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Fiscal Fails to Disappoint

Following the Democrats’ early January win in the Georgia runoff election, we expected the Biden administration and the Democratic majority in Congress to move quickly on fiscal stimulus, though there were some doubts as to whether the package would be as significant as the politicians were promising. True to their word, they delivered a $1.9 trillion stimulus plan, bringing the total aid passed since December to an astonishing $2.8 trillion, almost 15% of the GDP of the world’s largest economy. And there is more spending to come. On the last day of the first quarter, the administration announced an infrastructure plan of more than $2 trillion. The staggering amount of fiscal stimulus helped to push equities and bond yields higher during the quarter, with the S&P 500® returning over 6% and the U.S. 10-year Treasury yield nearly doubling to 1.74%.

U.S. policy: Wait, politicians doing what they said they would?

The $1.9 trillion stimulus package features several components focused on individual citizens, such as another round of $1,400 checks and a $300 per week unemployment insurance top-up. While the stimulus checks get much of the media attention, other wrinkles also caught our attention. For example, the bill includes $86 billion in aid for multi-employer pension plans, which will be invested into the investment-grade bond market. So, while this bill was broadly characterized as a COVID-19 stimulus package, it also contained a number of longer-term structural components.

As Congress and the Biden administration move on to new objectives, questions regarding how the infrastructure plan is to be funded remain to be worked out. The administration’s opening salvo included a proposal to raise the corporate tax rate from 21% to 28%, halfway between the current rate and 35%, where it was before the Republican-led 2017 tax bill. Other potential tax changes include the following:

  • Raising income tax on individuals earning more than $400,000.
  • Higher capital gains tax for those earning above $1 million.
  • Addressing tax preferences for pass-through business like LLCs and partnerships.
  • Expanding the reach of the estate tax.
  • A doubling in the tax rate for foreign affiliates of U.S. companies.

While few voters object to “free” stimulus checks from the federal government, everyone complains about higher taxes. This political conundrum will shadow the infrastructure debate, with Democrats needing help from tax-wary Republicans to pass a bill under current rules in the Senate or otherwise resorting to reconciliation. Given the number of Republican non-starters in the tax portion of the bill, we expect Democrats to ultimately choose reconciliation and aim to pass the bill along party lines again.

Powell pushes back

The prospect of a vigorous post-COVID-19 growth rebound in 2021 and fears of ensuing inflation increased the pressure on Federal Reserve (Fed) Chairman Jerome Powell to address the possibility that rate hikes would occur sooner than expected. The Fed’s own outlook for growth in 2021 increased notably to 6.5% (at the higher end of consensus among economists) and the unemployment outlook improved as well. Even with these improved estimates, the inflation outlook remained relatively modest, with expectations for a modest overshoot this year, return to 2% in 2022 and another modest overshoot of 2.1% in 2023.

Market participants got a bit nervous regarding short-term expectations during the first quarter, driving the 10-year Treasury yield to pre-pandemic levels and focusing intensely on the Fed’s “dot plot,” in which the median dots continued to indicate no rate hikes through the end of 2023. However, Powell downplayed the possibility of rate increases and was forceful in his defense of the Fed’s new inflation framework, asserting that the central bank will look past temporary inflation increases caused by base effects (i.e., low measured inflation versus one year ago at the height of the pandemic), oil prices or heavy demand from cash-flush consumers as the economy reopens.

While rising yields reflect market participants’ expectations for the near term, inflation data at this point remain somewhat mixed. Prices of durable goods have jumped sharply over the last year, while nondurable goods and services prices have fallen following the pandemic-induced lockdowns. In addition, medium-term expectations for inflation remain modest and closer to the Fed’s traditional 2% target.

5-year inflation rate

5-year inflation rate

Source: Federal Reserve Bank of St. Louis. Data through March 31, 2021.

We agree that heightened demand from the post-COVID economy will lead to higher prices, especially as businesses work to re-hire and supply chains continue to mend. However, over a medium- to longer-term timeframe, we still see disinflationary forces such as tepid productivity growth, an aging population and technological disruption helping to keep a lid on inflation. For these reasons, we think yields could continue to increase modestly due to optimism for near-term growth, but we do not see scope for a more meaningful backup in yields.

U.S. economy poised to escape the cage

The higher growth outlooks for the U.S. economy include two key assumptions. One of them is obvious: continuing to gain the upper hand on COVID-19. Vaccine deployment remains on track, and the efficacy of current vaccines against the variants that continue to appear around the world is encouraging, though questions will follow each time the virus mutates. The anticipated recovery still depends on a return to normal conditions, which can only happen when hospitalizations and deaths from COVID-19 decline to the point where health-care experts are confident enough to embrace a more comprehensive re-opening.

The second assumption is the significant consumer demand expected as the economy is freed from pandemic restrictions. Household debt levels have declined and savings rates have spiked during the pandemic, including another jump following the December round of stimulus.

Personal savings rate

Personal savings rate

Source: Federal Reserve Bank of St. Louis. Data through February 1, 2021.

The combination of excess cash and pent-up demand is likely to spur strong growth later in 2021 as consumers look to make up for lost time. We expect overall economic growth to increase and the mix of spending to shift away from the stay-at-home winners such as manufactured goods and toward services such as restaurants, theaters, travel and other leisure activities.

While the consumer outlook appears bright, there are some factors that could make this expected spending occur more gradually. Hopes for the recovery are pinned on the services sector, but as Chairman Powell quipped, “You can only go out to dinner once per night.” Furthermore, much of the increase in savings and net worth resides with higher-income individuals and thus may take more time to flow into the economy.

Though there is some risk to some consumers sitting on their savings, we believe this risk is lower than the most recent comparison point of 2008, when the drop in consumer confidence was deeper and more widespread. It will be a process to infuse this level of savings into the economy, but we remain confident it can happen over a shorter timeframe versus the recovery from the financial crisis.

Equity valuations still in focus

Equity valuations have been in the spotlight in recent months, especially with value stocks outperforming growth names since late last year. Outside of occasional short-lived rotations into value, growth has led the market for an unprecedented stretch, but we see a much more balanced outlook for value versus growth going forward. While investors seem to have finally acted on the valuation concerns hovering around mega-cap growth stocks, some of these concerns have eased a bit following recent earnings outlooks. We’ve seen a significant markup for first-quarter earnings expectations — from 15.5% as of December 31 to 23.3% as of March 26. This is notable, in part, because it is far more common for analysts to reduce earnings estimates within a quarter. The markup also eases valuation worries, as the larger “E” reduces the P/E multiple, a key driver of those concerns.


We remain optimistic for a strong bounce back in the U.S. and abroad as consumption increases and stimulus works into the economy. We expect the U.S. consumer to lead the way, increasing overall expenditure but also directing more spending into the beaten-down services sectors. As a result, we made a slight increase to our equity overweight during the quarter, adding to our allocations to U.S. small-caps and emerging-market equities while reducing our fixed-income exposure. We believe small-caps provide an attractive opportunity to capitalize on the very strong growth environment, while emerging markets should benefit from synchronized global growth coming out of the pandemic as well as a weak U.S. dollar.

Originally Posted in April 2021 – Fiscal Fails to Disappoint


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