Why are stocks rising in the face of a potential Blue Wave?
Bottom Line Since July 31, the S&P 500 has rallied by more than 6%. With the presidential election now only 25 days away, this should be good news for President Trump, as investors typically vote with their feet. Since 1928, when the stock market was collectively positive in the three full months leading into the election, the incumbent’s party held onto the White House in 20 out of 23 elections. In fact, this coincident indicator has correctly forecast each of the past nine presidential elections since 1984.
But if we flip over to the betting markets on RealClearPolitics and PredictIt, we see a radically different picture. Former Vice President Biden’s chances of winning the election are surging since he and Trump were tied on Labor Day. Biden now leads by a resounding 65% to 35%, and the odds of a Blue Wave, in which Democrats run the table by holding onto the House of Representatives and reclaiming majority control in the Senate, are now at 59% and rising.
Wait, what’s going on here? Complete control of Washington would provide the Democrats with a consolidated legislative mandate, and their plans are thought to include higher corporate and individual tax rates and tighter regulations, among other items, which historically have been unfriendly to the economy, businesses and financial markets. So why are stocks rising in the face of potentially slower economic growth and lower corporate profits?
To start, we believe the deepest recession in history ended in May or June, and we’re now just waiting for the National Bureau of Economic Research (NBER) to so date it. Trump has helped to orchestrate the most powerful rebound in history from the economy’s April trough, with a record third-quarter GDP of perhaps 23-24% or more, which will be flashed Oct. 29. As we roll into calendar 2021, we will be looking at a very easy year-on-year earnings comparison starting in the first quarter, which we believe that the market is beginning to discount now.
In addition, Biden’s surging poll numbers, and the rising possibility of a Blue Wave, reduce the odds of a contested election, whose results could be unknown for weeks or months after the election. Markets hate uncertainty most of all.
But aside from trillions of dollars of existing monetary and fiscal policy stimulus already sloshing around in the economic pipeline, markets must believe that a Biden sweep would result in a more friendly Congressional response to a pair of $2 trillion requests for more fiscal stimulus spending and a 10-year infrastructure plan. To be sure, Trump has also been requesting $2 trillion for infrastructure spending over the next decade, with a focus on new roads and bridges, modernizing the electric grid and rolling out 5G. But Speaker Pelosi has rejected his proposal.
Regarding another round of fiscal stimulus, Trump has proposed $1.8 trillion in additional spending, while Pelosi has countered at $2.2 trillion. While it seems intuitively obvious for them to simply split the difference, agree on a $2 trillion package and call it a day, there are three long-standing moral hazards that are roadblocks to a successful deal: reinstatement of the $600 weekly unemployment bonus (which expired at the end of July) through the end of January 2021; $1 trillion bailout for bankrupt city and state pension plans; and extension of liability protection from junk lawsuits for businesses that have taken the necessary precautions to protect their employees and customers from Covid-19.
Inversion reversion? When President Obama left office in 2016, we had a 35% federal corporate tax rate (and a 39% statutory rate), which was the highest in the developed world. In sharp contrast, the global corporate average was 22%. That significant gap had created an inversion problem. U.S. companies off-shored jobs, manufacturing and intellectual property. Some domiciled elsewhere for lower rates, such as Ireland’s 12%. Consequently, U.S. economic and labor market growth was tepid and well below trend, and we believe the economy was on a slow glide path back into recession.
Recognizing that we are in a competitive global environment, Trump cut the federal corporate rate to 21%, a level just below the 22% global corporate average. That solved the inversion problem, as jobs and manufacturing began to flow back into the U.S. In February, before the pandemic shutdown, we had the lowest unemployment rate (U-3) in half a century at 3.5%. Moreover, our research friends at Cornerstone Macro report that 176 companies have returned in 2020 alone, helping to spark the strong labor market and the manufacturing renaissance.
If a President Biden and Democratic Congress would vote to increase the federal corporate tax rate back to 28% (with a statutory rate at 32%) as proposed from 21% (statutory at 25%), does that begin to erode the economic benefits we’ve enjoyed over the past several years, in the form of higher GDP growth, a stronger labor market and a resurgence in manufacturing activity?
Industry analysts project Biden’s proposed corporate tax increases will reduce corporate profits by about 10-15% annually, depending on the industry, which ordinarily would be reflected in lower share prices. But perhaps investors believe that a sharp increase in government spending, from passing a Phase 4 fiscal stimulus package and a 10-year infrastructure deal, will manage to successfully offset the negative impact of higher corporate tax rates.