“The mistake is thinking that there can be an antidote to the uncertainty.”
David Levithan
The country is less than 15 days from voting for the next president of the United States and there has been a surprising lack of market volatility. This can be equated to either Wall Street believing Donald Trump will be re-elected, improving economic data, or hope for an additional stimulus package. Based on most major polls, I would generally conclude it is the latter two. Since a Joe Biden presidency seems likely, prudent investors need to start reviewing tax and portfolio strategies for the changes in philosophy.
Portfolio Strategies
History tends to repeat itself and the long term effect of ‘who is the president’ on the stock market is minimal.1 However, there is significant fear among investors that the repeal of the pro-business policies of the current administration will be disastrous. In a recent survey, 93% of investors believe the presidential race will affect the stock market and 45% expect to make changes based on the election result 2. MBM’s Investment Committee is cautioning people from making bold moves based on the upcoming election. Although early polls show a Joe Biden presidency increasingly likely, elections are notoriously hard to predict.
The drama of the election can make the imagination run wild, so it is important for investors to remember that investing trends and capturing the returns from those trends take longer than a presidential term. Maintaining a long-term focus with a custom-built allocation will provide a better risk adjusted return than trying to time the market. It will be critical for investors to continue following MBM’s fundamental approach of holding enough safety in our Lifestyle Capital Strategy to allow markets to go through a full business cycle. This provides a level of target liquidity in a portfolio so that equities do not need to be sold at an inopportune time to meet income or capital needs.
Our Lifestyle Capital Strategy continues to focus on high-quality, short and intermediate-term debt. At the start of the fourth quarter, the effective duration of the taxable portfolio is 3.13 years and 5.05 years on the tax-free side. This protects the capital from economic and interest rate shocks better than holding longer term bonds. In addition, the increased return on long-term debt versus the short-term debt is minimal which suggests a favorable risk skew to shorter term bonds. We believe that the risk versus return is better in the equity market, so we shy away from taking excess risk in what is supposed to be the safer part of the portfolio.
The election results will not drive a significant shift in the Tactical Core Equity Strategy. As the cornerstone of most portfolios, this strategy is designed to provide stability in relation to the general market indexes. In the second quarter, large-cap value was moved to underweight in favor of large and small cap growth and both sectors have significantly outperformed during this timeframe. Depending on policy developments, a shift back to a neutral allocation may be warranted as the technology stocks that drive large cap growth may be under attack and the tax implications may decrease the attractiveness of the small cap sector.
The Leaders and Disruptors strategy has capitalized on the large technology companies that have driven most of the market growth in 2020. As the most tactical strategy MBM runs, we are closely monitoring the election results, the proposed policy changes, and the ability to implement the desired changes. Small cap stocks, traditional energy, financials, and technology will likely benefit from a Trump re-election.3 If Joe Biden is elected, there may be better opportunity in infrastructure, clean energy, and select sectors of health care.4 In this scenario, MBM will closely monitor how the government focuses on the largest technology providers because there have been discussions of breaking up these companies due to antitrust laws. Although the companies would likely recover, this could have a drastic effect on the stocks over the short term.
If Joe Biden becomes the next president of the United States, there will be a change in the economic philosophy of the country. The ability to implement this will depend on which party controls Congress and the economic ability to withstand the changes during a pandemic. We expect November to be a volatile month unless Donald Trump is re-elected; however, the volatility should fade quickly. Although it may be tempting to overhaul a portfolio allocation in anticipation of a political shakeup, the MBM Investment Committee believes that removing the emotion from the investing process through a long-term investment process will provide superior results. However, changes within the investment strategies may be warranted and will be closely monitored.
Tax Strategies
If elected, Joe Biden’s goal is to repeal components of the Tax Cuts and Jobs Act passed during the Trump administration. This will result in higher taxes for all except the lowest of income earners. The claim that no one will pay higher taxes if earning under $400,000 is false based on our review of the proposed changes, and economic growth will slow down which will mute stock market gains. According to the Tax Foundation’s General Equilibrium Model, the Biden tax plan will reduce GDP by 1.47% over the long term.5 On a conventional basis, the after-tax income for all taxpayers will be reduced 1.7% on average.6 It is important to remember that tax law changes start with Congress and not the president. A split Congress would make it difficult to enact the proposed changes. Instead of focusing on all the details of the proposal, the changes that affect most of our clients are discussed. It is not a comprehensive list.
