Since our last Markets in Motion, our Global Macro view has begun to playout. Since mid-May, growth/quality equities have turned from laggards to leaders as cyclical assets have faltered. We think this move has only just begun and we remain convicted in our positioning.
This month, we wanted to address a question that frequently comes up in client conversations. With the Biden administration proposing $3.3tn in new taxes (Chart 1), will this stymie the new bull market in risk assets?
Over the past 20 years, successive administrations have failed to raise taxes by enough to finance increased spending -driving the federal budget deficit higher relative to GDP. The COVID-19 pandemic exacerbated the problem, blowing out the deficit to record peacetime levels. This has not caused any major financial problems because low (and falling) interest rates have helped contain debt servicing costs, and the Fed has been a large buyer of treasuries (effectively monetizing the debt). However, given the long run path of fiscal finances and the Biden administration’s ambitious spending plans with a majority in Congress, we feel higher taxes are inevitable.
The Biden tax plan has two major provisions to corporations and households that we believe will more than likely get passed. All other major tax proposals, such as eliminating favorable treatment for qualified dividends and capital gains, appear to lack significant support.
- Corporate: Raising the domestic corporate income tax rate from 21% to 28%. Thiswould bring the tax rate halfway back to where it was prior to the Trump tax cuts(35%). Likely to be negotiated down to 25%. (Chart 1).
- Households: Raising the top income tax bracket to 39.6% from 37%. Where the ratewas prior to Trump Tax cuts.
As a result of these two major provisions, corporate profits will decline, activity will slow, and higher income taxes will mean less investable cash. The top 1% of income earners own 43% of household US equity ownership, the highest concentration on record.
All things equal, this is bearish for risk assets. But the world does not exist in a vacuum! All things are not equal and the bullish effects of the new framework for fiscal spending will help offset the negative impact of higher taxes. Additionally, as we’ve highlighted in the past, business cycle dynamics are more important than the market narrative du jour – and the macro is currently robust.
And history is on our side (Chart 2): In the 13 previous instances of tax increases just since 1950, the S&P 500 has shown higher average returns, and higher odds of an advance, in times when taxes are increasing.
While this seems counterintuitive and correlation does not equal causation, it suggests other factors carry more importance and for the most part, tax hikes get discounted into markets in advance.
Therefore, investors are likely to shrug off the near-term impact of higher taxes, given strong economic growth and continued support from accommodative monetary policy.
Finally, know that all our Strategies will adapt to fundamental or rules-based, not emotional influences. We seek opportunities for solid risk adjusted returns and to preserve capital in asset market downturns.
Recent Portfolio Changes
We made no portfolio changes this month.
1 Information as of 06/15/2021. Individual account allocations may differ slightly from model allocations.
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Best regards, John A. Forlines III
Chief Investment Officer
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