As 2020 dawned, we anticipated spending most of our analytical time and energy this year understanding the implications of the election for investors and business owners. Our attention – along with everyone else’s – was quickly pulled in multiple directions, by an historic pandemic and equally historic economic reaction, by an incipient financial market crisis that has (so far) been forestalled by quick central bank action and by troubling reminders of how much further we have to go to fulfill our founders’ notion of genuine equality across all races. To echo the clichéd observation, we seem to have experienced a lifetime of news cycles in the space of just a few months.

To try to add some context to this cacophony of information, we gathered a (virtual) roundtable of Brown Brothers Harriman (BBH) subject matter experts from the fields of economics, investing, business strategy and wealth and tax planning to explore the implications of the current economic, market and political environment. I was joined in these conversations by Suzanne Brenner (Partner and Chief Investment Officer), Tom Martin (Head of Investment Research), Ben Persofsky (Executive Director of BBH’s Center for Family Business), Ross Bruch (Senior Wealth Planner) and Joe Fuschetto (Senior Tax Advisor). If you are a BBH client, all of these resources are available to you as well, and we encourage you to reach out to your relationship management team for details on how the issues raised in this article might inform your own financial decisions.

Scott Clemons: There is so much to discuss that it is hard to know where to start, but given the fact that it is an election year, and that the economy is of paramount importance to most voters, let’s start there. In his campaign for a second term in 1984, Ronald Reagan asked voters if they were better off than four years earlier, and Bill Clinton famously reminded himself daily through his campaigns for president that “It’s the economy, stupid.” Tom, you’ve done a lot of work on the intersection of economics and politics. Is the economy still the top issue for voters, as it has been in the past?

Tom Martin: Yes and no. In a recent Pew Research survey, 79% of registered voters characterized the economy as “very important” in influencing their vote for president, by far the top of the list of issues. This is completely in line with what we’ve seen in previous election years. Interestingly, though – and perhaps predictably – the order of importance differs between Democratic and Republican voters. Whereas 88% of Republican voters consider the economy a very important driver of their votes, Democratic voters rate healthcare, the COVID-19 crisis and racial inequality as more important issues. Conversely, these factors appear nearer to the bottom of the list of things that are important for Republican voters, mirroring the tenor and tension of current political discussion and debate.

SC: Surveys such as this perhaps imply that the historical causality has been reversed – that one’s political affiliation or preference for a candidate determines how important these issues are, rather than the other way around.

TM: There is, indeed, much difference between the two parties and what their constituents find important, but the economy is one area in which there is at least general agreement. And that’s not surprising, given the economic disruption that we’re going through.

SC: We’ll get back to the election, but let’s talk first about the economic backdrop, as it has historically influenced – or arguably, even determined – the outcome of an election. Whether it’s fair or not, voters often reward an incumbent candidate for a strong economy and hold him accountable for a bad one, and it is difficult for an incumbent president to win re-election when the economy is weak. How are we doing? Where do we stand in the recovery from the short and sharp recession of earlier this year?

TM: The challenge in answering that question is that economic data is, by definition, backward-looking and lagged, and much of the headline data is released only on a quarterly basis. This makes it difficult to get a precise picture of where we are, particularly when economic dynamics are shifting so rapidly. When we look at monthly data, or even higher-frequency daily data, the picture becomes a little clearer.

SC: As you and I often discuss, personal consumption is far and away the most important driver of economic activity, accounting for 68% of gross domestic product (GDP). How can we get a “real-time” picture of consumption trends?

TM: It’s not official economic data, but we have found that restaurant reservations, along with the volume of air and road travel, provide good insight into personal consumption trends on a daily basis. These are, admittedly, just a snapshot of a sliver of consumer activity, but people who dine out and travel are likely spending money in other ways as well, so it provides a useful secondary indicator of real-time economic activity. In brief, this data shows that a sharp rebound in the early summer has given way more recently to a slower pace of recovery.

