Modelling your future investment returns is most clearly done by writing down a list of scenarios, estimating how much money your investment would make or lose in each scenario, and then assigning probabilities to those scenarios. Like an insurance company writing a policy, or a casino choosing to offer a new game, we make the investment when the odds are in our favour, and if not, we look for other investments where the odds are in our favour. We have limited control over the future outside our own actions, so the honest investor must keep the list of scenarios and their probabilities as objective as possible, and not try and change those to many any investment look more rosy.
Warning: The following contains commentary on US politics. Reader discretion is advised.
“Interestingly” enough, 2021 started with a crystal-clear example of probabilities we’ll need to update, this time with scenarios of US political risk. And no, I’m not talking the violence at the Capitol, which by itself still seems unlikely to escalate into being financially material to investors. The main US political risk wealth managers have been modelling since at least the first Democratic primaries in 2019 is what will happen to the US Senate, and with it, what will happen to Trump’s pro-American business policies. Right after the November election, prediction markets estimated Democrats had only about a 10% chance of gaining control of the US Senate, but this week they seem to have beaten those odds and won both of Georgia’s Senate seats in this week’s runoff race. In total, this gives the US Senate a 50-50 split between 50 R Senators and the 48 D’s + 2 Independents that solidly vote with the D’s, and in the Senate, that gives VP-elect Kamala Harris at least two years to cast tie-breaking votes. Although incoming D Senator Jon Ossoff won his seat by only about 40,000 votes (that’s 0.013% of the US population, 0.4% of Georgia’s population, and 11% of US COVID deaths), those 40,000 voters have made the difference between the need to compromise versus one party being able to push through an agenda without compromise. Investors around the world are and should be very concerned about this balance of power in the world’s current superpower, which makes up 55% of global equity markets and 42% of global debt markets.
Professionally, I have tried my best to avoid the temptation to become a political analyst and instead focus on how this updates our models, scenarios and probabilities that impact our portfolios and overall wealth plans. Even with control of the White House, Senate, and House of Representatives, there is still plenty of uncertainty on what exactly America’s resurgent ruling party will agree on and get passed in the next 2-4 years, let alone how it may impact the next 20-40 year time horizon of a wealth plan. One simple rule of thumb to understand right vs left in most G10 countries is that where there is a cost, burden, or blame to be placed somewhere, the right will put that on foreigners while the left will prefer to charge their own country’s high earners. For example, several of Trump’s policies have solidly focused on benefiting American business and “making China pay”, while the Biden-Harris campaign has seemed to focus on instead making high income Americans pay. This is why many analysts, myself included, see China as one of the biggest winners of the recent US elections.
Below are just six of the main points that wealth managers should watch during the term of the 117th US congress (2021 and 2022):
First and most likely, I now put about a 70% probability of US corporate taxes rising from 21% to at least 28%. There were many other changes to US corporate tax in the “Trump tax cuts” (aka the Tax Cuts and Jobs Act of 2017), including a huge change to make the US corporate tax system territorial (making it competitive with Hong Kong or Singapore) rather than global, but it is much harder to guess at or model details of those changes than it is to simply look at rates. Back of the envelope, I estimate that this corporate tax change alone would shave about 2%/year off the S&P 500’s return on equity rate, lowering it from about 19% to about 17%. Based on the S&P 500 currently trading at about 28x earnings, I had already estimated that the expected rate of return on US stocks (again, about 55% of the world index) would only be about 5%/year, and this lowers that to about 4%/year, again with that 70% probability. This is likely an understatement given the knock-on effects of the 2017 corporate tax reform, which included many pay increases to American workers, repatriation of a significant amount of capital from overseas subsidiaries, and the downward pressure this had on US inflation (=upward pressure on the US dollar) in 2018 and 2019. I find it worth noting at this point that a significant share of strong US stock performance in recent years has been on the back of these tax cuts, and investors who bought stocks since have largely been paying for the expectation that the Trump tax cuts would last until at least 2025 if not 2030.
Second, I would also raise to about 60-80% the probability on various tax increases more directly affecting American individuals, including taxes on income, capital gains, payroll and estates / inheritance. Back of envelope again, I don’t think this will have a significant direct impact on foreign investors, but could have a significant personal planning impact for US persons, which we must consider on a client to client basis.
Third, I would re-state the >90% probability I believe the US will see above-trend inflation over the next 10 years, which would likely be reflected in a decline of the US dollar against currencies with lower rates of inflation, especially the Japanese Yen, the Singapore dollar, possibly the Australian and Canadian dollars, and towards the end of the decade perhaps even against the Chinese Yuan / Renminbi. This is effectively a form of tax on anyone who holds US dollar cash or bonds, domestic or foreign, and is the #1 reason I have been significantly reducing (or for many accounts, eliminating) exposure to USD cash and bonds since bond yields fell below stock dividend yields early last year. Even though this is a more significant factor for long-term investors than the first two, I mention it third because this probability is less changed by recent US election results than the first two. While commentators have pointed to this loss of faith in the US dollar to explain the recent surge in the prices of both gold and Bitcoin, I continue to see both as poor hedges against inflation, with the latter being far poorer than the former. Action-wise, it is better to own quality assets with “pricing power” and the ability to raise dividends over time. Best of all, we aim to buy shares in businesses that can borrow money at less than 2% fixed interest and invest that borrowed money in assets earning 4-6% (not fixed) or more.
