For investors, the election matters—hugely. Just how much so has been overshadowed by the housing collapse and the scores of banks and Wall Street firms fighting for survival. Because economic differences between John McCain and Barack Obama couldn’t be greater, we believe investors must start considering investment strategies determined largely by who will occupy the White House come January.
First a caveat: Cadinha & Co. is apolitical when managing client funds—nothing here about foreign policy, social programs, or anything outside of investments that thoughtful citizens should consider in choosing our next leaders. The purpose of this report is two fold: to summarize and put hard numbers to the fiscal policy proposals of Senators Obama and McCain; and to offer investors ideas about preparing for and taking advantage of the election’s outcome.
A new New Deal?
To supporters and critics alike, America’s growing enthusiasm for Senator Obama warrants a profound sense of awe. Despite an election year that’s the Democrats to lose, Senator Obama is not settling for an easy win. His campaign has become a movement, one that’s attempting to turn the political economy on its head and replace the supply-side economics that have reigned since Ronald Reagan with the government-centric principles of Keynes and FDR.
Senator Obama’s rhetoric envisions a second New Deal, an economic paradigm “that rewards work not capital,” where “economic justice will be served,”—all administered by an expanded federal government charged with a greater role in allocating capital and investment, redistributing wealth, and recasting a thicker welfare net. In policy decisions, Obama has promised the equity of growth will be considered equally with growth itself.
Senator Obama’s vision for a new Keynesian economy is to be paid primarily with changes to the tax code. He would raise the top marginal tax rates on income, dividend and capital gains put in place by the Bush tax cuts of 2001 and 2003, and phase out itemized deductions for high income taxpayers. He would uncap Social Security taxes, which are currently levied on the first $102,000 of earnings.
For investors, maybe the most immediate and dramatic effects of an Obama presidency will be felt by tax increases in capital gains and dividends that could rise to 28% and 39.6% or higher, respectively, from their current rates of 15% each.
If it were up to Senator McCain, the election would simply be a referendum on the Iraq war. It isn’t exactly clear what Senator McCain’s true feelings on economic policy are. He voted against the Bush tax cuts in 2001 and 2003 only to emerge in this election as a reformed student of supply-side economics. Although he has advocated keeping the current tax cuts as they are, in a recent interview with ABC’s George Stephanopoulos, he didn’t rule out tax increases in any form. “I don’t want tax increases,” Senator McCain said, “But that doesn’t mean that anything is off the table.” Much to the dismay of many conservatives, Senator McCain is no economic ideologue, apparently believing that he will need to negotiate on the tax front in order to achieve his higher priorities.
Regardless of Senator McCain’s true economic policy compass, tax increases are also likely in a McCain administration simply because the Bush tax cuts are currently set to expire in 2010. With fewer contested seats in Congress, Democrats will likely retain both houses of Congress, and, according to our analysis, will pick up additional seats in the Senate. A President McCain would be unlikely to extend the current tax rates as a budget item. The odds of him pushing any tax legislation through Congress resembling the current code is almost zero.
Certainly, financial markets constantly consider a myriad of factors in determining asset prices. One of the most important factors for equity investors is after tax earnings per share. Pre-tax corporate earnings are taxed twice before reaching investors. First, companies pay the corporate tax rate of 35%. Next, companies have two ways to get the remaining earnings to shareholders: by paying dividends or by retaining earnings for growth and future capital gains.
Currently, the tax rate on both methods is 15%. Thus, a dollar of dividends or capital gains results in an after tax return of $0.85. Should tax rates increase on both kinds of distributions, stock investing becomes a less profitable endeavor, all things being equal. As was the case prior to the Bush tax cuts, dividend income will likely be taxed at a higher rate than capital gains regardless of who wins the presidency. The tax code will favor capital gains, and thus, stocks with higher growth attributes and low dividend payouts. Tables 3a and 3b illustrate the effects of tax rates on returns to investors.
In our analysis, the Obama tax rates will result in lower after tax dividend and capital gains income for investors, resulting in lower valuation of equities by investors. It seems to us with less than 100 days until the election, the market may be already discounting an Obama presidency.
Looking at risks and opportunities
We may very well have seen the end of lower taxes for the investor class; after tax headwinds may be inevitable, albeit softer under a McCain presidency. If our analysis is correct, successful investment strategies will be those that anticipate those market sectors favorable under each administration while moving away from riskier ones. Tables 4a and 4b illustrate favorable and unfavorable sectors looking solely at the candidates’ proposals and speeches. The real value of this exercise lies in thinking about asset allocation on a forward-looking and proactive basis.
Most investors won’t change investment strategy based on political change. Financial advisors, armed with regression-analysis and performance-simulation software, generally recommend strategies and investment products with impressive track records. The past, they argue, is the best indicator of the future. That’s religion on Wall Street—and it’s wrong. Basing future investment decisions solely on past models has almost never worked well for investors.
The next few months and years could prove this once again as a watershed election changes the rules of the game for investors.