The theme of our last quarterly commentary written in July was centered around uncertainty. That theme remains with us today as we deal with the unpredictability of the COVID virus and upcoming election. Before we turn our attention to these matters, a brief review of the 3rd quarter is in order.
Most major stock market indices showed positive returns for the quarter ending September 30th. Large cap growth stocks continued to provide the best returns, however at the risk of stretched valuations. Small cap returns trailed large cap, and growth stocks outpaced value stock returns. Foreign stock index returns, while positive, trailed US stocks.
Interest rates remained stubbornly low, muting bond investment returns, although US Treasury Inflation Protected Bonds (TIPS) and shrinking credit spreads for investment grade bonds provided some welcomed support for the quarter’s fixed income portion of client portfolios.
Further commentary is offered below about reduced expectations for future investment returns as the result of today’s low interest rate environment and for what appears to be stretched stock market valuations.
Job recovery from the pandemic continued throughout the quarter, albeit at a slowing pace, as the economic support provided by the CARES Act ran out. Approximately 22 million jobs were lost in March and April as economic activity was dramatically reduced with the onset of the Coronavirus. About half of those jobs have been recovered during the past 5 months, but what is disturbing, besides the other half of jobs that have not yet returned, is that only 661,000 jobs were added last month, which highlights the slowing pace of the recovery.
Medically, the battle against COVID-19 continues, but some progress was made last quarter. Nationwide cases, deaths, and positivity rates were lower at the end of the quarter than at the beginning, but trends thus far in October are very concerning, particularly in the colder weather states where activities and gatherings move inside to more contagious conditions. Trade-offs between individual freedom, economic impact and, public health remain controversial and unresolved as government officials offer opposing paths forward in dealing with this crisis. There is currently a stalemate in Congress around the amount of stimulus, as well as who should be the recipients of this package. Unfortunately, Washington seems to be putting politics ahead of the needs of the American people.
Despite the disagreement on how our society should deal with the crisis, I think most people would agree that our nation’s economic performance is going to be negatively impacted until we get this virus under control. The medical community continues to make progress in this regard in the development of therapeutics and vaccines. However, none have reached the breakthrough category that we all yearn for. Nonetheless, I do not believe scientists doubt we will achieve the needed breakthroughs, as it appears to be a matter of when, rather than if.
One would not think that the continuing deaths of more than 1,000 US citizens a day from this virus could be pushed off the headlines, but our upcoming election has managed to do so. Most polling results thus far are showing Joe Biden with leads over Donald Trump. (One should remember that these same polls showed Hillary Clinton with leads over Trump in 2016, albeit with smaller margins and more undecided voters than the 2020 polls).
Biden’s success in the polls has created angst among some people for potential impact on stock market performance if he is elected. Candidate Biden has unveiled a tax plan that reverses many of the tax benefits that Trump’s 2018 tax plan provided to high income filers, generally affecting those with taxable incomes in excess of $400,000. The more impactful proposal in Biden’s plan is to increase the US corporate top income tax rate from 21% to 28%. While this would reduce corporate earnings, one should remember that the top corporate tax rate was at 35% from 1993 through 2017, so even if Biden’s proposal is passed, the rate would be less than what has been in effect for most of the past 27 years.
The question of “if” regarding Biden’s tax proposals is not insignificant. First of all, he would need to win the election, which is certainly not assured given our country’s 2016 experience. Secondly, tax legislation has to pass both the US House and Senate. While the Democrat’s majority in the House is likely to continue, their chances of flipping the current Republican control of the Senate is much more up in the air. Even if the Democrats do win the Senate, this would require that several of their moderate senatorial candidates prevail in purple states that have voted for Republican senators in the past. It is unlikely that these moderate Democratic senators will embrace radical legislative policies that their constituents would reject. Thus, even if Democrats sweep the White House and both congressional houses, it would not be surprising to see some of Biden’s tax proposals get watered down a bit before they become law.
This is not to suggest that a stock market decline might not occur if there is a “blue wave” on November 3rd, but rather that any decline is not likely to be permanently significant. History has shown that the US stock market has done well during both Democratic and Republican administrations. Other market forces beyond our elected leaders’ political party affiliations have a much more important impact on future stock market performance.
If one has confidence about the possibility of a temporary stock market decline due to potential Democratic victories, or social unrest that could occur regardless of which party wins the election, should one give in to the temptation to sell some stock holdings now and then reinvest later? I would strongly argue against such a strategy.
Our firm has frequently written about the dangers of attempting to time the stock market. Even if an investor is successful in timing the exit from the market, which is far from assured, they will even less rarely make the correct decision on when to buy back into the market. All of our client portfolios under our management are positioned for long term success and are not dependent upon the very unlikely case of correctly timing stock market performance. Being out of the stock market carries increased risk when future medical breakthroughs on vaccine development have the potential to be catalysts for sudden large gains in stock prices.
The convergence of influences of the pandemic, stretched stock market valuations and unprecedented low levels of interest rates is bringing into question what types of future investment returns should be expected over the intermediate to longer term. We believe that returns over the next decade or longer will likely be less than what has been experienced over the past decade. For the financial planning projections that we run for our Wealth Management clients, we typically review long-term investment return and volatility assumptions at the beginning of each calendar year. As we begin our analysis process for 2021, we anticipate that our base case return assumptions will likely be lower than what we have used in the past.
While we think intermediate investment terms could be impacted, we also believe that inflation will remain lower than the historical average. This decreased inflation expectation will help offset some of the revisions to our return expectations.
As many of our Wealth Management clients likely remember, we also run scenarios in their financial plans that utilize lower than base case return and inflation assumptions that show how much sensitivity their financial plan has when these variables are adjusted. For our more financially secure clients, the lower return assumptions will likely not have any impact on their day to day living. For others with less accumulated wealth, the impact may be more noticeable. Our financial planners will work closely with our clients to identify actions that should be taken to preserve their financial security.
We are also currently conducting detailed analysis on our investment models’ strategic asset class allocations for possible adjustment. The low interest rate environment is making the investment return case for bond investments more challenging, but does not diminish the important attributes of safety and portfolio protection during periods of stock market downturns that is provided by the fixed income and cash portions of an investment portfolio.
The bottom line is that we believe that it is very conceivable that for an investor to achieve future investment returns that are closer to what they have historically achieved, that they might have to increase their allocation to stocks and be willing to tolerate higher amounts of volatility. This will be an important point of discussion with our clients as we update financial plans in the upcoming months. We will look forward to working through these challenges with you in all of the years ahead.
While much remains unpredictable at this time in terms of the Coronavirus, future investment returns, upcoming elections and impact on tax policy, we remain confident that the foundations of our investment and wealth management remain well suited to assist our clients through these times of uncertainty. We remain committed to a disciplined evidence-based approach to diversified investment portfolio management. We also remain steadfast in optimizing our clients’ portfolios and financial plans with proactive income tax planning, not only for the current year, but over the full spectrum of their planning horizons. And most importantly, we remain mutually committed to your financial security and the accomplishment of your life goals. Please contact us with any matters in which we may be of assistance. We continue to be honored by the trust you place in our firm.
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