Fourth, there is little doubt that America’s new president and Senate will significant shift the direction of US-China relations for at least the next 4 years. While I have repeated that I don’t believe Joe Biden want to be remembered for making concessions to China within his first 100 days, I except Biden’s approach to China to revert to something like Obama’s within this year. There are dozens of areas of impact we could list, but perhaps the easiest to quantify would be those having to do with climate policy, where we would expect policy costs to be placed on US businesses and consumers but not Chinese ones. Back of envelope again, I expect this could raise the expected rate of return on profitable Chinese stocks from about 7% to about 8% per year over the next 10 years.
Fifth, there is a somewhat focused political risk on what we all know as the top five stocks in the world, the famed “FAMGA” stocks of Facebook, Amazon, Microsoft, Google, and Apple. These five stocks alone make up 39% of the Nasdaq 100, 18% of the US total market, and 10% of the total world stock market, and got that way for being exceptionally skilful and monopolistic on how they collect data on billions of people around the world. Many of us remember the anti-trust case against Microsoft in the late 1990s, and how the following 10 years were terrible for MSFT investors while the past 10 years have been wonderful. Before that, we can of course look to historic examples of the break up of “Ma Bell” (AT&T) and Standard Oil (into Exxon, Mobil, Chevron, and BP), and study how those pieces performed after those historic giants were broken up. Today, the political crosshairs seem most solidly aimed at Google, followed by Facebook, and I would raise the probability to about 35% that US government action makes a significant dent in one of these two companies. My older models underestimated how well these five companies were able to deliver for investors over the past 5-10 years, and if you’ve followed my writing, you know how focused I’ve been on trying to find opportunities like Microsoft was in 2010, and while I try and be humble about my predictions for these companies, I’m fairly confident that none of these five companies will be able to deliver double digit returns for another 10 years, especially with these political risks on top.
Sixth, and longer term, we must now also start watching some second order risks of how the current ruling party might try and further entrench their power by changing the rules so that they are more likely to maintain control past 2022 and 2024. This quickly becomes far more speculative, but ultimately leans on updating our understanding of left vs right, and our models of how long their policies are likely to have impact. One of the first things to watch for is mail-in voting being made permanent, and in a more extreme scenario, replacing in-person voting entirely. This could result in a national extension of the “ballot harvesting” practices in California, and it is clear to see the impact this has had on the balance between the parties there since the days Arnold Schwarzenegger was governor. Second, Reuters reports that one of Biden’s top priorities is likely to include full citizenship for roughly 11,000,000 illegal aliens, and compared with other immigration policies, this one is clearly political and cultural rather than economic, especially when combined with ballot harvesting. Third, Biden and Harris have indicated that they might try and pack the Supreme Court with additional judges more likely to rubber stamp measures the current 9 judges might rule unconstitutional. This was last tried by FDR in 1936 to stop constitutional challenges to his more extreme “New Deal” policies, but even his own party stopped this violation of checks and balances, so we’ll need to wait and see which way the 2021 Senate goes on this. It is worth noting that this happened after FDR confiscated Americans’ gold in 1933, making it illegal to own the precious metal in the “land of the free”. Even at this point, I would only raise the chances of this kind of confiscation within in the next 2-4 years to no more than 10%. Fourth, there are still active proposals to grant statehood (meaning two senators each) to Washington DC and Puerto Rico, but not to Guam or the Northern Mariana Islands (the latter two being military outposts, which tend to vote the other way). It is worth remembering the very clear historic reasons that the US capital district is above the states rather than among the states, with just one key example: the Missouri Compromise, which helped maintain a balance in the Senate from 1820 to 1854, a balance which held off the American Civil War for decades and gave the North time to industrialise. Without that balance in the Senate, it is likely the war might have happened earlier or have had a very different outcome. That is about as speculative as I want to get here, but should give some idea of the “tail risk” scenarios I try and prepare for.
Put another way, outside observers of US politics might see the two parties’ vision for the country as the Democrats wanting to make the US more like Europe (with high taxes, big government services, low growth, low mobility, and open borders), while the Republican Party has focused more on keeping up with China (with a focus on business competitiveness, debt-fuelled growth, a strong military, and a “home country first” policy), and so if we care to stretch our first five projections out past 2-4 years, it is fair to expect future US growth over the next decade to be closer to Europe’s than to China’s. In terms of second order effects, the balance of power between the branches of the US government is exactly what has kept the US system so stable and robust for 233 years and counting, and for the first time in decades, I feel that political risk in the US may now even be above that of the UK, which I’ve half-joked seems on its way to being an emerging market.
So in summary, while I’ve so far failed to keep US political news from distracting me, I’ve tried my best to summarise what US political risk is likely to mean for the expectations of global investors into the US and to US taxpayers globally. For years, I’ve been early in saying that US stocks seem overvalued relative to faster growing emerging markets (especially China), but since the 2017 tax cuts and 2020 Fed stimulus, US markets have continued roaring. Getting back to business, my focus remains on maintaining my “A-list” and “B-list” of high quality, income producing assets that are still trading at reasonable prices, and which are likely to see little risk to that income falling regardless of the uncertainty that is always out there. This first week of 2021 I’ve mostly had my nose buried in my spreadsheets updated these lists of assets and the rates of return I expect from them, and plan to start sharing those updates later this month.