A NEW ERA
Encouragingly, the S&P 500 and Nasdaq were on track on Friday for their best weekly performance since April. This might seem counter-intuitive given the US is in a deep health and economic crisis, with strong intervention, including massive additional fiscal stimulus spending, more of a pressing issue. Certainly, if Republicans retain control of the Senate, as looks likely, Mr Biden’s ability to pursue such a programme will be hampered. However, investors have instead focused on the positives for companies, such as the constraints the Democratic party will face in imposing higher taxes on corporates, individuals and investment income for at least the next two years. Gridlock also mitigates the prospect of tougher regulatory threats on Big Tech, banks, healthcare and energy companies.
Maintaining the current level of US corporate taxes will also help companies retain more of their profits, supporting expectations of a significant rebound in the growth of S&P 500 earnings during 2021. And this certainly helps forecasts; following a 15.5% decline in S&P 500 earnings for this calendar year, analysts are projecting earnings growth of 23% and revenue growth of 7.9% in 2021.
Equity sentiment and valuations also benefit from another important aspect of Washington gridlock. A drop in long-dated US interest rates this week represents the bond market signalling a bigger policy shift from monetary towards fiscal stimulus. This reinforces the current status quo of a financial system anchored by low interest rates.
Added to this, last Thursday the Federal Reserve signalled its intent to keep interest rates near zero until there is significant improvement in unemployment and higher inflation. Understandably investors see little reason to move away from a long standing trend of paying a premium for companies whose cash flows are growing a lot faster than those of banks and other cyclical sectors, which are reliant on robust underlying economic activity and a bit more inflation.
GROUNDS FOR CONCERN
Before investors become overly confident in more of the same, there are, of course, some grounds for concern. There is little sign of Covid-19 infections falling across a number of US states, and new lockdowns in Europe may soon cross the Atlantic. The US economy looks vulnerable should the pandemic tighten its grip during the winter months and, whilst there have been encouraging early results from Pfizer, we are still some time away from widespread rollout of a successful vaccine.
There also remains the risk of renewed concern over the economy in the coming weeks, with any forthcoming stimulus deal between Senate Republicans and House Democrats probably failing to plug the economy’s pandemic hole. On Wednesday, Mitch McConnell, the Senate majority leader, called for a limited package of measures to be approved before the end of the year. A repeat of the fiscal conservatism era from 2011 during the Obama administration may ultimately backfire on investors given the nature of the pandemic hit to the US economy.
Ultimately a reality check is a sensible strategy. After the Fed meeting on Thursday, chair Jay Powell warned: “Fiscal policy can do what we can’t, which is to replace lost incomes for people who are out of work through no fault of their own.”
So rather than rely on stimulus from the Federal Reserve, a far more constructive approach would involve a divided Washington getting ahead of the economic damage inflicted by the pandemic. Ultimately for investors, this response would stand a far better chance of aiding economic recovery, potentially sparking a faster pace of consumer inflation and stronger corporate profits growth. It’s worth noting that there is a very direct link between deficit spending and subsequent corporate earnings, which we’ve seen for several years. A surge in profits during 2021 and 2022 for companies who have survived the pandemic could surprise investors, providing something of a bullish shock that could justify today’s lofty valuations.
For investors the greatest fear from a Biden presidency was always the unwinding of Trump era tax cuts and subsequent impact on corporate profitability. On the flip side, the most significant opportunity is expanded fiscal spending, particularly in the short term as a response to the pandemic. Continued Republican control of the Senate will mitigate against the risk of the former whilst reducing the likelihood of the latter, a situation Wall Street continues to take in its stride.
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Julian Broom, Chief Investment Officer