is why US citizens, foreign citizens and other countries buy our bonds despite the fact they pay just 1.7%. If the US defaulted on just one bond, no one would ever loan us money at such a low rate again. Given that these debt payments are one of the US’s largest expenditures, the end result would be devastating.
Secondly, markets also do not like trade wars, something Trump has mentioned repeatedly. The reality is that US companies are no longer really US companies; they are global companies that trade on US exchanges. McDonald’s opens a location in China nearly every weekday, and plans to do so for the next five years. Walmart opens a store in China about once per week. The top 500 companies in the US get nearly half of their earnings overseas, including 5% south of our border and nearly 15% from Asia, two of Trump’s favorite targets. A trade war would mean less earnings for these companies, and would be quickly reflected in their stock prices. These are real companies that employ real people and make real money. Would it cause you stress if the business you work for was about to enter a trade war with another country?
Finally and most importantly, the markets do not like uncertainty. While a Republican candidate traditionally espouses principles the markets favor, the markets will take slightly higher taxes and the status quo over a largely unpredictable outcome.
With only 10 to 15 states really in play, either candidate could win. So why is the market apparently ignoring all of the hoopla? It is because Trump has tipped his hand on a few occasions and the market believes that Trump will not carry through with the campaign promises that could cause negative financial outcomes. When pressed on issues like a trade war and defaulting on debt, Trump has repeatedly answered that he is a negotiator and he wants to start from a position of strength, but that he knows he will likely end up with a moderated resolution. There is no doubt this has historically been one of Trump’s strengths. He has a long history of positioning prior to and during a negotiation. He has even written a book about it.
“Regardless of your political persuasion, election years tend to be good for the markets, with the stock market posting positive returns 19 of the last 22 election years.”
The markets would likely prefer a moderated Trump to Hillary. However Trump’s history suggests he will play hard ball until he is really at the table with China, Mexico and others, and given that none of that can happen unless he wins the election, the uncertainty will carry through.
Democrats argue that the economy contracted under President Bush and has been growing under President Obama (and therefore why not get more of largely the same?). This is true, but the growth under President Obama has been just 2% per year, an anemic growth rate when compared to the 4% historical norm. Trump supporters argue that we have had 8 to 16 years (depending on which Trump supporter you talk to!) of economic contraction and expanded entitlements followed by slow growth, and that it is time to try something totally new. Trump is either a breath of fresh air or a ticking time bomb, depending on your point of view.
Regardless of your political persuasion, election years tend to be good for the markets, with the stock market posting positive returns 19 of the last 22 election years. While the market is positive more often than normal during election years, presidential election years have seen average returns of around 6.5% versus 7.9% in all years. If you take 2008 out of the equation, election years are even better. The reality is the market normally does not care much about elections. These statistics are much like saying a certain baseball player has a slightly better baseball average when playing a night game with light rain on a turf field west of the Mississippi. There simply are not enough years for any of that to be statistically relevant.
“Markets ultimately care only about expected earnings. To the extent candidates bicker about small differences, markets nearly completely ignore elections.”
Differences in performance are far more tied to interest rates, whether or not the country is in a recession and other random factors. Markets ultimately care only about expected earnings. To the extent candidates bicker about small differences, markets nearly completely ignore elections. That certainly is not the case this year. It is hard to imagine differences greater than Sanders, Clinton and Trump. But with Sanders needing something cataclysmic to happen to win the nomination, the fight is between Clinton and Trump. Clinton needs to move further left to win over Sanders supporters and Trump may need to moderate his statements to win (only some people believe his stated positions are really where he will end up on the issues, and Trump has strongly hinted the same). For now, the markets expect the outcome to be Clinton or a moderated Trump as our next president. Unless either of those potential outcomes change (for example, Sanders finds a way to win the nomination or Trump takes an even harder line on the issues than he is currently espousing), the market will shrug its shoulders while everyone else generally freaks out.
Policies implemented by presidential initiatives have often resulted in portfolio adjustments for our clients. For many of our clients, adjustments were needed once the Affordable Care Act tax was implemented. Regardless of which candidate wins, we will monitor any changes likely to be implemented and adjust portfolios as needed.
As a final note, I shared this letter with two Republicans and two Democrats in my office. Three thought I was attacking their party, so I expect my inbox to be lively!