Americas CIO View

Bidenomics: Spend now, tax later…until the bond market objects

Democrats take control of U.S. Senate: opens the door to more Bidenomics

Fiscal spending restraint is unlikely from the Biden administration with Democratic Party control of Congress and an economy so unequally injured by the pandemic. Additional economic support and stimulus programs are likely within the first 100 days, including more assistance for those unemployed, state / local government agencies and medical response. More stimulus checks to households and grants to businesses are likely, but perhaps on a greater need basis than before. We believe this expected additional pandemic spending could exceed 1 trillion U. S. dollar, bringing total 2020-2021 pandemic spending over 4 trillion dollars or 20%+ of gross domestic product (GDP). This crisis spending is before the new administration and Congress explore new programs ranging from infrastructure investment to stronger social safety nets and more entitlements.

Bidenomics likely spends now and taxes later or until the bond market objects

Spend now and tax later, or until the bond market objects, will probably be the advice of President Elect Biden's economic advisors. The bond market will assess how effective the spending promotes strong economic growth versus waste and the credibility of weening off crisis spending and / or hiking taxes in the future to restore fiscal health. If the bond market is unconvinced of future fiscal health, it is likely to object with higher interest rates. Interest rates might move higher on inflation expectations, if the Federal Reserve (Fed) is not clear in its commitment to limit inflation's climb, or on higher real interest rates if budget deficits burden the savings pool. Fiscal aside, long-term real yields should rise at least closer to zero as the Fed achieves its inflation goals. But, kicking the fiscal can down the road does not necessarily lead to high inflation if the Fed eventually acts to contain inflation when it gets to target. However, there is still risk that overly expansive fiscal policy, brings significantly higher real interest rates. If overnight rates stay too low for too long the curve will steepen.

Political and economic challenges of possible tax hikes raise risk of higher interest rates

Although the day will be remembered for other reasons, a secular upturn in long-term Treasury yields might have started on January 6, 2021. The ascent in Treasury yields should be slow, but it could quicken if deficit spending is excessive. Federal Reserve actions have a fundamental influence on long-term inflation, but not on long-term real interest rates. If the Fed attempts to fight rising real yields from fiscal excess or rising yields from rising inflation expectations / risk with more asset purchases, this is likely to further raise inflation expectations and inflation risk and eventually cause a vicious upward rate spiral.

Higher inflation expectations can weigh on the dollar immediately and over time

Real interest-rate differentials affect spot exchange rates and inflation differentials affect future foreign exchange rates. The dollar has already lost strength vs. mature currencies owing to the closing of its superior real interest rate. But the dollar could weaken further over time, if U.S. inflation rises well above inflation in other currency zones. If this became the expectation of investors, it could significantly curb foreign Treasury demand. This could be acute if foreign buyers like China have less need for U.S. import demand. That said, high deficits, but 2.0-2.5% curbed inflation and rising medium term real interest rates could be dollar positive.

Corporate tax rates higher, but not foreign profit taxation or progressive brackets

Our 2021E (estimated) & 2022E S&P 500 earnings per share (EPS) are 170 dollars and 185 dollars and assume no corporate tax rate hikes. However, with a healthy economic recovery, an increase to 28% is very possible for 2022. Changing the domestic corporate tax rate is simple, but changing the structure of today's territorial U.S. corporate tax code or adjusting taxes by industry or firm size is complicated.

A jump in real interest rates can hurt P/Es fast, high inflation will hurt P/Es slower

If interest rates climb secularly owing mostly to higher real rates, it will hurt defensive and high quality growth stock price-to-earnings ratios (P/Es). If interest rates climb secularly owing mostly to higher inflation, it will hurt P/Es of capital intensive businesses over time, such as commodity producers and many industrials (broad based inflation is not pricing power) and it clouds capital planning at these businesses and raises operating risk owing to unreliable price signals. Capital light and intangible businesses with strong competitive positioning are best to weather broad based inflation. We believe the best inflation survival plays are intangible assets, regulated utilities and in this situation real estate investment trusts (REITs) and Banks. We think capital intensive, highly competitive and volatile input-output price businesses are at risk with high inflation.

Seek inflation protection, while also protecting against higher real interest rates

We consider adding more foreign equities to portfolio allocation strategies, keeping a quality bias and adding Banks; more Treasury Inflation Protected Securities (TIPS) and gold. We reduce our overweight on Tech and Communications, add to Health Care and Utilities.



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