SC: The restaurant reservation data points to some interesting regional variation. I can’t help but notice that my hometown, New York City, where reservations remain down 82% year over year, is the worst-performing major city, while Tampa, where outdoor dining can happen year-round, is the best. Overall, dining reservations in the United States are still down 38% from last year. The TSA travel data paints a similar picture. There has clearly been a welcome recovery from depressed levels of the spring, but the pace of improvement seems to have slowed. Air travel remains 63% lower than this time last year.

TM: The picture actually isn’t quite as bad as the restaurant and travel data would indicate. Consumer spending has declined, but perhaps more importantly, consumption patterns have shifted as well, dramatically in some cases. There may be less dining out and travel, but some of those unspent dollars have been redirected elsewhere.

SC: For example?

TM: Look at the range of data in the nearby graph of retail sales. For the first nine months of 2020, total retail sales are down a mere 0.9%, which is remarkable on its own, given the disruption we’ve been through. But some retail formats have thrived throughout this period. Clothing retailers (-30.7%) and restaurants and bars (-19.8%) have suffered the most, while non-store retailers (+19.8%), food and beverage stores (+11.7%) and building materials (+11.6%) are up sharply.

SC: It is still remarkable that 21.4% of personal income in August came from transfer payments, but a 10% reduction in this support from the spring is quite an economic headwind as we head into the fall, particularly when the labor market and more traditional sources of income haven’t fully recovered. How does all of this roll up into GDP?

TM: It will be important to pay attention to both the level and change in economic data, given all the noise in economic activity. The Atlanta Federal Reserve projects that the preliminary report on GDP, due to be released on October 29, will likely show GDP growth of something in the neighborhood of 35%. Since World War II, quarterly GDP growth has averaged 3.1%. For the statisticians out there, 35% GDP growth would represent an 8 standard deviation event, following a 7 standard deviation event in the second quarter, when GDP contracted at a record pace of 31.4%.

SC: These figures are literally off the charts. Put them into some sort of context for us.

TM: By practice, GDP is calculated and reported at an annual pace. In other words, these vast swings we’re talking about aren’t strictly period-to-period changes, but period-to-period changes that are then annualized. This doesn’t make a real difference in normal economic times, when the volatility of GDP from quarter to quarter is modest, but this year the annualization approach will serve to magnify swings in the pace of economic activity that are already historic.

SC: If the Atlanta Fed estimates are right, where does that leave the economic recovery?

TM: Thirty-five percent annualized growth in the third quarter would still leave absolute GDP about $620 billion lower than the peak of the fourth quarter of 2019. Make no mistake, this reflects a sharp rebound from the second quarter recession, but the recovery has further to go to return to the high-water mark established late last year.

SC: Economists love to assign letter shapes to economic cycles, from the greatly desired V-shaped recovery, to the dreaded L shape, and various shapes in between. The debate over the shape of the economic recovery rages on, but there is little question that the recovery in financial markets is clearly a V. Let’s bring BBH Chief Investment Officer Suzanne Brenner into the conversation and talk about why financial markets have rebounded so quickly, even while the coronavirus pandemic continues, and so many economic challenges remain.

Suzanne Brenner: This is the question that we hear from clients more often than any other. The large capitalization S&P 500 dropped 34% in a record 23 days in February and March, rebounded 44% over the next few months into early June and then crept higher over the summer to set a new all-time high on September 2. Never before has the equity market sold off and rebounded so quickly, particularly when headlines were still so worrisome. As of mid-October, the S&P 500 remains within 2% to 3% of that early September high.

SC: If you knew, on New Year’s Day 2020, exactly how the first nine months of the year would unfold, from the pandemic to the recession, from protests against racial inequality to the tense political environment, would anyone have predicted new highs for equities?

SB: No, of course not, and this is yet one more helpful reminder that trying to time markets is impossible. Returns are lumpy and unpredictable, and, as the past several months have demonstrated, missing just a handful of days (such as in April) can make all the difference, even in long-term returns. One of our managers put it as follows: “If you knew in advance that the unemployment rate in the United States would go from 3.5% in February to 11.1% in June (with a stop at 14.7% in April), what would be our prediction for the stock market? Down 30%? Down 40%? Down 50% or more? This example underscores why market forecasts play no role in the investment process. Our focus is on individual businesses: their quality, prospects and the valuations at which we would consider initiating or adding to positions.”

