With the 2020 election approaching, Wall Street strategists are starting to factor in the consequences of a possible Democratic sweep, which could create major headwinds for stock-market investors who have been enjoying a record run under President Trump – even after the outbreak of the COVID-19 pandemic.
Democratic control of the presidency and both chambers of Congress, also referred to as a "blue wave," may mean tax hikes and other legislation that hinders economic growth and weighs on the stock market.
“The implications for the stock market from this shift to higher taxes are generally negative,” wrote David Rosenberg, chief economist and strategist at Toronto-based Rosenberg Research.
Potential legislation would include raising the capital gains tax for the highest earners and increasing the corporate tax rate in an effort to pay for at least some of the $6 trillion of proposed spending over the next 10 years.
A bigger tax burden would reduce the number of resources allocated to the economy and hamper after-tax earnings for U.S. corporations.
Rosenberg pointed to a Congressional Budget Office report that said the economic benefits of President Trump’s Tax Cuts and Jobs Act have not yet been fully felt, and that they would likely never be fully realized in the event of a “tax revision.” Such measures would subtract about 1.51 percent from U.S. gross domestic product over the long run, the Tax Foundation said.
Taxes paid relative to before-tax corporate earnings were about 10.5 percent last year, and that number could reasonably rise to 14.6 percent, according to Rosenberg, implying a “one-time drag” of 4.1 percent on after-tax earnings.
The unwinding of deregulation initiatives would serve as an additional drag on earnings – especially in the energy sector, which is already reeling from the sharp drop in demand caused by the COVID-19 lockdowns. West Texas Intermediate crude has lost over 33 percent of its value this year.
The S&P 500 is overvalued by 4.3 percent before taking into account the impact that stiffer regulations could have on market sentiment, according to Rosenberg, which would erase another 1.4 points off the S&P 500’s price-to-earnings ratio.
“A drop in the S&P 500 of 10.5% from where it is today is well within reason,” Rosenberg said when factoring in the impact of a blue wave on after-tax corporate earnings and the market’s price-to-earnings ratio.
Others on Wall Street, including Morgan Stanley and Goldman Sachs, also think a Democratic sweep and the impending tax hikes would be a problem for the stock market.
Raising the corporate income tax to 35 percent from 21 percent would make “100-150 points on the S&P 500 a baseline for the impact of a tax cut rollback, all else equal,” wrote Michael Wilson, chief U.S. equity strategist at Morgan Stanley, in a note sent to clients last month.
He said a mid-single dollar impact on S&P 500 earnings was a good working assumption, and that the hit could be even bigger due to drags on investor confidence and business investment.
Meanwhile, David Kostin, chief U.S. equity strategist at Goldman Sachs, called tax policy a "larger risk to earnings and consequently to equity prices” than the COVID-19 pandemic, which led to the sharpest economic contraction on record.
But, not everyone on Wall Street sees a blue wave as a stock-market headwind. The U.S. equity strategy team at JPMorgan sees such an outcome as a “neutral to slight positive.”
They note challengers in Biden’s position “typically campaign at an extreme,” but veer back toward the center following the election.
The COVID-19 pandemic could lessen the size of Biden’s corporate tax hike while other proposals like infrastructure spending, reducing tariffs and hiking the minimum wage would be a net positive, they said.
The Biden campaign did not respond to FOX Business' request for comment.