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A Divided Government Puts a Premium on Compromise

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Thomas Lee, CFA

Chief Investment Officer

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Jim Evans, CFA

Chief Investment Officer, Fixed Income

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Our investment experts share their thoughts following one of the most dramatic presidential elections in American history.

With the 2020 election behind us, investors can now consider the implications of voters’ decisions. The end result is a divided government, with the fate of the Senate hinging on recounts in Georgia while Democrats retain a majority in the House and have narrowly captured the presidency. While some observers fear a divided government may inevitably lead to gridlock, a more likely outcome is that President-elect Joe Biden and Senate GOP leader Mitch McConnell, who served together in the Senate for 25 years, will be able to meet each other halfway in a select few areas.

Spending is always an easy place to find compromise. A second COVID-19 relief package seems likely while the pandemic is still raging. The question to negotiate is the amount of relief and timing. It’s possible a bill could make it through Congress during the lame-duck session, but it’s also very possible it could be delayed until a new administration is installed in January. In either case we expect a Biden administration to request something in the neighborhood of $3 trillion. Their priorities include payroll protection, funds for testing and tracing, and aid for small business and state and local governments. Senate Republicans are likely to revert to a more fiscally conservative stance, offering something closer to $1 trillion focused on payroll protection and testing and tracing, with little or nothing for state and local governments. The two parties should be able to find a compromise, but only after a lengthy and heated argument.

The next most likely area of compromise will be tax increases and spending adjustments. Biden has laid out ambitious plans for increasing corporate taxes, raising the top individual tax rate, and requiring high earners to pay the same rate on investment income that they pay on wages. Republicans will likely focus on large structural deficits and the need to reduce spending, with entitlement programs like Social Security and Medicaid their main targets. It’s unlikely either of these programs will be touched and more likely that less high-profile discretionary programs, like agriculture and housing, experience a decline in growth. The potential for a deal is there, but getting it across the finish line will be painful, requiring compromise on both sides. 

Health care is one area where compromise is likely to remain out of reach. Biden has proposed strengthening the Affordable Care Act (ACA) through the addition of a public option and extension of more low-cost tax credits to low-income families. Republicans have spent the last decade trying to eliminate the ACA through legislation, lawsuits, and executive action. It’s hard to expect Senate Republicans to support legislation that enhances the ACA in any material way. It’s more likely that a Biden administration reverses some of the Trump administration’s executive orders and terminates Department of Justice support for lawsuits adverse to the ACA. 

Now that we’ve set the stage for the changes that are expected to take place under the mixed majority, let’s look at how they’ll impact investors. 

Taxable investors will get some breathing room as Biden settles in

There’s plenty of uncertainty about the future of tax policy and the details of what, if any, part of Biden’s proposed tax plan can make it through the Senate. Investors wondered in the weeks leading up to the vote whether to anticipate further tax cuts under Trump or potential tax increases under Biden. Given other pressing matters, such as the ongoing COVID-19 pandemic and its economic effects, it’s unlikely that any changes to tax policy will be implemented early in 2021. It’s more likely that after months of addressing other issues, some form of tax policy could be passed in mid- to late 2021 and put into effect in 2022. 

Biden’s proposals included increasing the highest marginal tax rate from 37% to 39.6%, eliminating the preferential treatment for long-term gains and dividends for those earning more than $1 million, and eliminating the step-up in cost basis upon death. It’s anyone’s guess if or when his administration will put these proposals forward and how they’ll need to be modified to gain approval in the Senate. Many believe some type of tax bill that includes some subset of these rate increases could be passed in 2021, with the change going into effect in 2022. However, although still considered less likely, there’s a chance that some tax increases pass in 2021 and are retroactively applied to January 1. Investors who believe this to be a probable scenario will need to quickly assess whether they should strategically realize gains in the current tax year to avoid a higher tax rate in the future. 

A mixed bag for muni investors and little change for the corporate market

Senate Republicans are likely to perform an obstructionist role not dissimilar to the way they operated during the second term of the Obama administration. Elements of the Biden agenda relevant to the municipal bond market that we believe are likely to be enacted are corporate and personal income tax increases, a revision in the deduction cap for state and local taxes (SALT), and possibly some form of infrastructure plan. The outcome should provide a tailwind for the municipal bond market.

We anticipate the top personal income tax bracket reverting to 39.6% and some increase in the top corporate tax bracket, though not the 28% that Biden has proposed. This should increase demand for municipals from wealthy investors, banks, insurance companies, and other nonfinancial institutions. An offsetting factor on the demand side would be a possible revision to the SALT deduction cap.

