Welcome to the 2020 homestretch! It’s been quite a year, and the final three months are sure to offer plenty of sensational developments. This newsletter will bring you up to speed on both the US economic recovery and the much-anticipated election. Best efforts were made to avoid the words unprecedented or extraordinary, but keep in mind that much of the news and data are both.
As always, we are keeping a trained eye on the potential risks as we approach year-end. We are pleased with our performance thus far and are looking forward to finishing strong. If you have any questions or concerns, we’re here. Just let us know how we can help.
As we assess the strength of the economic recovery and gauge its future prospects, the U.S. consumers’ ability and appetite to spend will play a key role. The former will largely be determined by incomes. Even though millions of people lost their job during the sharpest recession in history, aggregate personal income is actually higher than it was before the pandemic. For that, we can thank a fiscal stimulus package of unprecedented size that sent direct payments to Americans and increased unemployment benefits to such levels that many people filing claims received a temporary raise. As evidenced below, Personal Income has declined from March levels, but remains 4.8% higher than it was a year ago.
However, stimulus payments have subsided, and gridlock in Washington has reduced odds of another large package. Barring a breakthrough in negotiations, the private sector will be responsible for maintaining consumers’ ability to spend. Since our July update, the unemployment rate has fallen from 14.7% to 7.9% - a marked improvement, but still more than double the 50-year low of 3.5% achieved in February. And while many of the jobless still believe their positions will return with the end of COVID-related shutdowns, an increasing number shifted from ‘temporarily-unemployed’ to ‘not temporarily unemployed’ in the latest BLS report. The longer shutdowns (and the virus) last, the harder it will be for struggling employers to stay afloat. If the jobless are correctly classified (and an increasing number of workers no longer have jobs to return to), it will be difficult for employment growth to continue at its current pace.
The lives of workers in some industries, notably leisure and travel, have been completely upturned, while many of the people that managed to keep their jobs had to significantly change their lifestyles. The forced, widespread transition to work-from-home has wholly altered the employment landscape. But it’s also helped fuel a surge in the housing industry. After weeks, or in some cases months, of time in captivity, families have a newfound appreciation for large and versatile living-spaces. Suddenly, millions of people need a home office, or two, and a learning area for children. A rampant appetite for spending was put on display – consumers couldn’t use their increased incomes on travel or entertainment, so instead pushed sales at home improvement stores to all-time highs. And those without homes to improve were willing to spend to get them. Despite an ongoing recession, new home sales are at the highest level in more than a decade, and traffic of prospective home buyers is at a record.
Aiding the booming housing market are record-low rates. The average rate on a 30-year mortgage is now just 3.04%, compared to more than 4.50% at the end of 2018. It’s not just mortgages, though. Driven by lower benchmark rates from the Federal Reserve and Federal government guarantees on business loans, banks have issued more loans than ever before, and all at low rates. Unfortunately, it may not last. Loan default rates have stayed low throughout the pandemic, thanks to widespread forbearance agreements, but defaults are set to rise as those agreements come to an end.
Banks are wary of the losses new, risky, loans could generate - in a survey of senior loan officers, 61% said they were tightening lending standards on consumer loans; similarly, more than 70% said they were tightening standards on commercial and industrial loans to large, mid-sized, and small firms. If both consumers and businesses lose access to credit as a result, it could be a drag on the economic recovery. Lower credit quality consumers would be forced to reduce spending levels, and many industries hit hardest by the pandemic would struggle to return to normal.
Compulsory Political Commentary
Every four years, we dread writing our third-quarter update. The disdain originates not from seasonal affective disorder, but from an obligation to make broad pronouncements about the market impact of the upcoming election. While governmental policy is an inescapable input into markets, election season injects emotion into the equation. And emotion is the enemy of sound decision making in markets.
