July 1, 2021 Letter to Clients

As we reach the midway point of 2021, I hope you and your families are in good health and beginning to enjoy the start of Summer. With the reopening of many parts of the country, I know many of us are looking to resume our summer traditions.

Halftime Report: Supply-Demand Mismatch

When we spoke last, many parts of the country had not yet fully reopened, however as people become increasingly more vaccinated and it being summertime, folks are venturing out and the economy is reopening faster than anticipated. Not surprising, we are experiencing a spike in prices resulting from supply and demand imbalances and shifting consumer preferences from pandemic related goods (think new hobby related items, home décor and exercise equipment) to travel, leisure, and experiences. In their most recent statement in June, the Federal Reserve (the Fed) signaled that interest rates will need to rise sooner and faster than the original projection of 2024, and instead is projecting two rate hikes in 2023, to keep inflation more in line with its long-term target of 2-3%. Despite inflation having increased notably in recent months, the Fed and Federal Reserve Chairman, Jerome Powell, remain convinced that this higher inflation is transitory, and their focus continues to be on regaining a strong labor market and low unemployment in the near-term.

Since February 2020, nearly 3.5 million Americans have dropped out of the labor force and are not actively seeking employment, at least temporarily, who were working and earning prior to the pandemic. Many economists point to a few things keeping people from reentering the workforce so far including childcare obligations and the fear of getting COVID-19, with less than half the population vaccinated as of the end of June. Combine this with pent-up churn in the job market, being called “The Great Resignation,” with nearly 95% of employees considering a job change based on post-pandemic lifestyle needs, employers are finding it harder to entice employees to stay in current jobs. Many employers are having to put more money on the table, offer flexible hours, remote-work options, and offer child- and elder-care benefits to draw people back to work, many benefits that were barely part of the equation prior to the pandemic.

Some sectors are recovering relatively quickly as restrictions are eased this summer and businesses are allowed to reopen; however, the labor market is still more than 7.5 million jobs short of its pre-pandemic level with the services sector trailing in the U.S. jobs recovery. But restarting the economy isn’t as easy as flipping a switch. Even with the unemployment rate falling to 5.8% in May, the increase to unemployment benefits coming to an end early for 25 states and nearly 9.5 million job openings in the U.S., getting people back to work won’t happen overnight. These are unusual times and patience is needed for many to truly understand what work means to them, how they are valued, and how they spend their time before reentering the workforce. With many K-12 schools returning to in-person learning and resuming other school related activities this Fall, I anticipate an increase in the labor force participation rate heading into the end of the year.

What’s Happening on Capitol Hill?

The Biden Administration has moved forward with three key elements of his Build Back Better program. To date, the White House has unveiled three plans; The American Rescue Plan (enacted), The American Jobs Plan (proposed) and the American Families Plan (proposed). I have discussed the American Rescue Plan in previous letters and would like to focus on the current proposals moving through Congress as they relate to the stock market and economic recovery.

The American Jobs Plan

Investment in infrastructure is vital to a country’s economic development and prosperity. It not only enhances the efficiency of production, transportation and communication, investing in infrastructure helps shape domestic firms’ investment decisions and determines a region’s attractiveness to foreign investors. A generational investment to modernize infrastructure improves the education, health and entrepreneurial opportunities by giving more people access to schools, hospitals and centers of commerce that ultimately strengthen a country’s economic potential and global competitiveness.

Recently President Biden met with members of the Senate infrastructure group to discuss a major infrastructure initiative. The announced deal, named the Bipartisan Infrastructure Framework, includes components of the original American Jobs Plan and if passed could be the largest long-term investment in American infrastructure in nearly a century. The $1.2 trillion proposal includes investment in clean transportation, clean water, universal broadband, clean power, and remediation of legacy pollution among other items. A framework of well-paying job creation in areas such as construction, transportation, technology, and engineering as well as additional skilled trades for decades to come is a focal point of this initiative.

The package includes $579 billion in new spending to fund the following areas:

$312 billion will fund transportation of which $109 billion will be invested in roads, bridges and other major projects, $66 billion in passenger and freight rail and $49 billion in public transit
$15 billion will go to electric vehicle infrastructure and electric buses and transit
$266 billion will be put towards non-transportation infrastructure
$55 billion is reserved for water, $65 billion for broadband and $73 billion for power

Lawmakers have met for weeks to craft a deal that could warrant support from both parties in Congress, however determining how to pay for this plan has posed the biggest challenge. Closing the tax gap through Internal Revenue Service enforcement efforts, redirecting unused state and local COVID-19 emergency relief funds and private-public partnerships and bonds are among a wide list of potential funding sources. The financial markets appeared to take the prospect of a deal in stride, but the full breadth of the market’s reaction may not be felt until the legislation is fully enacted.

