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WashingtonWise Investor: Episode 5

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Analyzing Democratic candidates tax policy proposals and the impact they could have on the markets.

In this episode of WashingtonWise Investor, Mike Townsend digs into the factors fueling the unpredictability of the 2020 election, with special focus on the policy proposals of the leading Democratic presidential contenders and what they may mean for investors.

Mike also shares his cautious optimism over the “phase one” U.S.-China trade deal, looks at Congressional concerns over the record pace of corporate stock buybacks, and considers the Supreme Court’s decision to hear a case on the constitutionality of the Consumer Financial Protection Bureau. Finally, he responds to a question about historical market performance during election years.

WashingtonWise Investor is an original podcast from Charles Schwab.

If you enjoy the show, please leave a rating or review on Apple Podcasts.

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MIKE TOWNSEND: The 2020 election is one year away, but the unpredictability of this election, and the potential implications of its outcome, are already making investors anxious and uncertain about their long-term strategies.

And they have every right to be—there are multiple storylines fueling the unpredictability.

The ongoing impeachment inquiry against the president of the United States raises the possibility that, for the first time in the nation’s history, an impeached president will be running for re-election.

Then there are 17 candidates still vying for the Democratic nomination, all working to distinguish themselves and their ideas.

Plus, there are 35 Senate seats up for grabs next year—and the battle for control of the Senate may well be the most important aspect of the election from a policy standpoint.

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and today we’re going to take a closer look at Election 2020, one year out. We’ll discuss the key dates to watch for, the most important races to keep an eye on, the trends to pay attention to, and most importantly, what will really matter to the markets and investors.

But first, let’s begin with a look at the top of the news and a few quick comments on what’s important for investors to know right now.

It seems like I start every episode with a discussion of China, and that’s what I’m going to do once again, because I really believe the U.S.-China trade relationship is one of the most important issues the markets are watching.

I’m cautiously optimistic on the progress reportedly being made in turning the so-called “phase one” handshake deal reached last month into a written agreement. Positive comments have come from the chief U.S. negotiators, Treasury Secretary Steven Mnuchin and U.S. Trade Representative Robert Lighthizer, about a series of phone calls over the last two weeks with their Chinese counterparts, in which several issues have reportedly been resolved. Last week, President Trump said the talks are “ahead of schedule.”

But maybe even more significant are the positive comments coming from the Chinese side. Even after Vice President Mike Pence delivered a “tough on China” speech on October 24, which the Chinese harshly criticized, Chinese officials were able to separate their criticism of that speech from their upbeat comments about progress in the trade talks.

For the moment, at least, China and the U.S. appear to be on their way to signing some kind of written agreement. But a new wrinkle arose last week. President Trump and Chinese President Xi Jinping were scheduled to be in Santiago, Chile, for a summit of Asian heads of state on November 16 and 17—and that was the logical place for the two leaders to sign a deal. However, Chile, which has been rocked by widespread social unrest in recent weeks, cancelled the summit. Now it’s unclear when, where, and how a U.S.-China agreement will be signed.

Despite this new development, the market has reacted positively to the news of progress. But the cautious part of my cautious optimism is that this “phase one” deal still leaves aside the more complex issues in the U.S.-China relationship—issues like China’s technology transfer policies and its state subsidies for Chinese businesses—and those issues aren’t likely to get resolved anytime soon. A “phase two” agreement, in other words, is likely to be much tougher. So we as investors will have to live with some ambivalence: feeling positive about the progress being made in easing U.S.-China trade tensions while still having concerns that a true end to the trade war may be a long way off.

One other news item to mention is a recent subcommittee hearing on Capitol Hill that focused on stock buybacks. Now buybacks are in the news this year because companies have been purchasing their own stock at a record pace, and a number of voices are questioning whether this is a good thing. That question has now reached the halls of Congress and the presidential campaign trail, where several Democratic candidates are pushing solutions that would curtail stock buybacks.

Legislative proposals range from an outright ban on stock buybacks to requiring a “worker dividend” that would give each employee a dollar for every million dollars spent on buybacks.

And this is not a purely partisan issue. Senator Marco Rubio, a Republican from Florida, is one of a number of Republicans who have raised questions about buybacks, and Rubio has proposed a bill to reduce the tax-preferential treatment of buybacks.

