What Happens if the Democrats Sweep?

The COVID-19 crisis has laid bare some of the growing social anxieties in the U.S., with millions out of work and the recovery largely skewed in favor of higher income workers. As we search for a letter to best describe the shape of this recovery, Peter Atwater, in an article for the FT has suggested we use “K”; a two-pronged outcome where higher-income Americans who can work from home will recover quickly while those in lower-income brackets (often minorities) will face unemployment, bankruptcies and further disenfranchisement. This kind of growing disparity (to destabilizing levels, mind you) will be a huge campaign issue leading up to the Presidential election in November.

The Democrats, with Joe Biden at the helm, have already taken a wide lead over President Trump in the polls and PredictIt now puts the probability of a Biden presidency at a whopping 60% compared to Trump at 40%. The impact of this shift will be most pronounced in industrials, materials and energy (as we’ll explore below); areas that are most sensitive to the re-regulation and additional tax burdens associated with a Democratic government.

The changes that we expect to see are even more likely if the Democrats take the Senate as well – not an unlikely scenario, having gained an increasing lead over the Republicans in recent weeks, while maintaining the House of Representatives. This means that we are very likely in for an even more left-leaning Democratic Congress (think $15 federal minimum wage, Green New Deal, strengthened unions) than what we saw under Presidents Obama or Clinton. This “blue wave” would result in a strong push to enact as much legislation as possible, unencumbered, before a potential return to GOP control in the House later in the term.

So, let’s look at what that legislation might involve. Mr. Biden’s current public platform includes a massive $6 trillion spending program over the next ten years at a time when the fiscal deficit has already ballooned to a record $1.9 trillion in the first 8 months of FY2020 (according to the CBO). Which means he’s raising taxes, starting with reversing President Trump’s Tax Cuts and Jobs Act (TCJA). This includes higher payroll taxes on those making in excess of $400,000; a move to fully tax capital gains at the top marginal rate instead of 20%; reduce the non-corporate business income deduction for incomes over $400,000; raise the federal corporate income tax rate to 28% from 21%; and lift the top personal income tax rates to 39.6% from 37.0%. Take a look at the summary table below for details of this platform.

To be clear, given the largesse in fiscal spending we’ve witnessed this year even a Republican government would need to consider raising funds through tax hikes in 2021 and the TCJA cuts to income taxes were already set to expire in 2025. But the composition of tax reforms will be different under the Democrats, and the additional support to those with lower income through collective bargaining and a higher minimum wage are distinctly tools of the Left.

Reducing inequality through redistributive policies is a key feature of the Democrat’s agenda. And there’s a good reason for this: remember that since the early 1970s, the share of income going to the top earners in the country has skyrocketed to levels not seen since 1929. While temporarily disrupted by the recessions of 2001 and 2007-2009, inequality has continued to grow, with the top 1% receiving over 20% of all income in 2018. For the top 10%, it’s close to 50% of all income. Meanwhile, the bottom 50% have seen their share decline for over 40 years, to just under 13%. And with the COVID-19 crisis, these social tensions have been amplified.

However, the implications for the stock market from this shift to higher taxes are generally negative. There are two ways the added tax burden feeds through; 1) an increase in taxes could affect the allocation of resources in the economy (shrink the total pie affecting long term growth) and, 2) it will directly affect after-tax profits of firms (a one-time level effect on the bottom lines of companies).

The first point is complicated since the data are still coming in; however, the Congressional Budget Office estimated the impact of the TCJA on the supply side of the economy to be negligible. While there is room for uncertainty, the conclusions were not optimistic.

The report highlighted that the major growth in investment after the TCJA was passed was mostly in intellectual property, not equipment and structures as were targeted by the legislation.

They also found the repatriation of funds, a key objective of the legislations, was mostly directed to share buybacks ($1,000 billion, versus $4.4 billion for bonuses for workers).

The punchline of the CBO report was that the likely supply side benefits had not manifested themselves, and likely wouldn’t.

Specifically, that:

“[while] investment grew significantly, the growth patterns for different types of assets do not appear to be consistent with the direction and size of the supply-side incentive effects one would expect from the tax changes. This potential outcome may raise questions about how much longer-run growth will result from the tax revision.”

However, as an upper bound for the entire economy, we will use the Tax Foundation estimates that the Democratic tax measures would put a drag on growth of about 0.15% per year (more on this later).

The direct tax effects are more straightforward to address. From the national accounts we know that taxes paid relative to before-tax corporate profits were roughly 10.5% in 2019, versus 19.0% in 2016. Given how the tax share responded after the decrease in 2017, a rise up to 14.6% would be well within the range of plausible outcomes. This would imply a one-time drag of 4.1% on after-tax earnings.

