Policy Shifts May Challenge Markets


Hatem Dhiab, CFP®
Managing Partner

LPL Financial, our custodian and a leading provider in investment and business solutions, releases commentaries weekly. I believe that it is of great importance to discuss some of the potential impact and ramifications of the massive government intervention last year and what’s planned from a policy standpoint. These are the insights that LPL has provided us that I would now like to share with you:

Fiscal stimulus, which was central to the market rebound in the last year, may start moving to the sidelines over the rest of 2021 and into 2022 as the recovery continues. Economic growth can compensate for the loss of government checks to households and businesses, but potential tax increases may be more challenging for markets to navigate. Business tax increases, in particular, may gradually pull gains out of markets about equal to their size, but with economic growth supporting corporate earnings, we believe a positive backdrop for equities remains in place.

Federal Spending Unlikely To Change Market Trajectory
Much of the approximately $5 trillion in direct COVID-19 related stimulus in 2020 and 2021 did not flow through directly as government spending. Instead, the federal government used its borrowing power to distribute funds to households and businesses. That impact will fade over the remainder of the year but will be replaced by the private economy accelerating. There is some threat of a fiscal headwind from the decline in government largesse, but that headwind will be felt only if the private economy can’t make up the difference and we continue to expect above-average growth well into 2022.

Taxes May Change Market Path, But Not Direction
Federal spending is generally funded by taxes or debt, and the Biden administration plans to raise taxes to help pay for BBB. President Biden has proposed increasing taxes on both corporations and wealthy households, including an increase in the capital gains tax, the tax on investment profits. Markets so far have taken the proposed changes in stride, largely due to expectations that the proposed tax increases will be reduced during negotiations and the economy will be strong enough to absorb the impact.

President Biden has proposed increasing the corporate tax rate to 28%, but that should be viewed as a bargaining position and we believe the more likely outcome is that we see the rate end up closer to 25%. Alternative approaches, such as increasing the minimum tax on businesses and raising the top rate less—or not at all, are becoming part of the conversation. The negative news for markets is that corporate earnings growth will likely take a direct hit that is approximately equal to the size of any tax hike. Because the stock market is fundamentally driven by earnings growth, the tax impact will likely be a headwind for equity markets.

Proposed tax provisions to raise funds for BBB (Build Back Better) on the household side include increasing the top tax rate on ordinary income from 37% to 39.6%, and raising the capital gains and dividends taxes on those who earn more than $1 million to a maximum of 43.4% from the current 23.8%—a stunning increase if fully instituted. At the same time, only 0.32% of the population makes more than $1 million a year, so the truth is this won’t impact the other 99.68% of the population.

A Way Too Early Peek at 2022 Mid-Terms
This brings us to the final point—the durability of any large policy change in an era of near political balance. President Biden is unwinding some Trump administration policies, and President Trump unwound policies of the Obama administration. Neither party has held the White House for more than eight years since Bush beat Dukakis. Congress has also been hotly contested with more frequent swings. Over the last 40 years, the House has changed hands seven times and the Senate four. If you don’t like the policy environment, wait a few years—we’ll get a new one. The American electorate is nearly evenly divided right now, fostering more frequent swings and certain wisdom in rejecting the excesses of both parties.

The massive fiscal and monetary policy support that helped the economy (and the stock market) get through the pandemic is starting to move toward the sidelines. Markets like stimulus, and even a gradual move to the sidelines may cause some bumps. But overall, we think that macroeconomic conditions, rather than policy, will be the most important driver of the return environment in the year ahead. We are watching negotiations over corporate taxes closely, but if history holds, tax increases may slow markets, but they shouldn’t fundamentally shift the return outlook. U.S. businesses remain agile, and even with the potential hit from higher taxes, there will be plenty of opportunities ahead.

Hatem Dhiab is a Financial Advisor of Santa Monica, Calif-based Gerber Kawasaki Inc., an SEC-registered investment firm with approximately $1.8 billion in assets under management as of 02/22/21. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss. Readers shouldn't buy any investment without doing their research to determine if the investments are suitable for their situation. “All investments involve risk and one should consult a financial advisor before making any investments. Past performance is not indicative of future results.”