I note this not because I think any of these bills are likely to pass—they’re probably not—but because it feeds into a growing discussion that will be part of the 2020 presidential campaign. And that’s the question of whether companies should always act in the best interests of shareholders, or whether their purpose should be more balanced, encompassing shareholders, employees, vendors, suppliers, and even the environment.

There’s no easy answer for these questions, and they are not likely to be resolved any time soon, but I will be keeping an eye on these discussions in the context of the presidential campaign and beyond.

That brings us to our Why It Matters segment, where I take a look at a story you may have missed and tell you why it matters to investors.

Late last month, the Supreme Court agreed to hear a case that challenges the constitutionality of the Consumer Financial Protection Bureau. That’s the agency that was set up after the 2008 financial crisis to oversee retail financial services and products.

The CFPB is where consumers can go to register complaints about unfair practices by financial institutions, and it is also responsible for producing rules and regulations for products like mortgages, auto loans, and student loans.

When the agency was created, it was set up differently than other financial regulators. Both the Securities and Exchange Commission and the Commodity Futures Trading Commission are led by five-member commissions, with three commissioners nominated by the party that controls the White House and two commissioners nominated by the party that does not.

But the Consumer Financial Protection Bureau is run by a single executive director, who wields enormous authority over the agency and who can only be removed by the president “for inefficiency, neglect of duty, or malfeasance in office.”

There is a long-running dispute in Washington that the structure violates the separation of powers clause of the Constitution—and now that question will be decided. The Court will hear the case early next year, and a decision is expected by sometime in mid-2020.

Interestingly, in deciding to take the case, the Court specifically asked the parties to prepare arguments about whether the bureau can continue to exist if its structure is found to be unconstitutional. That would seem to signal that there is real chance the Court has concerns about the single executive director structure.

So there’s a lot riding on this case. Consumers are waiting to see if the regulator that is focused specifically on retail financial services customers is going to continue to exist. And financial institutions are waiting to see whether their newest regulator will still be able to set rules and take enforcement actions.

There’s one other interesting aspect of this case—and that’s the fact that a leading contender for the Democratic presidential nomination, Senator Elizabeth Warren of Massachusetts, is widely credited with being one of the main forces behind the creation of the agency, something that she has made a centerpiece of her presidential campaign.

So candidate Warren is waiting to see if this key part of her campaign narrative will be intact next year—something that could be really important if she becomes the Democratic nominee.

As I said at the top of the episode, I’m going to focus my Deeper Dive on the 2020 election one year out from Election Day. I’m not going to prognosticate who I think will win the Democratic nomination or the White House in 2020—you can find plenty of people doing that on your favorite cable network.

But I do want to share some thoughts on what I think investors should be keeping in mind as we head into the election year.

Let’s first set some context for what’s coming up.

You hear a lot about the first four primaries and caucuses—because, historically, these early voting states hold enormous influence on the presidential race. Candidates who don’t do well in these early opportunities usually see their fundraising and media attention quickly dry up. They are forced to reassess their campaigns and often decide to end their run.

In 2020, the first four races are all in February, beginning February 3 with the caucuses in Iowa, followed quickly by the New Hampshire primary, the Nevada caucuses, and the South Carolina primary.

Then, on March 3 it’s “Super Tuesday,” with 14 states voting on the same day, including the two largest prizes, California and Texas. By the end of that day, just 30 days after the first votes are cast in Iowa, more than 40% of the delegates to the Democratic National Convention will have been awarded, and we should have a good idea who the true contenders are.

Right now, the race for the Democratic nomination sure looks to be a three-way fight among former Vice President Joe Biden, Senator Bernie Sanders of Vermont, and Senator Elizabeth Warren of Massachusetts.

While there are more than a dozen other candidates still running, I’ve been surprised at how little ground any of them have managed to make up over the course of 2019. Mayor Pete Buttigieg of South Bend, Indiana, and Senator Kamala Harris of California, who have been fourth and fifth in the polls over the last couple of months, have both had moments during the campaign when it seemed like they might mount a challenge to the top three, but it’s never really materialized.