TM: This helps to explain the rally, at least in part. The equity market doesn’t perfectly reflect the economy because the equity market is not the economy. Equity investors, such as the manager that Suzanne just quoted, focus on the future prospects of companies, not the current economic or political headlines. This is not a new development. Recall from the last economic cycle that the equity market bottomed in March 2009, long before the recession ended and the labor market began to improve. Unemployment in that cycle didn’t peak until October 2009, by which point the S&P 500 had rallied 59%. The seeming disconnect between economic reality and market fundamentals is just a matter of future perspective. Investors are looking beyond the current economic challenges to the expectation of a recovery and return to something like normal in 2021.

SC: We’re starting to get some better insight as companies report third quarter earnings, and some companies – at least the braver ones – offer some guidance as to what 2021 might hold. Consensus expectations call for a year-over-year earnings decline of 16% for the third quarter for the S&P 500, followed by a slight decline in the fourth quarter, but then a rebound over the course of 2021. I’m not sure there’s a great deal of confidence in the 2021 forecasts, but for now, investors are expecting a sharp increase. The consensus estimates captured in the nearby graph of S&P 500 earnings growth imply that corporate earnings will establish new highs by the end of 2021.

TM: Note how short this earnings recession is expected to be, at least for now. During the global financial crisis, corporate earnings dropped for 10 consecutive quarters. Earnings declined for seven quarters from 2014 to 2016, even during a bull market. Compared to those declines, investors are readily looking through what appears to be a short four quarters of earnings contraction this time around.

SB: If one reason for the market rally this year is the expectation of improving fundamentals, a second has to be the monetary backdrop. When it became evident in early March that the COVID-19 pandemic would have broad economic and financial repercussions, the Federal Reserve responded with the monetary equivalent of shock and awe by slashing interest rates to zero and introducing a wide range of programs to support financial markets. We are by no means out of the woods yet, but the Fed deserves credit for preventing the economic crisis from cascading into a lasting financial crisis. As a matter of fact, some of the market support programs announced in March have yet to be implemented. The Fed is not out of powder.

SC: The Fed’s commitment was abundantly clear when Chairman Jay Powell pledged in a June 10 press conference to “do whatever we can – and for as long as it takes – to provide some relief and stability, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.” Unlike many of his predecessors, who preferred to speak in riddle, these sentiments are pretty clear.

SB: Fixed income markets are taking Chairman Powell at his word. The Fed lowered the fed funds target rate to effectively zero on March 15, and the futures market indicates that investors expect the fed funds rate to remain there all the way into summer 2025.

SC: What does this mean for financial markets?

SB: Corporate fundamentals remain the most important thing, but interest rates are a close second. Low interest rates don’t dictate the direction of the equity market, but investors need not fear the headwind of rising interest rates, at least for some time to come. The equity market is a discounting mechanism, and when the discount rate (or interest rate) falls, the present value of future cash flows goes up. Lower interest rates encourage investors to allocate capital to riskier areas, as the return on safe money falls to a handful of basis points at best.

SC: What does this imply for fixed income?

SB: It’s challenging. In a more normal market environment (and we can debate what that even means anymore), bonds provide three benefits to a balanced portfolio: They are a provider of income, a store of value and a source of liquidity. With interest rates at or close to zero, these three benefits are fractured. Traditional fixed income, such as municipals or Treasuries, continue to be a liquid store of value, but offer little or no income. Conversely, investors can find higher returns in fixed income by taking on credit or duration risk, but that requires them to give up some price stability and perhaps even liquidity. For most of our clients, a bond allocation plays the primary role of safety, which we complement, where it is suitable and appropriate for specific clients, with smaller allocations to managers who pursue returns through fundamental research into non-investment grade credits.

