Fiscal bickering over US economic stimulus is likely to end following a stunning Democratic victory in both Georgia senate run-off elections on Jan 5.
By winning both the senate seats of this once solidly “red” state, Democrats now have control over both the White House and congress. Democratic Vice-President-elect Kamala Harris controls the deciding vote in an upper house split down the middle between Democrats and Republicans.
With the fiscally liberal Democrats now possessing the senate’s “power of the purse”, fiscal stimulus will likely be more forthcoming.
According to Bank of Singapore (BOS) Head of Investment Strategy Eli Lee, President-Elect Joe Biden is likely to pass a substantial relief aid package in 1Q2021 of around US$1 trillion ($1.33 trillion). Subsequently, major spending is expected to take place in infrastructure, renewable energy, sustainability and healthcare.
“Some of this spending will likely be offset by Biden’s proposed tax increases, which may lead to some market nervousness,” Lee warns in a broker’s report dated Jan 11.
The outlook for the US Dollar is also likely to be bearish as a result of this Democratic sweep. But all in all, Lee argues that this “Blue wave” will accelerate the US recovery and be bullish for risk assets while putting upward pressure on Treasury yields.
Bullish on stocks
Consequently, Lee has upgraded US equities to overweight, expecting 30% growth in S&P 500 earnings-per-share in 2021. The BOS macro team has also raised its US GDP growth forecast from 5% to 6% and one-year estimate for 10-year US Treasury yields from 1.2% to 1.5%.
Inflation expectations have risen since the Georgia polls due to the likely aggression of Democratic fiscal stimulus. US 10-year breakeven inflation has risen 7 basis points from 2% to 2.07%.
Historically, US equity returns have been strongest when inflation is rising from low levels; S&P 500 12-month forward performance is highest when inflation levels are below average and rising.
SEE:Volatility in equities expected in short term on Biden win, split Congress
“The combination of an economic recovery and rising inflation from low levels forms a sweet spot for markets. Importantly, in this phase of the business cycle, there is sufficient leeway for the Federal Reserve to maintain a loose monetary policy stance”, Lee comments.
Equities will also benefit from negative real yields, which Lee calls a “key tailwind” for risk assets. Moreover, rising inflation and growth expectations driving US Treasury yields higher and will result in a steeper yield curve. A rise at the long end of the Treasury yield curve from lower levels as a result of stronger growth expectations is usually supportive of equities.
“In the last post-GFC (or global financial crisis) business cycle, rising real yields only became a disruptive factor for risk assets when the 10-year US real yield rose above 0.50% in 1Q2018. Currently, the 10-year US real yield is at -0.96%, which is quite a distance away,” assures Lee.
In terms of valuation, despite the S&P 500’s price-to-earnings (P/E) levels not looking outright cheap, ultra-low yields currently prevailing means that equities are not excessively valued.
Amid lower bond yields and a contracting equity risk premium during an economic recovery, equities become more attractive to investors relative to fixed income assets. Consequently, investors re-orient to equity markets in a bid to obtain higher returns, driving up P/E ratios.
Cumulative changes in US money market fund holdings indicate that only half of pandemic-driven inflow into cash has so far been reversed. There therefore remains a large store of “dry powder” that can be deployed into risk assets going forward. In the past two financial crises in 2001 and 2008, such reverse flows fuelled post-recession bull markets.
With reflation on the cards, cyclical stocks are likely to benefit due to their greater sensitivity to economic growth. Examples include financials, industrials, energy, materials and real estate plays.
“Considering that the valuations of these cyclical sectors remain at relatively attractive levels and that the performance of cyclical sectors have significantly lagged growth sectors, such as technology, since March 2020, we expect cyclicals to outperform the broad market ahead as the reflation theme gains momentum,” comments Lee.
For more stories about where the money flows, click here for our Capital section
Stay vigilant
Still, Lee warns investors that risks remain in the form of short-term volatility owing to the sharp V-shaped market rebound since March last year. Some technical indicators also suggest that the market is technically over-bought in the near-term.
Investors should take note that stock markets tend to experience a 10% correction every 1.5 years since the 1920s. Still, Lee recommends that long-term investors not try to time these near-term market gyrations - these , he says, are nearly impossible to predict with certainty.
And any economic recovery is also at the mercy of the global vaccine rollout, with new strains of Covid-19 including B.1.1.7 in the UK raising questions about the effectiveness of the global vaccine rollout. This is likely to be a key market driver in 1H2021.
On the bright side, scientific consensus is that existing vaccines should be able to combat the new strains, or be otherwise modified to fight off new strains. Herd immunity in major economies is expected to be reached by 2H2021. To date, only Israel, Bahrain and the UAE have vaccinated more than 5% of their population.
As of the close of trade on 10 January New York Time, the S&P 500 is up 0.55% at US$3,824.68.