Biden has a proposed $2 trillion infrastructure plan, which includes incentives for debt issuance for infrastructure projects. The Trump administration failed to advance any infrastructure program despite widespread bipartisan support for the idea. With new political dynamics in Washington, we believe a scaled-down version of the Biden plan could pass. As part of any package, we might see reintroduction of Build America Bonds and an expansion of Private Activity Bonds. This may increase municipal supply in general, but it could significantly expand the already growing taxable muni market, which may see more participants, better liquidity, and more opportunities to apply investment strategies such as laddering or relative value trading.

From a corporate market standpoint, we don’t anticipate a dramatic shift in demand, supply, or credit fundamentals. The Democratic victory offers the likelihood of less uncertainty regarding trade and stimulus policies. Investment-grade fund flows were consistently positive going into the election, which is an indication that investors aren’t overly concerned that the election results will materially impact credit spreads.

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Closed-end fund investors may look to the Fed for guidance 

Election results may profoundly impact closed-end funds (CEFs) due to heightened sensitivity around tax laws changes for two reasons: CEFs are primarily owned by individual investors, frequently in taxable accounts, and they tend to distribute most of their long-term value creation, decreasing the likelihood of funds to have a much lower cost basis than market price. While many funds offer access to institutional strategies in fixed income and equity segments, more than 40% of aggregate US-listed CEF market capitalization is associated with either municipal bonds or tax-efficient equity strategies. Year-to-date share price performance can therefore be a leading indicator of how CEF investors may respond to a given election result.

The Democrats’ failure to capture a decisive Senate majority diminishes the likelihood of major one-way tax and policy overhauls. Investors may instead focus more intently on the resolution of uncertainty associated with the ongoing COVID-19 pandemic. Additional Federal Reserve intervention to stave off disappointing developments may be received warmly by retail investors; as we witnessed in April, bad enough news can be good news for risk assets. While more typical year-end loss-harvesting patterns may challenge share prices for CEFs that declined in 2020, the urgency and magnitude will likely be less pronounced than if a single party won with a clear mandate.

Expect solid but subdued support for responsible investors from Biden’s White House

Even amid the turbulence of the Trump administration, it’s become clear that responsible investing is no passing fad. Long-term investors are eager to encourage companies across the business spectrum to address and mitigate ESG risks. This eagerness has only become more potent as the COVID-19 pandemic and the Black Lives Matter movement have turned responsible investors’ focus to social issues such as workplace safety, health care access, diversity, and racial justice.

Investors should expect Biden’s administration to encourage this trend. However, the second Obama administration’s limited movement on the environment and social justice may be a sign of what’s to come in the first Biden administration. With his reputation as a defender of blue-collar America, Biden has carefully avoided promising large-scale green initiatives or health care reforms that have little appeal to his base. Without the backing of an activist Democratic-led Congress, he may stick to workplace protection and conservation efforts that can more easily attract bipartisan support. Biden’s lack of recent emphasis on these areas makes the outlook murky for any major environmental or social policy achievements.

Stimulus could impact long-term Treasury rates for pension plans 

It’s unknown how the markets and the economy will react once they transition to actionable law. However, many pensions have been on a liability-driven investment (LDI) path for the past decade or longer. The election results are unlikely to change the general trajectory of those plans. 

Defined-benefit (DB) pension liabilities are governed by discount yields, which consist of Treasury rates and credit spreads. Longer-term Treasury yields can be thought of as expected growth plus inflation. The expectation of a stimulus will likely impact longer-term interest rates, which have the biggest influence over liabilities. 

It may be tempting to assume that rates will rise quickly above forward curves or market expectations. But given the low interest rate levels that exist now, it’s also hard to see how a rate hike might materialize with a new administration. Inflation resulted from past stimulus following the 2008 global financial crisis, but a similar phenomenon has been elusive since. While many experts say this time is different, there’s been little data supporting arguments for either cost-push or demand-pull inflation. On the other hand, new policies increasing corporate taxes could affect credit spreads. Negative equity expectations could lead to an allocation shift toward bonds, which might lead to tightening.

All of these variables are anyone’s guess. However, for DB plans on a derisking path, speculation is likely one of the levers that should be dialed down. For plans that are already hedged, it’s hard to make a case for taking that hedge off, given the downside risks that decision might introduce. If you aren’t hedged, you might think twice about the payoff expectations of taking that bet.

The bottom line

Washington will be a different place by January 2021—but it won’t be different enough to cause a seismic shift. The Biden administration’s progress will be incremental, and its priority will be restoring the US economy to a state of relative normalcy. Individuals and corporations alike won’t be forced to reassess their approach to investing for at least the next couple years. We encourage investors to remain focused on their long-term goals and take advantage of all available opportunities to maximize their after-tax returns.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.