SC: Tom, you conclude that part of the disconnect between economic fundamentals and financial markets is simply due to the fact that the equity market is not the economy, but increasingly the equity market is also not the S&P 500 index.

TM: Yes, and I think this is a third reason that helps to explain the apparent rally in equities over the past half year. The widely followed S&P 500 is a capitalization-weighted index, and a mere five companies – Alphabet, Facebook, Microsoft, Apple and Amazon – account for almost a quarter of the index value. These companies have rallied sharply this year, thereby driving the index higher and higher. In other words, the index is not as representative of the average stock performance as it is when leadership is broader.

SC: The red bars in your graph indicate that this tyranny of large-cap tech seems to have slowed down, if not even reversed a bit since Labor Day.

TM: Thereby illustrating a real risk in markets at present. Narrowly led markets tend to be more fragile. If investor sentiment turns against a small handful of large companies, this can be reflected in the overall market averages, as we saw in September and early October.

SB: But there’s good news here, too, as not every company has participated in the strong rally that the broad indices indicate. For an active manager such as BBH, plenty of investment opportunities remain, and, for the most part, our managers have deployed cash since February in pursuit of these opportunities. It is important to remember that active management requires a balance between seeking returns and managing risk. One of our managers recently noted: “It is also important to highlight something we did not do during the recent market plunge: Namely, seek opportunities among the hardest-hit names and industry sectors without regard to quality. … We did not relax our quality standards and long-term compounding approach in order to rent beaten-up stocks with one eye on the exit.” This is precisely the response we look for from managers. Discipline is important in any market environment, but it is critically important in periods of heightened volatility.

SC: How are companies adjusting to this “new normal” operating environment of pandemic, lockdowns, fluctuating demand and disrupted supply chains?

SB: It differs from company to company and industry to industry, but a common theme is that the pandemic and associated economic distress are serving to accelerate many trends already underway. Companies have had to integrate technology more thoroughly throughout their business models and are discovering that there are silver linings to remote working for many employers and employees. Companies are rethinking the role, or even the necessity, of real estate – whether in the form of a corporate office or bricks-and-mortar retail. Costs that were previously thought to be fixed turn out to be more variable than managers would have thought a year ago. Companies are reconsidering the wisdom of far-flung supply chains and bringing suppliers closer to home, or even duplicating them in an effort to establish more robust and durable sources for critical inputs.

SC: How are company balance sheets changing?

SB: Similar to what we saw in the wake of the global financial crisis, companies are paying more attention to the strength of their balance sheets, preferring to pay down debt rather than raising dividends, and letting cash balances rise to protect against future uncertainty.

SC: I think we’ll learn a lot more about these trends in public markets as the earnings season unfolds, but let me now turn to Ben Persofsky, the Executive Director of BBH’s Center for Family Business, for insight into the private sector. Ben, you spend a lot of time with our clients who own and manage private businesses. How is the private sector dealing with this unique set of challenges?

Ben Persofsky: There are many similarities to the experiences of public companies. In the early days of the pandemic, most of the businesses we work with suffered a clifflike drop in demand, with the exception of those companies providing mission-critical services, such as retail food processing and distribution. The retail sales statistics that you and Tom discussed demonstrate a wide range between the winners and the losers, and we’ve seen those same dynamics play out in the private sector.

SC: Are there common themes across this wide range of experiences?

BP: Yes. One challenge that every company faced, and is still facing, is worker safety. In the early days of the pandemic, it wasn’t entirely clear how COVID-19 was transmitted, and it was difficult to obtain necessary protection equipment, such as N-95 masks and plexiglass. It’s better now, but companies have to remain vigilant as infection rates are rising in parts of the country. A second common theme, which Suzanne touched on, is supply chain management. Disruption to global supply chains got a lot of attention, but domestic supply chains were disrupted as well.

SC: How helpful were the various aspects of the CARES Act?

