Pondering the Post-Election Debt Markets

Greenleaf Trust has written and spoken a fair amount about the 2020 U.S. election. If you pay attention, you know that we do not advise speculating with your portfolio on the outcome. In his last article, our Director of Investment Research, Nick Juhle wrote:

“Your investment objectives have a longer life than politicians and election cycles… the short-term market experience is always unpredictable, but we build portfolios for the long-term.”

He is absolutely right.

Nevertheless, in this article we will side step this sage wisdom and ponder what might be in store for debt markets after the election. Federal policy, especially tax and spending policy, can impact the economy. We will consider the candidates’ proposals and provide our outlook on the potential consequences of certain proposals, if enacted.

A Quick Example

Back on the campaign trail in 2016, then-candidate Trump’s tax proposals included limiting itemized deductions, but did not specifically mention the State and Local Tax Deduction (SALT). This deduction allows taxpayers to write off the property tax and either the income or sales tax paid to their state and local governments when filing their federal tax returns. For high-income taxpayers in high-tax states, that deduction could be quite valuable.

Fast forward and, at the end of 2017, President Trump shepherded the Tax Cut and Jobs Act (TCJA) into law. The new tax plan placed a limit on SALT deductions at $10,000 beginning with the 2018 tax year.

Back in 2016, real estate values on the coasts were booming. High tax states like California and New York had some of the hottest property markets in the country. Shelter prices in San Francisco were increasing 6-7% per year.

Well, after the SALT caps, San Francisco property owners and residents could no longer deduct their relatively high state and local taxes. By our estimate, the SALT cap increased the median San Francisco household’s federal tax bill by about $2,300.

Shortly after the TCJA implementation, the San Francisco property market cooled and reverted to the national averages for price appreciation. We believe the new tax policy was a contributor to this dynamic.

If you were an investor depending on real estate appreciation on the coasts, or on inflation-linked bonds tied to further appreciation in shelter costs, you would have been wise to ponder the post-election impacts back in 2016 and 2017.

The 2020 Candidates’ Tax and Spending Proposals

Now let’s consider some of the primary differences in policy proposals among the candidates in 2020. We will focus on the main points of differentiation and some of the potential implications for debt markets.

Policy Differences:

1. Personal and Corporate Income Tax Rates:

• Biden favors a slight increase of income tax rates on individuals making more than $400,000 per year (from 37% to 39.6%).
• Biden favors increasing the corporate tax rate from 21% to 28%.

Potential Investment Implications:

• Higher income tax rates increase the value of tax-exempt investments, like municipal bonds.
  • The corporate tax rate is important here. Since 2017, banks and insurance companies (taxed at the corporate rate) have reduced their holdings of municipal bonds by about 10.5%. A higher corporate rate could incentivize them to consider adding municipal bonds.

2. SALT Deduction Limitation:

• Biden favors removing the $10,000 SALT deduction limitation.

Potential Investment Implications:

• A lower tax rate (by allowing property and income taxes to be deducted) should benefit property values in high-tax jurisdictions. (Effectively reversing the dynamic we noted in our ‘quick example’ earlier in the article.)

3. Infrastructure and Federal Spending Plans:

• Both candidates’ spending plans include large deficit spending.
  • Under a baseline scenario, CBO projects cumulative deficits of roughly $5.35 trillion for 2021-2025.
  • Moody’s projects deficits under Trump’s plans to add roughly $250 billion to this figure.
    • Trump has called for a $1 trillion infrastructure plan, which would be offset by other spending cuts.
  • Moody’s projects deficits under Biden’s plans to add roughly $2.5 trillion to this figure.
    • Biden has called for a $2 trillion infrastructure plan.
• The ability to implement spending plans will depend heavily on whether we have unified federal government or divided government.

Potential Investment Implications:

• Large federal deficits are considered inflationary, which generally influences interest rates upward.
• However, the impact on interest rates may depend on the Federal Reserve’s action.
  • So far, the Fed has responded to the COVID recession with very accommodative policy, including setting the Fed Funds rate at 0%-0.25% and using unlimited quantitative easing.
  • If the Fed changes course, and is no longer the primary purchaser of new Treasury issuance, then the private market will need to absorb the supply and interest rates may drift higher.
  • Fed Chairman Jerome Powell’s term does not end until January 31, 2028, so a dramatic change in the Fed’s orientation will likely depend more on the economy than on the results of the election.

4. Additional COVID Stimulus:

• There are two main points of differentiation in the latest negotiations:
  • Democrats favor $600/wk. in supplement unemployment benefits, Republicans have offered $400/wk.
  • Democrats favor $436 billion in aid for state and local governments, Republicans have countered with $300 billion.

Potential Investment Implications:

• The main question is whether we will see another aid package passed at all. After some hope in early October, odds have shifted out until 2021 before we see another round of stimulus.
• If a more generous aid package is passed, it could be positive for creditworthiness in both municipal and corporate bonds.
• If no package is passed, it would be negative for credit and for struggling sectors like transportation, real estate and leisure and hospitality.

Conclusion

Regardless of the outcome of this election, our advice is always to vote with your ballot and not with your portfolio. We will have time to digest federal policies over the next presidential term and will take advantage of any planning or investment opportunities that arise. This article mentioned several potentialities, but we will remain vigilant to the dynamics on the ground and will act in a prudent manner to help you preserve and grow your wealth in these next four years and beyond. Thank you for the opportunity to serve on your behalf. Please contact a member of your client centric team if you would like to discuss any of these ideas further.

Sources:

Bureau of Economic Analysis, SIFMA, the Tax Foundation, Moody’s, Congressional Budget Office, St. Louis Federal Reserve