This election is as contentious as nearly any other in our country’s history, and you already know why/how we got here. In the interest of being fully transparent in our analysis, let me offer this relatively simple disclaimer: Our analysis of the potential outcomes is entirely focused on the impact on markets and the economy. We do not intend to express any judgment on the merits of a policy based on its values or social implications. Please keep in mind that a great deal of our data and conclusions come from reputable third-party sources. If you’d like to engage in a more detailed conversation, please let us know; we’ll be happy to share our sourcing and logic.
We won’t spend much time on polling or odds of the various outcomes because there are so many sources available. And if you’re interested enough to read this politics section, you probably already know which sources you prefer.
Given the current polling and seats in-play, there are four probable outcomes:
- President: R Senate: R House: D (status-quo and probable gridlock)
- President: R Senate: D House: D (probable gridlock)
- President: D Senate: R House: D (probable gridlock)
- President: D Senate: D House: D (blue-wave)
Of those outcomes, only the fourth configuration likely results in a significant change to the policy outlook. If there’s a silver lining to our terrible political discourse, it’s that a split in the branches by party probably means we’re in for at least two years of gridlock. Typically, gridlock in peaceful times has resulted in positive outcomes due to predictable and stable ‘rules of the road’ for businesses.
In our view, there are positive cases to be made for most potential outcomes. Both candidates, and both parties, have shown a propensity to run budget deficits and support accommodative monetary policy. In the short-term, spending more than you tax, or taxing less than you spend will create a surplus of dollars for the private sector – and markets live in that private sector.
Say what you will about the long-term dangers of deficit spending, the past 20 years have led to a broadly espoused conclusion that the reserve status of the U.S. dollar has afforded the U.S. a capacity to borrow and spend that few other countries have ever enjoyed. Low interest rates and a stable currency have bolstered the concept that global markets can easily absorb U.S. debt. We are not downplaying the potential consequences of reckless financial management, but those consequences are likely longer-term in nature. And while not within the scope of this note, we’re happy to set up an individual review of this important concept as needed.
Let’s review the projected fiscal programs of the two candidates:
The Biden plan is directly from the campaign, and the Trump plan has been compiled and scored from a combination of his public statements and specific programs set to expire from the 2017 tax legislation. All figures are cumulative of each candidate’s incremental taxing/spending over the next four years and do not reflect existing tax/spending programs.
Before the pandemic, the United States was on pace for a $1.0 trillion per year budget deficit, which was the largest since the great recession of 2008 and 2009. Assuming the existing deficit persists over each of the next four years, by 2024, we’ll have a baseline addition to the national debt of $4.0T. Under the Trump plan, we would add roughly $334 billion to that baseline, and under the Biden plan, we’d add $2.5T. And the aggregate budget deficit over those four years would be $4.3T under a continuation of the Trump administration, or $6.5T after the first term of a Biden administration. In other words, these proposals would constitute a roughly 20-30% increase in the national debt over the next four years.
It’s worth noting that this analysis does not account for the prospect of additional pandemic aid, which could come in at $1.6-2.4T. If either pandemic aid plan is eventually passed, we should assume a baseline addition to the national debt of nearly 40% over the next four years. Unsurprisingly, an addition to the debt of that magnitude in such a short period would be unprecedented.
The thought of adding to the country’s already substantial debt load may not feel like a favorable scenario to most people reading this newsletter, and it’s completely understandable. But remember, in the short-term, the government’s deficit is the private system’s surplus.
By all accounts, both administrations will likely offer very accommodative fiscal policies. They would also probably prefer a continuation of accommodative monetary policy. The Federal Reserve is currently exerting historic levels of monetary accommodation. Through active measures (quantitative easing and zero interest rate policy) as well as guidance about future accommodation, they’ve successfully kept financial markets buoyant and interest rates low.
The Federal Reserve is an entity that sets its policy course independently, but the president nominates the chairman and board of governors. It is unlikely either president would make any changes until Jerome Powell’s chairmanship ends in 2022. And given the successful monetary policy experiments over the past 12 years, it’s tough to see why Biden or Trump would appoint a chairperson with a dramatically different philosophy than Mr. Powell.