BP: It was critical economic life support for many companies. Indeed, most of the details of the CARES Act were specifically targeted toward smaller employers. As is the case with any large government program, there were challenges in implementing things like the PPP, and smaller companies scrambled to compile the necessary information to apply to the program. However, the program generally worked. It enabled companies to retain employees while providing a much-welcomed financial cushion that allowed companies time and resources to adapt to these new challenges. One of the reasons I love working with private companies is that the creativity and innovation in the middle market is inspiring. Necessity really is the mother of invention, and we’re seeing a lot of invention this year.

SC: And how helpful has the Federal Reserve been in lowering interest rates?

BP: All else being equal, lower interest rates are better. Falling interest rates don’t turn bad strategic decisions into good ones, but a lower cost of capital may serve to accelerate strategic investments that are fundamentally sound on their own merits. It is important to note, however, that a 0% fed funds rate doesn’t translate into free money for businesses. Having learned the lessons of 2008, many lenders long ago established interest rate floors on their credit facilities, thereby limiting the minimum rate a borrower would pay, regardless of the Fed’s decisions on interest rates.

SC: What does the mergers and acquisitions (M&A) market look like given the combination of economic challenges, low interest rates and the potential for tax code changes?

BP: M&A activity stopped on a dime in the second quarter, as you would expect given the sharp downturn in financial markets and unprecedented economic uncertainty. Having said this, we’ve been impressed by how quickly activity has bounced back in the third quarter, driven partly by a revival of transactions that were put on hold in the spring, but also, as you note, by a drop in interest rates. Obviously, the economic and pandemic uncertainties haven’t evaporated, but the prospect of changes to the tax code following the election is prompting many owners who have been thinking about a transaction to think long and hard about completing it before year-end.

SC: Are you expecting a surge in M&A activity in the fourth quarter?

BP: It wouldn’t surprise us, and it would be in keeping with what we’ve seen in the fourth quarters of previous election years. But it’s not a one-decision question. There are some businesses that would benefit from a Biden presidency, for whom the prospect of a transaction might be delayed in anticipation of better earnings growth in the next few years. Of course, higher capital gains taxes would argue for a transaction to be completed in 2020, in case a Biden administration raises taxes retroactively to the beginning of 2021. As with most implications of changes in tax law, the fact pattern differs from company to company.

SC: This is a good segue into discussing the elephant (and donkey) in the room. We’ve danced around the obvious changes that may follow a change of control in the White House or Congress. Tom, you’ve done some historical work on this topic. Conventional wisdom holds that Republican control is better for markets and business than Democratic leadership, but history argues otherwise, right?

TM: Yes, that’s right. Interestingly, if we look back across the history of the S&P 500, the equity market has performed better during Democratic administrations (14.2% annualized average return) than Republican administrations (8.5% annualized return). The best historical scenario has been when the president is a Democrat and the GOP controls at least one branch of Congress. In those periods, the annualized market return has been 16.6%.

SC: What conclusions should we draw from this?

TM: The only conclusion I draw from this historical analysis is that correlation is not causation! There are so many factors that drive equity returns – interest rates and monetary policy, the business cycle, exchange rates, valuations and inflation, just to name a few – that it would be dangerous to attribute market performance to any particular party controlling any particular branch of government.

SC: So, the election doesn’t matter, and we can move on, right?

TM: Yes, at least for fundamentally driven, long-term investors. There is no question that the anxiety surrounding the election poses a risk to short-term market sentiment, especially if the outcome depends on absentee ballots that may take some states days or weeks to process. But the fundamental direction of equity markets depends far more on progress in battling COVID-19, a continued recovery in the economy and the future of personal spending and corporate earnings.

BP: This may be true for financial investors, but a change of control in Washington does pose some risks for operating businesses. The risks and opportunities will vary from industry to industry, but a Biden administration is likely to reverse the deregulatory efforts that the Trump administration has undertaken over the past four years.

SC: I notice that you characterize this as both a risk and an opportunity.