The American Families Plan

On April 28, 2021, the Biden Administration unveiled the American Families Plan with the mission to invest in American families and the nation’s economic future. To accomplish this, the plan will invest in education by providing at least four years of free education including two years of preschool and two years of free community college, expand existing institutional aid for higher education, provide additional training and support for teachers, assist low- and middle-income families in joining the workforce by limiting childcare costs and implement a national comprehensive paid family and medical leave program. In addition, the proposal aims to strengthen and reform unemployment insurance and extend or make permanent tax cuts and credits included in previous legislation passed under the American Rescue Plan in March of this year.

The proposal, which would significantly increase federal spending in these areas, would be funded by increased taxes for high-income earners. While still under debate, the proposal includes key changes to the following areas:

Federal Income Tax: The top income tax rate is currently 37% for individuals with taxable income exceeding or above $523,600 for single filers and $628,300 for married joint filers.

The proposed plan would raise the top income tax rate for households earning more than $400,000 a year to 39.6% and lower the income thresholds for which the rate would apply. Even if Congress doesn’t pass Biden’s proposal, the top rate is slated to increase under the Tax Cuts and Jobs Act after 2025 due to how Congress structured the law in 2017.

Capital Gains Tax: Capital gains are profits made from the sale of investments, real estate and personal property. The length of time the investment is held determines if the profit is categorized as short- or long-term for tax purposes. Short-term, being defined as profits made from selling an asset owned for one year or less and long-term as profits earned from owning the asset more than one year. Under current tax law, short-term capital gains are taxed as ordinary income while long-term gains are taxed more favorably at either 0%, 15% or 20%, depending on your taxable income and marital status. It is important to note that the capital gains tax does not apply to IRAs.

The proposed plan would tax long-term capital gains and qualified dividends as ordinary income, however only for those with taxable income above $1 million.

Inherited Assets: Under current law, when an individual passes their assets receive what is known as a step-up in basis which minimizes capital-gains tax for their heirs. For example, if an investor purchased a share of stock for $100 and that share had appreciated to $150 on the date of their death, their heir would receive a step-up in basis, meaning the heir would not pay capital-gains tax on the $50 of appreciation if they sold that share for $150. If the heir chose to sell the share at a later date, they would only pay capital-gains tax on the appreciated amount above $150.

The proposed plan aims to end this basis step-up for gains in excess of $1 million for single filers and $2 million for couples, ensuring the gains are taxed if property is not donated to charity and ending what many view as a loophole allowing wealth to be passed on through generations without being subject to taxation.

Internal Revenue Service Reform: The Internal Revenue Service (IRS) has had years of underfunding which has resulted in personnel cuts causing reduced auditing and enforcement efforts. This has cost the government substantial tax revenue, estimated to be in the hundreds of millions of dollars. The White House estimates boosting the budget of the IRS (by $80 billion distributed over 10 years) could raise over $700 billion in revenue that would have otherwise been lost to tax evasion and will ensure enforcement of tax law compliance for high-income earners, large corporations, businesses and estates.

It’s unclear how much of President Biden’s tax agenda will make it from the current proposal into law, however we know that the markets most likely have already priced in some form of tax hike in the future. Historically speaking, tax increases have little correlation to the overall performance of the stock market or the economy as there are often other economic factors occurring that influence market behavior.

Looking Ahead

We’ve seen an extraordinary recovery over the last year in both the stock market and economy on the heels of having experienced one of the sharpest downturns in history since the Great Depression. Only six months into the year, many metrics show the U.S. economy has made a full recovery from the COVID-19 pandemic. Robust spending, better-than-expected corporate profits, a healing jobs market and unprecedented policy support from Washington and the Federal Reserve is propelling the new economic expansion and has the stock market poised to produce strong gains in the second half of the year. We could, however, see bumps along the way over the next six months as the market digests and adjusts to a backdrop of better economic and corporate earnings growth against the worries over higher taxes and the potential for interest rate hikes sooner than expected.

Markets aside, with summer finally here and life beginning to resemble some normalcy, I hope you and your family find time to kick back, relax and enjoy your favorite summer activities.

Best wishes,

Steve LePage