The tax brackets on ordinary income will increase for everyone except the lowest income earners. The current brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37% would be replaced by 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.7 If possible, ordinary income items should be shifted into 2020. This could include bonuses, option exercise, or Roth IRA conversions.
The favorable treatment of capital gains tax may be eliminated. At the moment, this would happen when income exceeds $1,000,000 but recent discussions have hinted at a much lower threshold to ensure taxpayers whose income is primarily capital gains pay more taxes. There is not a lot of detail in this part of the proposal but investors who are contemplating portfolio shifts may want to consider doing so in 2020.
Higher income tax payers whose blended tax rate exceeds 28% would see a limit applied to their itemized deductions.8 However, taxpayers below that would see a return to an uncapped state and local tax (SALT) deduction.9 It is uncertain if the standard deduction would be kept at its current amount or reduced to previous levels. The majority of taxpayers will not be able to manipulate this situation; however, if a larger charitable gifting strategy is being considered, it may be prudent to implement it under the known tax laws of 2020.
The 20% pass-through income tax deduction for businesses would be phased out once taxable income reached $400,000.10 Although there are planned changes to the deductibility of retirement plan savings, business owners that have a profitable business may want to consider deferred compensation plans or retirement plans that allow for significantly higher pretax deferrals than what a traditional 401(k) plan allows.
The consensus belief seems to be that the estate tax exemption will be reduced from $11,580,000 per person to either $5,600,000 or $3,500,000.11 This would increase the number of individuals that could be subject to an estate tax at death. For individuals that exceed that limit, there are strategies that would allow the transfer of assets out of the taxable estate while utilizing the current $11.58 million exemption. However, this must be complete before the end of 2020.
The step-up in basis at death would be repealed regardless of the size of the estate. This is designed to ensure all estates are taxed at death even if they are not large enough to warrant an estate tax. There are very few details about this part of the proposal, but this would have significant tax implications and heighten the need for the multi-generation tax plans that MBM develops for clients.
Changes that cannot be planned for:
- The alternative minimum tax will be reinstated for most taxpayers.
- Social Security Tax for employers and employees would be payable for income over $400,000.
Conclusion
The market will do what the market needs to do to prove the largest number of people wrong. Changes within the investments may be needed based on the outcome of the election; however, making wholesale changes to the stock to bond allocation is not advisable if it is built specifically to a financial plan. Doing so equates to market timing a single event when the factors that influence the market are extremely diverse. The tax implications of a Joe Biden election will depend on the Congressional races as well. If a blue sweep occurs, the MBM Investment Committee believes that preparation for tax increases will be easier to predict and plan than market changes. Investors will be best served to focus on their tax planning.
Citations
1. US Bank. July 27, 2020 “How presidential elections affect the stock market” https://www.usbank.com/investing/financial-perspectives/market-news/how-presidential-elections-affect-the-stock-market.html
2. Hartford Funds. September 2020 “2020 Consumer Election Survey” https://www.hartfordfunds.com/investor-insight/investor-behavior-strategies/2020-election-survey.html
3. & 4. Konish, Lorie. September 11, 2020. Trump vs. Biden: How the election outcome may influence your stock investments. https://www.cnbc.com/2020/09/11/trump-vs-biden-how-the-election-may-influence-your-stock-investments.html
5. & 6. Watson, Li, & LaJoie. September 29, 2020. Details and Analysis of Democratic Presidential Nominee Joe Biden’s Tax Proposals. https://taxfoundation.org/joe-biden-tax-plan-2020/
7, 8, 9, 10, 11 City National Rochdale. Election Special Bulletin: Tax Plan Proposals. September 2020. https://www.cnr.com/insights/article/tax-plan-proposal.html
Please note – investing involves risk, and past performance is no guarantee of future results. Asset allocation does not ensure a profit or protect against a loss. This material is intended for illustrative purposes only and should not be construed as specific investment or tax advice.
Investment advisory services offered through MBM Wealth Consultants, LLC, a registered investment adviser. Registration does not imply a certain level of skill or training.
