What seemed like an outside probability just a few weeks ago looks increasingly likely to become reality. With Democrats likely to take both GA Senate seats, the balance of power will shift significantly and so will the legislative agenda for the next two years.
From a broad market standpoint, we do not see this result as an instant negative, but we believe the downside risks to this market have certainly increased once the market digests this result. At current market levels, we do believe that the market is not pricing in tougher regulation, substantially higher rates or an earnings headwind, and the chances of all three went up overnight. But that doesn’t mean the market will go down.
What we think a Democrat-Controlled Senate Would Mean for Markets:
Yes, we do believe that yesterday’s Georgia Senate runoff could have substantial implications for the markets if both Democrat candidates win, which appears likely, given the high levels of complacency in markets right now. So, what does a Democratic Senate mean for markets?
1) Potentially Higher Taxes: Even if the Democrats win both Georgia Senate seats, the majorities they would have in both chambers would be historically small (11 seats in the House and VP Harris as the tie breaker in the Senate) and as such, is potentially not likely to pass major legislation. I think that is likely true on very complicated issues such as the healthcare overhaul and other progressive policy initiatives. However, I do not think that is necessarily true when it comes to tax increases.
Consider this, in 2017, the Tax Cuts and Jobs Act passed 51-49 in the Senate. Every single Democrat voted against it. I highly doubt any Democrats joined the Senate in 2018 or 2020 that would have supported it. Point being, we believe it’s entirely possible that the 2017 TC&A Act gets repealed if Democrats control the Senate. From our perspective, that matters to share prices because the corporate tax rate would move higher (how much higher is unknown), but we believe it will put pressure on corporate earnings, plain and simple. We’ve seen figures between a 7%-9% headwind to S&P 500 earnings. To take it one step further, if the 2017 Tax Cuts and Jobs Act can be passed by a single vote, then I don’t see why a Democrat tax bill, which could potentially include increases on corporate taxes, capital gains taxes and inheritance taxes, could not pass a Senate where the Democrats have a one vote majority. Point being, we believe that the increased risks of higher taxes, specifically corporate taxes, will weigh on share prices if the Democrats gain control of the Senate.
2) Potentially More Stimulus: If Democrats gain control of the Senate, we expect more stimulus bills coming in 2021, as the Biden administration will focus on helping the economy get back on track as quickly as possible (remember the midterms are just two years away). But, while back in November massive stimulus was universally desired by markets, we believe on now has to watch yields closely. As we’ve said over the past few weeks, we could potentially reach a point in early 2021 where mountains of stimulus help boost short-term growth, but also inflation and Treasury yields, and massive stimulus may speed the time when surging yields become a material headwind on equities and market multiples. Point being, we believe more stimulus is not necessarily universally positive for stocks in 2021.
3) Potential Regulation: Republicans controlling the Senate means that Biden will have to appoint more moderate (as opposed to progressive) cabinet members that will run the country’s various Federal agencies, and theoretically speaking, we believe that should limit a reversal of the de-regulation that was witnessed during the Trump administration. But with a Democrat Senate, Biden will be free to appoint more progressive cabinet members, and we believe regulation could become another headwind on corporate earnings.
Bottom line, we don’t view a Democrat Senate as a bearish game changer in the short-term because there are still be a lot of positives in this market. But some of these potential outcomes would be a new and unaccounted for initial headwind on stocks.
What Does This Mean For You?:
Given what we view as a high likelihood of a potential tax increase, let’s look at what President-Elect Biden’s proposals would mean for individual taxes. We believe individual tax changes are likely under a Blue Wave, including higher capital gain and dividend tax rates, as well as tax increases on high-income households. Per Jefferies, the federal government is surprisingly expected to lose $20 – $30B in revenue over a 10-year period under higher capital gain taxes, as taxpayers become more incentivized to not realize gains until death. Democrats have proposed different ways to eliminate the incentive, such as eliminating step-up in cost basis at death and/or imposing taxes on gains every year whether it’s realized or not, which could potentially go through under a Blue Wave. This is all speculative.
Luckily, we do not see any tax changes occurring in 2021, as we believe stimulus should be a priority for a democratic-controlled Congress. Furthermore, some Senate Democrats have expressed discomfort with raising taxes as soon as Biden gets sworn in as the economy is still recovering.
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