Negative scenarios are always easier to think up. Risk-aversion is very natural, especially amid a global pandemic, social unrest, and a no-holds-barred political food fight. While we won’t dwell on the political or social negatives, it’s worthwhile to review a few of the market-negative scenarios that could unfold over the next 1-12 months. Again, this is a relatively short-term focused exercise. They are not presented in a particular order, and the decision to lead off with a Biden administration negative was determined by a coin-flip.
Biden Policy Negative?
The headline grabber/low-hanging fruit of the potential Biden negatives is a possible increase in taxes. If you want to go line by line on where these taxes might be levied/increased, please refer to the table above. When measuring the negative impact of increased personal income tax and payroll taxes, you must have a discussion of incentives and behavior – two notoriously difficult areas to measure. In the behavior and incentive discussion, you’d also have to weigh potential positives of the increased spending that would result from the incremental revenue raise. Increases/decreases to statutory corporate rates on the other hand are mathematically straightforward. JP Morgan has done the math, and the corporate income picture under the Biden tax plan for the S&P 500 is as follows:
Before considering spending programs or tariff reductions, JP Morgan calculates that the new corporate taxes could cause a 7.2% contraction in S&P 500 earnings. The long-term annualized earnings growth for S&P 500 earnings is about 7%. So, the question under this scenario is: Is losing a full year of S&P 500 earnings a catastrophe?
Trump Policy Negative?
Restrictive international trade policy is the key risk to earnings from a second Trump administration. Much like long-term fears around running persistent budget deficits, the multi-faceted and complex US-China relationship is worthy of detailed analysis. But for this note, we’re reviewing the direct policy impact on corporate earnings and investor confidence.
The market volatility during the escalating trade war in 2018/2019 was dramatic at times. Still, it didn’t get out of hand because both sides had a vested interest in keeping the relationship from completely falling apart. That ‘mutually assured destruction’ feature of the first trade war was at least in part due to President Trump’s desire to win reelection in 2020. In a second Trump term, it’s unclear whether there would be much sensitivity to sudden bouts of trade-war induced market volatility. An unbridled approach that leads to a dramatic decoupling between the U.S. and China would be very disruptive to supply chains and investor/consumer confidence. A less dramatic trade war would likely see a renewed 2-5% drag on S&P 500 earnings, just as we saw in 2018/2019. The prospect for a prolonged conflict could also dampen valuation multiples.
Of all the fundamental risks posed by either an unverified republican platform or a full-fledged shift in policy preferences, the most concerning short-term risk to markets is an almost self-fulfilling one. Every election, we tend to present a measure of consumer comfort for each party. As you’d expect, the party in power generally has higher consumer comfort at the individual voter level. Rarely has that phenomenon been more pronounced than right now. The chart below is the difference in confidence between republican and democrat consumers. When the purple line is trending to the upper-right, republicans are increasingly confident in their financial situation relative to democrats.
Note the dramatic increase in republican consumer confidence immediately after the 2016 election of Donald Trump. That shift in confidence coincided with substantial capital inflows into the U.S. equities. The concern here is that a Biden win could cause those same investors to change their optimistic tune. And if the inverse of the 2016 reaction occurs, we may see more investors willing to return to the sidelines until they feel better about their prospects.
Ironically, the most troubling outcome has very little to do with the policies of either candidate or their sponsor party. And if you’ve made it this far into the politics section of this quarter’s newsletter, I’m guessing you already know where we’re headed. It is, of course, a contested election. From a market perspective, the only playbook for a contested election is Bush v. Gore in 2000. Notably, the defining feature of the year 2000 in market history is not the contested election, but instead that March of that year marked the peak for the dot-com bubble. That should give us hope that our markets can handle the uncertainty as our legal process plays out.
Our plan heading into the election is to continue our 2020 strategy of keeping our exposures balanced. We view the potential outcomes with a hint of positivity and a healthy respect for the unpredictability of the risks. Our active management approach has shined in many periods of dramatic volatility – including the COVID crash in March of this year. And given that track record of risk mitigation, we feel perfectly suited to managing the unique risks and opportunities that the upcoming months will yield.