(BPT) - By Daniel LaPlante, CFA
Investors have already been on a wild ride in 2020 and are understandably bracing for the potential impact of the upcoming election on the stock market. If there is a dominant emotion on Wall Street around this election, it’s uncertainty.
That uncertainty is focused on the outcome in several key areas: an orderly election not contested in the courts, a second fiscal stimulus, and the availability of a safe and effective COVID-19 vaccine.
The outcome of the election—and its effect on Wall Street—remains uncertain for several reasons. First, while Democratic nominee Joe Biden is favored in nearly every poll over incumbent Donald Trump, his lead in several important swing states is within the margin of error. As the presidential elections of 2000 (Bush-Gore) and 2016 (Trump-Clinton) remind us, it is the electoral college and not the popular vote that decides the presidency.
Wall Street is focused not only on the presidential race, but also the control of Congress, currently split between the Democrat-controlled House of Representatives and the Republican-controlled Senate. The control of Congress will dictate the ability of either candidate to implement their policies—particularly changes in the tax code. Biden has called for increasing taxes on households with more than $400,000 in income, including raising payroll tax and income levies on these taxpayers, although many say this wouldn’t happen until well after the economy recovers from the COVID-19 pandemic. He has also indicated a willingness to increase capital gains tax rates. Meanwhile, Trump has proposed cutting taxes to boost take-home pay and expanding opportunity zones, a tax incentive that spurs investment in economically distressed areas.
Wall Street is also increasingly anxious that a contested presidential election with delayed results could deal a blow to the market, as it did in the contested Bush-Gore election in 2000. However, unlike 2000, we are experiencing an economic recovery, with a responsive Federal Reserve pledging to keep interest rates low for the foreseeable future. The general consensus is that even if the election is contested, market risks will likely be tempered unless there is a disruptive legal or legislative battle and political breakdown that threatens lasting damage to the economy or corporate America. However, periods of high market volatility leading up to and after any contested election results might occur.
Wall Street is hyper-focused on the negotiations around a second consumer and small business fiscal stimulus to boost the economy. Negotiations are currently stalled, and if an agreement can’t be reached before the election, talks will likely not resume for nearly three months because of the lame duck Congress. If Congress is unable to reach an agreement on a stimulus, it could have a significant negative impact on growth next year. JPMorgan estimates that an expiration of the coronavirus relief measures may turn into a 2.4 percentage-point drag on GDP growth in 2021.[i]
A strong economy is normally a strong indicator of incumbent re-election for the presidency. But in 2020, that has been clouded by the COVID-19 pandemic, which has sent shockwaves through the US and global economies. The extreme uncertainty about the path, duration, magnitude, and impact of the pandemic might dampen currently robust business and consumer confidence.
Wall Street is closely monitoring news on efforts to produce a safe and effective vaccine, responding negatively to reports of setbacks in trials and the first cases of COVID-19 reinfections in the United States. The successful development of a vaccine will likely trigger a stock-market rotation into industries that have been depressed by the pandemic, including transportation, sports, hotels, restaurants, hospitals, food, and beverages.
So how do you respond to all of this uncertainty?
As we know, short-term, the market doesn’t respond well to uncertainty, which is why the long-term approach is still the smartest strategy.
Interestingly, putting party politics aside, when it comes to your portfolio, it doesn’t matter much which party wins the White House. There has been little difference in the performance of the economy under Democratic and Republican presidents since 1977. According to recent analysis by Deutsche Bank, the average growth rate for a Democrat president is 2.9% compared to 2.7% for a Republican president.[ii]
With important exceptions, the stock market has generated rich returns for decades, regardless of the outcome of portentous events, including presidential elections.
In addition to the election, some end-of-the-year housekeeping and reassessment is in order. Advisors should be engaged with their clients on a range of topics including asset allocation, risk assessment, and taxes.
Despite all of the volatility we’ve experienced since the COVID-19 outbreak, the majority of long-term investors have realized significant growth in their equity positions in recent years. That means portfolios have likely become overweighted to risk assets and a reassessment of asset allocation is in order. Asset allocation is the primary determinant of portfolio return and risk exposure over the long term. Maintaining an appropriate portfolio allocation is the single most important topic for which advisors can provide guidance. In volatile market environments investors can come to question their portfolio alignment and consider emotional short-term actions that are not in their long-term interests. It is a good time to review the rationale for the established portfolio allocation and affirm its appropriateness for achieving long-term goals. If a reassessment is in order, a risk tolerance profile can guide conversations. Risk tolerance questionnaires come in many varieties. The better ones include an assessment of both capacity for and attitude toward risk. Capacity is mathematically derivable from client goals, timeframe, and withdrawal expectations. Attitude toward risk is less quantitative, but equally important. Particularly in periods of uncertainty or volatility, clients can become more risk conscious regardless of their risk capacity. Advisors provide a great value to their clients by reviewing their risk profile, staying on course for the long term, and avoiding emotional decision making.
For taxable investors, rebalancing portfolios that have become improperly weighted necessarily includes consideration of capital gains taxes. This is another area where investors might be inclined to act against their best interest and, therefore, an area where advisors can provide valuable guidance. Avoiding capital gains realization is not an appropriate reason to maintain a portfolio that has grown riskier through market value changes. The additional return volatility from a portfolio that is 10% or more overweighted to equities is potentially much more damaging to goal attainment than the very modest impact from paying capital gains tax. Remember that capital gains are currently taxed at 20%, so even the realization of capital gains of 5% of a portfolio’s total value only results in a 1% one-time tax liability. Portfolios that are materially overweighted to equities can easily incur greater market value losses than that in any market decline or recessionary scenario. Since it is late in the calendar year, capital gains recognition can be easily split between two tax years in order to spread out the tax liability. Additionally, there is at least a possibility that capital gains tax rates might increase in the future as legislators come to grips with the breathtaking fiscal deficits racked up during the pandemic.
Finally, some portfolio adjustments at the margins should be considered in this environment. Diversification is always important but should be emphasized in periods of uncertainty. Small allocations to asset categories that are less correlated are helpful to build resiliency in portfolios in volatile times. Most analysts continue to expect lower than average capital market returns in coming years, consistent with a maturing economic cycle. So, internal portfolio management costs, the fees included in mutual funds and ETFs, become a more meaningful consideration. Adding some index exposure and adjusting where active management is most appropriately utilized in a diversified portfolio can reduce overall manager costs and provide a rational risk budgeting benefit.
While the uncertainty around presidential elections can cause some short-term volatility in the stock market, the key for investors remains the same in the long term, regardless of who sits in the White House. Focusing on your personal goals, rebalancing your portfolio, and diversifying are solid strategies now to be prepared for all potential outcomes.
If you need help creating or modifying your investment plans, the Enterprise Wealth Management team can help.
Investment and Insurance products are not a Deposit, not FDIC Insured, not guaranteed by Enterprise Bank, not Insured by any government agency, and may lose value.
Daniel LaPlante is senior vice president, director of investments and chief investment officer of Enterprise Wealth Management. He can be reached at Daniel.LaPlante@ebtc.com or 978-441-5924.
[i] “Next Big Shift in Economics Takes Shape Under Covid Shadow” Bloomberg, October 11, 2020
[ii] “Are Republican or Democratic Presidents Better for the Economy? Here’s What History Says.” Barron’s, January 23, 2020