Posted 12 April 2021
Overview: US policy measures drive hopes for a ‘Goldilocks’ economic recovery
The second quarter has started in positive fashion. The combination of fast progress on mass vaccinations – and real long-term structural improvement plans for the US economy – have provided investors with a very welcome perspective for sustained growth beyond the initial post-pandemic recovery phase. While the returning sense that stock markets are potentially getting ahead of themselves is nothing new, the renewed surge of large-cap US tech stocks is. The tech sector’s resurgence has provided more clarity, given it has coincided with falling yields but also growing threats to long-term earnings growth. This threat has stemmed from increasing government talk of raising corporate taxation to fund fiscal stimulus. Interestingly, that is how the more conservative utility stocks (often held as alternatives to corporate bonds) used to behave.
The direction of travel of long-term government yields tells us something about the collective market expectations for the wider economy. Fears of overheating gripped bond markets in February and early March, when rising corporate bond yields outpaced those of government bonds. But since then, those fears have been replaced by falling costs of finance for corporates while government yields have traded sideways. This latest development is good news for the near-term outlook for investors with the majority of their portfolios invested in global stock markets. It indicates a market expectation of a ‘Goldilocks’ environment for the economy, of just the right balance between growth and the ability of companies to cope with the inevitable gradual rise in yields, as the rise in earnings is expected to outpace the rising cost of finance. This latest development may well be more driven by recent US policy initiatives, rather than the previous ‘end-of-pandemic’ driver of sentiment. The Biden administration has thus far proven to be even more adept in steering the US economy towards a sustained recovery than many (us included) had dared to expect after the chaotic Trump years.
After initially merely stabilising from their previous upward momentum, long-term US government bond yields declined slightly last week. This followed assurances from the US Federal Reserve (Fed) that it firmly expects recovery-driven price rises to be transitory, and should not result in structural inflation pressures to necessitate monetary tightening in the near future. So, we can reasonably expect that the growth/tech section of the stock market will face more headwinds when yields resume their gradual upward trend – in line with the expected upward trend of broader economic activity levels. Perhaps this is a sign for things to come. The growth stocks of the past decades have become so big they can hardly be expected to continue to grow at the same rate as in the past, while at the same time adopting more and more of the subscription-type business propositions that defines utility companies.
Q1 tells the tale of regional differences becoming more evident
As the first quarter drew to a close, markets were clearly eager to pounce on any early ‘vaccine dividend’, as those countries with higher vaccination rates fared much better than those with slow uptake. The FTSE 100’s 5% gain – compared to just 2.5% in Europe – had a lot to do with this, but Britain’s global large cap businesses have also benefitted greatly from the wider cyclical rotation, as UK equities have a distinct exposure to global growth.
Investors are clearly most excited about the US, however, where a rapid vaccine rollout has been complemented by two of the most significant fiscal packages in recent times: A $1.9 trillion recovery act aimed at supporting citizens through the pandemic and a $2.25 trillion infrastructure plan that promises to boost US growth beyond it.
Things appear much less positive in Europe, where the vaccination programme has famously stalled, virus cases are rising, and tighter restrictions are coming into force. The political finger-pointing does not offer much hope, but there are a few bright spots on the horizon, particularly that the vaccination campaign should now finally be gathering speed as large volumes of various vaccines are becoming available. The other one is that the Purchasing Managers’ Indices (PMIs) are showing an improvement in business sentiment on the continent, despite all the bad news. We fully expect the political drama to dissipate as we move through the year – if only as the rate of vaccinations picks up. We suspect this is the low point as far as market expectations for Europe are concerned, which makes the region’s low valuation levels attractive for investors.
Centrist Biden puts global taxation in his sights
In the long run-up to last year’s US election, Joe Biden was seen as the rather uninspiring compromise candidate. He gained the Democratic Party nomination to run against Donald Trump by convincing enough voters that he promised no more than a return to the status quo. But, just a few months in, those expectations look wide of the mark. While pledging $1.9 trillion to see Americans through the COVID pandemic could be labelled as an emergency one-off measure, his latest plans for long-term infrastructure investment and tax reform are something else entirely. Spending more than $1.7 trillion on new infrastructure, clean energy and manufacturing over ten years, would be the biggest public investment programme in the US since the 1960s.
The plans to rejuvenate America’s ailing infrastructure will excite capital markets on the country’s long and short-term future, but what stands out even more is how Biden plans to pay for it – by raising corporate tax rates from 21% to 28%, generating up to $2.5 trillion in extra revenues over the next 15 years. Far from an immediate injection of stimulus to get the economy roaring, the tax and spend plans amount to a significant restructuring of the US public sector, and a vision for redistributing America’s uneven wealth. Judging from price moves last week, markets seem unconvinced that corporate taxes will rise by anything like the Biden proposal. Equity earnings, particularly those for the dominant big tech companies, would be materially affected if those companies were forced to pay out more of their profits – and yet the US stock market hit new all-time highs. Given the delicate political balance in Washington, we are inclined to agree with markets that there will be some compromise on the legislative front. We also suspect some negotiation tactics are in play, with Democrats aiming high before the political process dilutes the final version. In this sense, the corporate tax rate may well go up by less than to 28%.
Even so, higher corporate taxation is a policy with substantial support across the political spectrum and the world. The fact that Biden – the centrist choice – is pushing forward such an ambitious plan tells us everything we need to know about how the tax agenda has changed over the last decade. Yellen wants to not only raise America’s levies; she wants to create a global minimum in the corporate tax rate, and is willing to leverage US political power to do so. Here in the UK, we have already seen politicians – Conservative ones no less – planning a hike in corporate tax, with Chancellor Rishi Sunak explicitly citing Yellen’s plans as justification. Similar conversations are ongoing in the European Union (EU), underlining that this truly is a global movement – and one investors would do well to recognise.