For the other candidates languishing far behind, failing to qualify for the debate stage and barely registering in the polls, there’s a legitimate question about why they are still running.

The answer is almost always that they have a secondary goal in mind. Maybe they are auditioning for a Cabinet position, or even a spot on the ticket with the eventual nominee. Maybe they are building name recognition and a network of support for a future run. More often, they just want to make sure that the issues they care about stay on the front burner and ultimately get included in the party’s platform.

That said, many of the Democrats I’ve talked to in Washington are growing increasingly eager for the field to shrink down to a handful of true contenders. Among other things, that would mean fewer candidates in the upcoming debates, which usually leads to a more robust discussion of the issues.

And the issues are important. Presidential campaigns are filled with policy proposals. Go to any candidate’s website and you can see a raft of proposals on all sorts of topics. Some get lots of attention—think “Medicare for All” or the “Green New Deal.” What all of the big ideas in this campaign have in common is that they will cost money. Lots of money. 

To pay for their proposals, most of the Democratic candidates have plans to increase taxes. It’s how they go about it that differs.

My sense is that investors are paying a lot of attention to these tax proposals. They are certainly asking me a lot of questions at my in-person events.

So let’s look at four different categories of tax proposals that have the most potential impact on investors.

The first category is simply increasing the existing tax rates on income, capital gains, dividends, and/or estates. Virtually every Democratic candidate has proposed rolling back the 2017 Tax Cuts and Jobs Act, which reduced both corporate and individual tax rates. Senator Bernie Sanders would go even further, setting a marginal tax rate of 40% for income over $250,000 and further raising the rate as income rises, peaking at 52% on income above $10 million.

Several candidates have also endorsed raising the capital gains tax rate to match ordinary income tax rates. That’s the one that investors should pay the most attention to. Under current law, taxpayers pay either 0%, 15%, or 20% taxes on long-term capital gains, depending on income. Treating long-term capital gains as ordinary income would be a significant tax increase for almost all investors.

And several candidates have talked about raising the estate tax rate and lowering the threshold value of an estate subject to taxation.

These proposals would be the simplest to administer, because they only involve adjusting the rate of existing taxes.

The second category is financial transaction taxes. At least three candidates—Senators Sanders and Harris, as well as businessman Andrew Yang—have proposed collecting a small tax on trades of stocks, bonds, and derivatives. Now, this is an idea that has been floating around Congress for many years, and some countries, notably France and Italy, already have transaction taxes in place.

Sanders is calling for a tax of 0.5% on stocks and 0.1% on bonds. Harris has proposed a lower tax rate of 0.2% on stocks, and Yang’s is lower still at 0.1%.

Historically, there has been little enthusiasm for a financial transaction tax here in the United States. Critics say that it unfairly taxes even small transactions by investors without huge portfolios, that it hurts retirement savers, and that it would discourage trading, even when it might otherwise be wise for a regular investor to trade.

Proponents point to the significant amount of revenue it would raise to pay for other priorities. They say it would discourage speculative trading by high-frequency traders and argue that the tax is so small that it would hardly be noticed by most investors.

But even those small-sounding amounts add up quickly. On a $1,000 investment, that’s $10 to as many as $50 in taxes, cutting into your return and impacting your savings.

The third category is what is known as “mark-to-market” taxes on wealthier taxpayers, which includes a tax on unrealized gains. Senator Ron Wyden, a Democrat from Oregon, unveiled a proposal earlier this year that would levy a tax on unrealized gains, as if the assets had been sold during the year. It’s a complicated proposal that is aimed at millionaires and billionaires, and a lot of details still need to be worked out. But the taxing of unrealized gains, even if it affected a relatively small percentage of the population, would be a fundamental change in how investments have been treated for decades.   

Finally, there are the wealth tax proposals, essentially a surcharge on wealth. The two most prominent advocates are Senator Warren and Senator Sanders, both of whom have announced plans for an increase in taxes on the ultra-wealthy.

Wealth taxes can be tricky, especially when it comes to valuing certain kinds of assets, like a privately held business or art. And there are legitimate questions about whether such a tax would survive a legal challenge on its constitutionality. But the idea has proven popular with progressive voters as simple to understand and addressing income inequality.