BP: Of course. Biden has committed to raising corporate taxes and reversing the broad deregulatory trend, and these prospects might accelerate a strategic effort or transaction that is already underway. At the same time, changes in regulations might benefit some companies over others. Don’t get me wrong, the prospect of any change is a management challenge, but well-managed companies often find ways to turn these changes into competitive advantages.

SC: Suzanne, what are we hearing from our managers about election risks and opportunities in public markets? Are our managers repositioning portfolios in anticipation of a Biden administration?

SB: The short answer is no, because of the way we invest. Our managers seek to invest in companies with compelling fundamentals, not companies that are reliant on a particular economic, monetary or political outcome for their business models to thrive. And why would you want to invest on the basis of a binary outcome? As you often remind us, the future is forever uncertain, and surprises linger around every corner. We would rather allocate capital to managers and companies that have the creativity, flexibility and resiliency to succeed in any political environment. One of our managers noted in a mid-year letter to clients: “The first six months of 2020 have reinforced our belief that we are far better off reacting to the changing market environment than trying to predict the future. As we move into the second half of the year, we’re not deluding ourselves into thinking that the intersection of COVID-19, global political tensions, government and central bank actions, and a U.S. presidential election are going to have a calming effect on global markets. Regardless, we believe our focus on fundamentals, particularly earnings and earnings stability, will provide direction as we look to compound our clients’ capital.”

SC: This quote reminds me once again of the perils of market timing, particularly in response to uncertainty. It’s far better to patiently own well-managed, competitive companies and let compounding be your friend over time, rather than try to anticipate economic or political implications. 2020 has taught us at least that so far, if nothing else!

SB: That’s not to say that our managers aren’t analyzing the potential implications of higher taxes that a Biden administration might introduce, just to observe that companies have many ways to mitigate the drag of higher taxes on their bottom lines, such as raising prices or shifting production locations. And the implications aren’t as radical as some headlines indicate. For example, although the 2017 Tax Cuts and Jobs Act lowered the statutory corporate tax rates from 35% to 21%, the effective tax rate for the S&P 500 was already 26.4% when this law was passed.

SC: Companies I speak to – both in the public and private sector – claim that the deregulatory efforts of the Trump administration have been far more helpful than the lower tax rates.

SB: Yes, but, as Ben noted, regulation can work both ways. One of our investors observed that they “are perfectly happy owning businesses where the biggest competitive threat is regulation, as regulation has historically led to increasing the difficulty of new competitive entrants, and usually does not have the intended effect on the business. Additionally, we think that these businesses generate outsized returns over the long term, while regulatory regimes can shift over the short and medium term.”

SC: So, keep calm, and manage your business and portfolio for the long run.

SB: Precisely.

SC: There are probably broader implications from a wealth planning perspective, given the likelihood of higher taxes in a Biden administration. Let me turn to two of BBH’s wealth planners for a discussion of these issues. Ross Bruch is a senior wealth planner in BBH’s Philadelphia office, and Joe Fuschetto is a senior tax advisor in our New York office. Which of you wants to go on record and predict the outcome of the election?

Ross Bruch: 2016 taught us not to make such predictions, but the polls are pretty convincingly leaning in Biden’s favor. Now, polls are not votes, but Biden holds a lead in polls across the handful of key swing states that won the election for Trump four years ago. The nearby graph shows President Trump’s margin of victory in 2016 in red, and Joe Biden’s margin in recent polls in blue. These seven swing states add up to 199 electoral college votes. Not to dismiss the other great states in our nation, but this is likely where all the action will be on election night.

Joe Fuschetto: From the standpoint of future tax policy, the balance of power in the Senate is just as important. If a newly elected President Biden has any hope of changing tax policy, he needs at least 50 Democratic senators to vote for his plan. As you know, roughly one-third of the Senate is up for re-election every two years, and by luck of the draw, most of the competitive races in 2020 are currently held by Republican incumbents. Each party has a practical lock on 46 seats, so the outcomes of eight races will determine control of the Senate. As Ross said, it’s a fool’s game to predict this or any political environment, but on the basis of recent polls, it seems likely that the Senate will swing into Democratic control by at least a seat or two.