The Democratic “Blue Wave” scenario has finally happened. Will this be a game changer for financial markets? Find out with David Nowakowski (DN), Senior Investment Strategist and Fabio Faltoni (FF), Multi-asset & Macro Investment Director.
FF: What is all the hype about Democrats gaining control of the Senate?
DN: It really has huge implications. The results effectively mean that the ‘Blue Wave’ scenario has finally happened: a Biden presidency alongside a Democratic majority in both chambers (House and Senate) of Congress. Republicans become the minority opposition and cannot block laws or appointments that need congressional approval, such as cabinet posts and judges.
One of the most important ramifications is that the likelihood of an even larger fiscal package in the US has increased in probability. For markets, this is fuelling greater expectations around the reflation trade.
FF: Will your outlook for US growth be revised as a result?
DN: Yes, it will be upgraded, though by how much depends on the size and nature of the fiscal spending. For example, “multipliers” on infrastructure spending are considerably higher than those on transfers, which are partly saved.
FF: What about reforms around taxation, could this also become in greater focus?
DN: Definitely; it might not be right away, but we do expect a harsher attitude towards business to grab the headlines at some point once President-elect Biden comes to office.
We do expect a harsher attitude towards business to grab the headlines at some point
Reforms toward taxation of corporate earnings and a more stringent regulatory vision for energy and technology companies have been some of the main pledges throughout Biden’s campaign. In the summer, Biden was explicitly talking about the “era of shareholder capitalism coming to an end”. Investors should therefore start to embed these considerations into their base case scenario.
FF: Larger fiscal spending vs taxation reforms. Which will be the dominant force for equity markets?
DN: We can get a sense of this by looking at how equity markets behaved in the last couple of days. Equity markets generally moved higher but what is also interesting is the sector rotation that has taken place under the hood. We have seen some of the more cyclical sectors such as financials and materials outperform as it became clearer that Democrats would gain a majority in the Senate and increase domestic investment. On the flipside, Tech stocks underperformed on a relative basis. Rising bond yields alongside fears of higher taxes and new regulation have acted as headwinds.
FF: Onto the million-dollar question… could these moves be sustained?
DN: Broadly speaking yes. In the House View 2021 Outlook document published in December, we had already outlined our more constructive view on the world economy. This is largely a function of the symbiotic relationship between exceptionally easy monetary and fiscal policy alongside a rapid and robust recovery expected in 2021.
We see potential for the recent outperformance of “value” stocks to continue into 2021
Our view on equities was upgraded as a result. While some parts of the market may now be “priced for perfection” — e.g., segments within the equity growth sector, such as technology — others still look attractive from a valuation perspective. We see potential for the recent outperformance of “value” stocks to continue into 2021, as the economic recovery supports financials and travel and leisure sectors.
FF: Moving onto fixed income, what has been the market response on the back of this outcome?
DN: Market moves have been quite substantial in the last couple of days. US Treasuries for instance naturally sold-off, with the 10yr yield moving over 10bps to above 1%, a level last seen in mid-March 2020. Interesting moves also took place around the shape of the yield curve, with US yield curves steepening noticeably, as the Fed’s forward guidance limits moves on the shorter maturities.
The 2s10s curve for instance reached the steepest level in the last 3 years and 5s30s hit its steepest in 4 years. Last but not least, US 10yr inflation breakevens, a barometer of inflation expectations, moved past 2%, reaching levels last seen since late 2018.
Figure 1: US Inflation expectations and bond yields grinding higher
FF: As yields rise, do we need to prepare for the Taper Tantrum “spectre” to reappear?
DN: Taper Tantrum 2.0 is not our base case scenario, as the Fed has learned from that communication mishap. Nonetheless, we do expect interest to continue to grind higher and for yield curves to steepen further, even after the moves seen since the start of the year. However, central banks are set to keep policy rates at the effective lower bound well beyond 2021 and maintain quantitative easing (QE) programmes to monetize fiscal deficits, so there is a limit to how much government bonds are likely to rise.
Ultimately it will all be about inflation. At present, we do not expect inflation to rise materially over the next year, though y/y CPI will jump due to base effects, and then settle down again.
For most economies there will continue to be spare capacity throughout 2021
For most economies there will continue to be spare capacity throughout 2021, keeping inflationary pressures low. As that spare capacity is eliminated however, and with monetary policy set to remain loose, we could start to see inflationary pressures building, albeit from a low starting point, in 2022. Markets should start to anticipate this before it is realised. This may prompt a reassessment of our interest rate outlook as the “Monetary Policy” reset theme moves into its next phase.