In a similar vein, a return to Democratic leadership will usher in a return to regulations as the party looks to reinstate the climate change agenda as well as increase support for the working class over business interests. Overall, we would expect a concerted shift away from the Trump administration’s deregulation efforts towards greater oversight in several key sectors. In order to estimate what the resulting economic burden could look like we use estimates of the present value of the regulatory costs savings from the Office of Information and Regulatory Affairs. From 2017-2019 the present value of the total economic burden lifted has been $50.9 billion, with an expected benefit of another $51.6 billion to come in 2020. Obviously, the pandemic upends most forecasts, but if we take what is given here to be the most optimistic estimates, the total benefits of the administrations deregulatory efforts is $102.5 billion.

Again, these are present value numbers encompassing the total benefit. Depending on the discount period (30 years vs. perpetuity) and the discount rate (say 1.8% expected inflation over the next 30 years), the deregulation initiatives from 2017 through 2020 will net the economy about $2 billion per year. At the risk of being flippant, given the total output of the economy was roughly $21 trillion in 2019, it’s not exactly moving the needle overall.

However, the regulatory burden is not evenly distributed. So, when mapped into the sectors of the S&P 500, their impacts on the bottom-line projections can be profound. Should the deregulation initiatives be unwound by a Democratic White House, the industrials, materials and energy sectors would have the most to lose. The energy sector stands out given its already depressed earnings forecast due to the feeble recovery after the coronavirus lockdowns.

And these are just the impacts in the first year. The fact of the matter is that these drags would operate in perpetuity, absent any offsets.

Now, as we had mentioned, the tax implications of reverting to a 28% corporate tax rate mean that the aggregate tax bill will be roughly 4.1 percentage points higher than it would otherwise be. So, layering that onto the effect from the regulations, and re-applying the current P/E multiple shows that, solely based on the earnings projections for the next 12 months, the energy sector could currently be priced off an earnings forecast that is still 7.0% too high.

But while there are segments of the market that are exposed to a considerable amount of regulatory risk, there are those that are relatively insulated: information technology, consumer staples and utilities.

However, our modelling suggests that there may very well be an added effect on market sentiment (and thus the multiple) from the prospect of additional regulations. Using the NFIB measure of small businesses reporting government requirements being “their most important problem,” and adjusting for QE and the business cycle, a 10-percentage point lift in the survey measure would be associated with a drop of 1.4 points in the S&P 500 P/E ratio the following year. For some context, from October 2009 to September 2013 this measure increased by 14 percentage points. Thus, for the overall S&P 500, when the after tax earnings effects are combined with a potential 1.4 drop in the P/E ratio, a drop in the S&P 500 of 10.5% from where it is today is well within reason.

Finally, let’s look at the overall fiscal impact. The Tax Foundation's General Equilibrium model estimates the total cumulative effect on real GDP to be roughly 1.5% over 10 years (or roughly 0.15% per year). However, due to the increases in corporate tax rates, the increase in the floor and the raft of personal income tax measures, the estimates of revenue gains are in the $300-$400 billion per year range (equivalent to a 7.5%-10% boost to the CBOs current 2022 revenue projections).

This means, that even accounting for the reduction in the economic pie, when we layer these assumptions on the CBO’s projections, the Democratic tax plan would lead to roughly a 1 percentage point reduction in the deficit-to-GDP ratio relative to where it would be without the added taxes. The most recent CBO projection is for a deficit to GDP ratio of 5.5% in 2030, though that will likely change given the large bands of uncertainty around the lasting economic impacts of the pandemic. Regardless of the level, the added tax measures will leave the fiscal situation in a marginally better spot than it would have otherwise been.

So, the bottom line is this. The President had counted on a strong economy to win his second term; however, with the COVID-19 fiasco and his abysmal results in recent polls, it seems increasingly likely that there will be a Democratic sweep in November. And while parties rarely push through all of their legislative promises even with complete government control, we have to expect that many of the tax hikes and regulations in Mr. Biden’s platform will come into play. Even with the Fed’s ongoing support, it’s hard to believe that equities would rally under this scenario: it will blaze a trail for an elongated period of lower P/E multiples and elevated risk premia. Sectors that we see coming out ahead include information technology, consumer staples, and utilities (which, as an aside, are also supported by our “homebody” economy theme coming out of the pandemic). Those that will be hurt are energy -- unsurprising as the government will begin a strong push towards a renewed climate change plan; industrials (which will see a large share of the regulatory burden) and materials (again related to climate change and natural resource extraction). 

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