Objections arise to Bidenomics?: Spend now, tax later, until bond market objects
For markets, the main event this fall is the fiscal fight in Congress related to longer-term tax and spending plans of the Biden Administration and Democratic controlled Congress. These longer-term plans were delayed, despite Democratic Senate control since January, given a focus on pandemic crisis fiscal aid. But now, just as Congress wrestles with shaping its post crisis fiscal policies, the Federal Reserve (Fed) signaled that inflation is running above its target more than expected and that the time is coming for less accommodative monetary policy. Thus, Congress finds itself evaluating its grand spending plans just as the Fed is about to reduce asset purchases and contemplate the path to a normal Fed Funds interest rate. These circum-stances have intensified Republican and even moderate Democrat calls for spending restraint and most importantly the bond market has issued a word of warning.
Will US Treasury default? No, but risk of unruly process or unorthodox means
If Democrats are intent on passing a $3.5 trillion spending package through reconciliation, then perhaps Republicans are willing to risk technical default. Nothing stops spending like cutting credit cards. Delayed payment on Social Security or to a Federal contractor without cause or agreement is technical default. For what it’s worth, we think this is a terrible idea. But it’s leverage the Republicans might use until it risks leaving lasting damage. We do not believe any Treasury bond interest payments will be missed, but the Treasury department might go looking for coins in the couch. Treasury owns marketable assets like gold and oil. While the Federal government has other assets and of course taxing power, it’s disturbing that the Treasury Department account at the Federal Reserve was $2 trillion at the start of this year and might be down to $0 in the coming weeks without lifting the debt ceiling limit.
At what rate will inflation normalize? Eventually, probably where the Fed wants it
Without political interference, we believe the Fed will stick to its long-term inflation target of 2% (with tolerance for above that near-term) and has the tools to achieve that target. Some believe that inflation is likely to significantly and persistently over-shoot the Fed’s target owing to supply side challenges. We recognize supply side challenges, but see these as risking slower real growth more so than accelerating inflation. This is because if commodity, labor, import, etc. costs rise and are passed on to consumers on essentials it results in consumers having less money to spend elsewhere. Consumers will need to tap into savings or borrowings to keep real spending unchanged if prices rise. A wage-price spiral also requires growth in money supply to sustain. This would cause excess reserves held at the Fed by the banks to start dropping and a further climb in cash in circulation. If this occurs, the Fed should raise overnight rates or sell assets. That said, we acknowledge the political risks facing the Fed in achieving its mandate, as well as the Fed’s own concerns about risking recession by fighting inflation too aggressively. We believe inflation will slowly trend toward the Fed’s target, but we seek inflation protection. We expect 10yr Treasury yields to reach 2.0% in a year and core personal consumption expenditures (PCE) inflation to average 2.5% in 2022.
S&P 3Q EPS season ahead: Physical economy remains supply side constrained
Many companies that move or make things have been warning of profit pressures owing to rising input costs and supply chain related production shortfalls. This is reflected in prudent analyst consensus earnings per share (EPS) estimates for 3Q. They only raised 3Q consensus by 3.0% during July-September, despite huge 2Q beats and strong economic momentum since. S&P 3Q bottom-up EPS is $49.10 now, down 6.5% vs. $52.55 in 2Q. We expect S&P companies to deliver a 5-10% aggregate beat, putting 3Q S&P EPS at $53-55. By sector, EPS was cut in September, led by Industrials (-2.5%), Consumer Discretionary (-1.0%), Financials (-0.5%) and Communication Services (-0.4%); sectors raised most are Energy (+1.9%), Utilities (+0.3%) and Consumer Staples (+0.2%); other unchanged. Energy’s 4Q EPS outlook is improving. Our 2021E S&P EPS of $215 might be a tad too high, probably $212-215, but we aren’t changing our estimates before 3Q results given the reoccurring pattern of strong beats from Tech, Communications and Health Care. Our 2022E S&P EPS of $215 still seems reasonable inclusive of an about 7% hit from higher corporate taxes.
Our base case remains fair S&P PE at 20+ and 4400 yearend price target
Unless Treasury Inflation-Protected Securities (TIPS) yields shoot well above 0%, we see a 20+ price-to-earnings ratio (PE) as fair for the digitally dominated S&P 500. We think the current dip is unlikely to go much deeper, as we don’t see a US default and while much of the proposed tax hikes are still coming there is likely to be some tempering of the spending plans, should slow the Treasury yield ascent. At 20x 2021 or 2022 S&P EPS likely over $210, 4200 should be support and fair to raise S&P allocation.