My guidance for investors is to not get overly caught up in any of these proposals. It is three months before the first votes in the primaries and caucuses will even be cast. There is not unanimity among Democrats on any of these proposals. All will be heavily debated, and if they do make it into the Democratic platform, they’re likely to look far different than they do today. All are very much dependent, of course, on the election outcome. And none will be in play until 2021 at the earliest.

For all these reasons, investors should not overreact. There will be plenty of time to study the details and form a strategy that is right for you, if and when these proposals move from the idea stage to actually becoming legislative proposals that are being considered in Congress.

In the year ahead, the media will focus relentlessly on the presidential race, but here on WashingtonWise Investor we’ll be keeping an eye on what’s happening in the Senate races. Whether or not policies that have the potential to really swing the market can get passed could ultimately come down to which party has the Senate majority in 2021.

And that’s not just the case with tax policy proposals—it extends to so many issues that will be debated over the next year and have real implications for the markets: whether it is health care or energy policy or just about any other major issue. We live in a time when the nation’s capital is so divided that it has become almost impossible to imagine the two parties coming together to pass major legislation.

And that’s why, in some ways, the most important part of the election from an investor’s perspective is the battle for control of the Senate. It’s the Senate that is most likely to determine whether these tax proposals, or any other major legislation, will be able to pass. So let’s walk through the facts:

The current count is 53-47 in favor of the Republicans. Democrats need to net three seats if a Democrat wins the White House, because the vice president breaks a 50-50 tie.

There are 35 Senate seats up for election next year—23 are currently held by Republicans, and 12 are held by Democrats. So that seems like a big advantage for Democrats.

But, 18 of the 23 Republican seats are in states that President Trump won in 2016 by 10 or more points. That doesn’t mean it’s a certainty that these Republican incumbents will win, but it does mean that those are pretty red states that are favorable for Republicans.

That leaves five Republican-held seats that are considered very competitive—Arizona, Colorado, Maine, North Carolina, and perhaps one of the seats in Georgia, where both Senate seats are up next year, one for a full six-year term and one to complete the term of Senator Johnny Isakson, who announced that he will resign from the Senate at the end of this year due to health reasons.

On the Democratic side, there is one seat that will be particularly tricky—that’s in Alabama, where Senator Doug Jones won an unusual special election back in 2017 but will have a real challenge winning election to his own full term in a very red state.

And every election year, there’s always a race or two that turns out to be more competitive than expected. For 2020, Republicans think they have a shot to pick up a seat in Michigan, while Democrats think they have a chance to win a Republican-held seat in Iowa.

The bottom line is it looks like the race for the majority in the Senate will come down to just a handful of states, and everyone expects the outcome to be very close.

In future episodes we’ll revisit these hotly contested Senate races to see how policies are shaping up and what’s happening with the campaigns.

It’s time for the Question of the Week segment, and this week, I’ve got one that follows nicely on our discussion of the election.

While speaking recently in Oregon, I was asked whether history tells us anything about what to expect from the markets in an election year.

Historically, presidential election years have been good for the markets. If you go all the way back to 1928, the average return for the S&P 500® in an election year has been 7.1%. In fact, the S&P 500 has been down for the year in a presidential election year just four times over the last 23 elections.

Of course, you all know the saying: Past performance is no indicator of future results. And I don’t think anyone should be investing based on whether it’s an election year or not an election year. But it’s an interesting question nonetheless.

I’ll be back with another episode of WashingtonWise Investor on November 19. I’m excited that Kathy Jones, Schwab’s chief fixed income strategist, will be joining me. Kathy’s fantastic at explaining how issues like trade and federal spending affect the bond market, and she’s an expert at breaking down what is happening with the Federal Reserve and interest rates. So be sure to tune in for what I’m certain will be a great discussion.

Until then, thanks so much for listening. Please consider leaving us a review or a rating on Apple Podcasts or your favorite listening app—it takes just a few moments to leave a quick review, and those really do make a difference in getting our show out to a wider audience. Also, make sure you subscribe so that you don’t miss an episode. For important disclosures, see the show notes or schwab.com/washingtonwise, where you’ll also find transcripts of every episode.

I’m Mike Townsend, and this has been WashingtonWise Investor. See you next time—and keep investing wisely.

Important Disclosures

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

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