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The Deepening Income Drought and Potential Election Impacts

It is hard to believe fall has already arrived, ushering in the start of Q4. The end of summer was particularly challenging as COVID-weary Californians endured horrific wildfires in yet another addition to the “Things We’d Like to Forget About 2020” list. After a September swoon in the equity markets, Q4 has started off positive, leaving many investors perplexed and some investors concerned as the November elections loom just around the corner.

Evidence appears to indicate an increasingly probable change in administration as well as a flip in the Senate, so how can markets rally in the face of these events? We believe there are three key reasons: 1) lagged effect of massive global fiscal and monetary stimulus, 2) persistent and durable improvement in key multipliers in the economy and 3) increasing clarity on the probable election outcomes.

Prior editions of Capital Insights have described the knock-on effects of the stimulus pumped into the system and we see continued strength in many key areas such as housing, manufacturing, and capital expenditures as the world continues to learn how to live with COVID. We do expect the rate of improvement in employment and growth to slow in coming quarters, but there is not a lot of evidence that would suggest our economy is suddenly heading for any sort of stall, regardless of what happens in November. 

Figure 1: Employment, Optimism and CapEx Plans Continue to Rebound

Source: Cornerstone Macro

On the plus side, low interest rates stimulate borrowing and lower financing costs which helps businesses and consumers. However, on the opposite side of the ledger, a near zero-rate world leaves income investors in a quandary: where does one go to find yield in a safe and responsible manner? Additionally, because starting yields are now so low, global bonds are becoming much less effective in offsetting portfolio risk during equity market drawdowns.

 Figure 2: Government Bonds: Vanishing Income, Reduced Diversification Benefits

Source: AQR

Our investment team continues to source creative new ideas and evolve our client portfolios to help solve for these challenging issues. Over the past quarter, we have started to expand allocations to public and private investment vehicles in both debt and real estate sectors. These allocations help to diversify portfolios as well as provide consistent income, without introducing inordinate credit or leverage risk. Our team also remains committed to our secular Innovation theme and recently added direct exposure to Financial Technology firms as a corollary to the challenged traditional banking sector. We believe these enhancements will allow our clients a reasonable mix of growth and income while still allowing them to participate in investment opportunities that have long-term tailwinds, no matter what results from the elections.

Figure 3: Glass Half-Full or Half-Empty? Depends on Perspective – Weekly Confidence Readings

Source: Cornerstone Macro

We consistently receive questions about potential market volatility surrounding the elections next month. While there seems to be a general consensus that a Democratic sweep would be dramatically negative for equity markets, we would caution our clients from becoming too bearish, too soon. Equity markets tend to price in the coming six to twelve months, and in the scenario of a Democratic sweep there is strong evidence that higher levels of additional fiscal stimulus would be enacted, as well as continued deficit spending, which would actually benefit equity markets. The prospect of higher corporate taxes and anti-trust legislation would certainly act as a headwind, but these items are somewhat dependent on how much control the Democrats would have in the Senate and if they were able to actually end the filibuster.

In terms of client portfolios, we believe we have set the proper allocations given the current circumstances and uncertainty. For clients who want to further mitigate volatility risk on a custom basis, we can employ some additional tools and techniques to help in that area.

Although the results of the election are yet to be determined, it is important to understand the potential tax implications given a Democratic sweep.  Candidate Biden has broadcast his desired tax proposal to create a more progressive tax system, which translates to higher taxes on higher-income households, specifically those with taxable income over $400,000.

Figure 4: Current versus Proposed Individual Tax Rates

Source: Michael Kitces

The following is a summary of the proposed tax legislative changes affecting high earners:

  • Revert the top ordinary income tax bracket rate back to 39.6%. It currently is unclear if the $400K income threshold applies to single, joint or both. Households could be faced with the top tax bracket at much lower income levels than current tax law.
  • The 20% Qualified Business Income tax deduction for “pass-through” business owners introduced in the 2017 TCJA will be eliminated for anyone earning more than $400K.
  • Limit the value of itemized deductions at no more than 28% for those earning more than $400K. Taxpayers in the 24% marginal tax bracket and under will be mostly unaffected.  Those in higher tax brackets could see substantial increases to their effective tax rate.
  • Replace tax deductions for IRAs, 401k and other retirement accounts with a flat credit aimed at equalizing tax benefits of retirement plans for low- and middle-income contributors vs high income earners. This could create additional state tax liability as well, given that taxable income is no longer reduced with retirement plan contributions.
  • Increase long term capital gains tax to ordinary income tax rates (39.6%) for households making more than $1 million and eliminating 1031 exchange tax deferral on real estate gains for households over $400K.
  • Elimination of the stepped-up basis on all inherited assets. This proposal has floated around for the past 50 years, but there are significant implementation issues and the practicality of executing such change.
  • Revert estate and gift tax exemption to previous levels of $3-$6 million, versus the current exemption of $11.6 million per individual. The Treasury has issued guidance that any wealth transfers utilizing existing exclusion amounts will not be clawed back.
  • New and expanded personal tax credits targeted at low- and middle-income households with dependents, first-time home buyers and caregiver credits. While not specified, the Biden plan would also like to improve current tax breaks for purchasing long-term care insurance.

Once there is more clarity surrounding any potential changes to tax law, it will be important to consider some year-end tax planning strategies to mitigate the impact of any proposed changes.  If you have questions about how you might be affected, please be sure to contact us and we will be happy to discuss ideas with you.

Our Capital Insights readership continues to grow substantially and now encompasses clients, prospective clients, strategic partners, as well as friends of our firm. To our clients, we deeply appreciate your business and trust in your Capital Planning Advisors team. If you are not a client and are contemplating initiating a relationship with us, either directly with your personal or business assets, or by referring someone you think could benefit from our services and approach, we would be delighted to speak with you.

We continue to experience steady and stable growth and we are grateful that everyone on our team is healthy and safe. We sincerely hope that you and your loved ones are keeping safe and well and please do not hesitate to contact us if you have any questions or if we can be of further assistance.

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