- The Senate’s arcane rules typically require 60 votes (out of 100) to pass major legislation. However, raising taxes to offset increased spending can be done with 50 votes plus the VP’s tie-breaker vote. In 2010, Democrats passed health care reform without Republican support, while in 2017, Republicans passed tax cuts without Democratic support.
- With that said, every piece of legislation is likely to come down to what the 50th Senator is willing to stomach, meaning moderates and progressives could be forced to find common ground. Citi analysts believe this Democratic Senate could prefer to raise the corporate tax rate from 21% to around 25% or increase taxes on wealthier individuals rather than impose industry specific taxes like a financial transaction tax or provisions that allow real estate investors to avoid capital gains taxes, as moderate politicians have ties to the business community. Also, some may want to make sure the economy is on better footing before doing anything that could potentially slow it down on their watch, so there may not be an appetite to undo all of the $2 trillion over a decade in revenue reduction derived from the 2017 tax cuts.
The Recovery from COVID-19: Still No.1 Factor
- While a narrow Democratic majority in Congress was not the market’s base case coming into 2021, Citi analysts continue to expect the recovery from COVID-19 to be the dominant driver of returns in the first half of 2021. Time horizon may matter significantly when making tactical allocations. For example, as demand for travel and leisure improves in the coming months, oil prices and therefore energy stocks could continue to rise over the short-run. Similarly, the improvement in macro and credit fundamentals, driven by both stimulus and effective vaccines, could boost bank stocks even if more regulation and higher taxes loom in 2022.
Sector Implications: More Spending versus Higher Taxes
- Equity investors are likely to now grapple with what on the surface seem like cross-cutting factors: the potential for more stimulus coupled with higher corporate and individual taxes. The initial market reaction on Wednesday appeared to focus on the former, with higher odds of further fiscal support boosting interest rates and therefore cyclical value equities. Given the fact that tax cuts in 2017 drove a wave of increased buyback activity, Citi analysts expect Democrats may seek to at least partially reverse corporate statutory rates to fund any spending package in a process called budget reconciliation. These bills tend to be unwieldy and complex, so it is premature to say which sectors could be targeted or spared.
- With that said, the clearest beneficiaries from the Tax Cuts and Jobs Act were Utilities, along with higher-growth sectors like Health Care and Information Technology. A modest increase in corporate rates could reduce profitability among the most prolific share repurchasers in these sectors, likely preventing a speedy return to 2018 and 2019 buyback levels. In addition, to the extent that large cap equities are more profitable and therefore pay more in taxes, Citi analysts believe united Democratic control could have relatively less of an impact on smaller, high-growth companies, especially if scrutiny on mega-cap tech names increases.
- Financials also benefitted from a reduction in both tax rates and regulation during the Trump administration, both of which could be partially reversed in the coming years. However, a significant steepening of the yield curve and reduction in loan loss provisions could support the recovery in banks which remain depressed versus pre COVID-19 levels. Meanwhile, other cyclical sectors like materials and industrials only experienced marginal benefit from the 2017 tax cuts and may feel less of a profit shock if corporate taxes rise. More importantly, improving fundamentals with potentially more stimulus on the way could continue to boost industrials, and particularly the capital goods segment, which has lagged the improvement in new manufacturing orders. Another clear beneficiary of unified Democratic government is the project of “cleaning” the US energy system. Citi analysts expect the Biden team to focus intensely on renewable energy transition and electrification of the transportation system, while regulation of traditional energy companies is likely to intensify.
Fixed Income Implications: Treasury Yields to Drift Higher; Curve to Steepen
- Long-dated US Treasury yields were already set to face some challenges in 2021 from a recovering economy and rising reflationary undercurrents. With the run-off elections in Georgia putting Democrats in a position to take full control of Congress, some other implications must now be considered such as fiscal stimulus and infrastructure spending. While Citi analysts’ previous expectations called for 10-year US Treasury yields to reach 1.5%, the outlook for fiscal stimulus increases the risk towards 2.0% by the end of 2021.
- Federal Reserve policy cannot be completely dismissed. Their current pace of Treasury and agency mortgage-backed security purchases are not expected to change in 2021. That said, a dovish shift cannot be ruled out if they felt compelled to keep long-end yields low. At the same time, if the macro environment improves meaningfully over the course of the year, it is equally possible that markets begin to discount a potential pull-back in asset purchases in 2022.
- Collectively, Citi’s existing high conviction for a steeper U.S. Treasury curve remains intact. Despite increasing risks to rising long-term yields, the Federal Reserve’s zero interest rate policy is still expected to keep the short-end of the U.S. Treasury yield curve well-anchored for the next few years.