The Outlook: January 2021 Economic Commentary

Democratic sweep

The storming of the US Capitol building by an angry mob of Trump supporters will mean that January 6^th 2021 will forever be remembered as a dark day in American history. However, for investors, the more significant news that day arguably came out of Georgia rather than Washington. Confirmation that the two Democratic candidates had beaten off their Republican rivals in Georgia’s 5^th January Senate election meant that President-elect Joe Biden’s party would now control both the upper and lower house of the US Congress – a Democratic sweep.

Sure enough, the Democrats have only taken the Senate with the slimmest of margins. With both parties effectively holding 50 seats each, the Democrats only control the upper house by dint of the Vice President’s role as tie-breaker. Nevertheless, this significantly improves the chances that President Biden will gain Senate approval for his Cabinet nominees and that key elements of his policy agenda will be enacted.

The first big test will come with Biden’s proposals for an enhanced coronavirus stimulus package. On 14^th January, the President-elect outlined US$1.9 trillion worth of proposals - dubbed the “American Rescue Plan” - which include cash to curb the spread of the virus, support state and local governments, and boost the economy.¹ The plan allocates US$160 billion for vaccination, testing other healthcare investment. In addition, there are several proposals to support households: an additional US$1400 stimulus cheque for most Americans, on top of the US$600 granted in December’s fiscal package; an increase in weekly federal unemployment benefit to US$400; an extension of eviction and foreclosure moratoriums until the end of September; and a doubling in the federal minimum wage to US$15 per hour.

A ‘diluted’ stimulus

With President Biden seeking bi-partisan support for his rescue plan, and therefore requiring the votes of moderates on both sides of the aisle, the package will probably be watered down. Fiscal hawks will no doubt see the US$1400 direct payment as overly-generous, funding state and local governments has always been a contentious issue, and the hike in the minimum wage is also likely to face opposition. Nevertheless, even if President Biden secures just half of what he is seeking, it would amount to a fiscal boost of nearly 5% of GDP.² This, it should be remembered, will come on top of the US$900 billion stimulus agreed by Congress at the end of last year.³

Moreover, in February, President Biden is planning to put forward additional proposals for his “Build Back Better Recovery Plan”. This will make historic investments in infrastructure and manufacturing, innovation, research and development, and clean energy. It is not clear how big this package will be, but prior to the election, Biden’s manifesto outlined plans to spend US$2 trillion in this area over the course of four years.⁴Again, securing congressional backing will be tough. However, there is talk that the Biden administration might use a process known as “budget reconciliation” – under which a simple majority in the Senate is required rather than the 60 votes needed for most legislation - to approve the increase in spending, along with possible tax hikes on businesses and wealthy households.⁵

Stronger growth, higher inflation

The prospect of a splurge in government outlays in the world’s largest economy, mainly funded by debt, is supportive of the broad macroeconomic trends – historically strong global growth, higher inflation and rising bond yields – that we have been pencilling in for 2021 (see our commentary of December 2020).

With high rates of coronavirus infection acting as a continued drag on activity, the swift roll-out of vaccines clearly offers the key to economic normalisation going forward.⁶Increased funding for such programmes and President Biden’s aim of vaccinating 100 million Americans in his first 100 days brings such a prospect closer.⁷  

Another round of stimulus cheques will add further fuel to the burst of pent-up demand that is expected when economies reopen. Estimates suggest that US households have already accumulated around US$1.5 trillion of ‘excess’ savings over and above their pre-pandemic trend, and extra direct payments will add to this total. The extension of enhanced unemployment benefits and limits on evictions should make consumers less fearful, and therefore more inclined to run down precautionary savings balances.

The prospect of a strong economic recovery reinforces the view that inflation will pick up in 2021. Increased infrastructure spending should further support commodity prices, which have already bounced sharply in recent months, not least as the ‘resource-hungry’ Chinese economy has staged a rapid, ‘V-shaped’ recovery.⁸ The recent up-tick in the oil price will also serve to lift headline inflation as the plunge in energy costs witnessed in spring 2020 drops out of annual comparisons.⁹Global supply chain disruption resulting from the pandemic has also put upward pressure on manufacturers’ input prices,¹⁰ and the recent depreciation of the US dollar is also likely to push up import prices going forward.¹¹

Expectations for higher growth and inflation have been reflected in rising yields on US government bonds. In the wake of the Georgia election result, the yield on the benchmark US 10-year bond jumped by around 20 basis points (a basis point is one hundredth of one percentage point) to a 9-month high of 1.15%.¹² Given that bonds prices fall as yields rise, holders of longer-dated US government bonds have experienced capital losses since the beginning of the year.

Fed response is key

A key question for fixed income investors going forward is how the US Federal Reserve (the US central bank, known as the Fed) responds to recent developments. Any imminent withdrawal of monetary stimulus seems highly unlikely. Fed Chairman Jerome Powell has repeatedly called for more fiscal stimulus,¹³ and he has recently pushed back against the idea that Fed policymakers were considering scaling back, or ‘tapering’, their quantitative easing (QE or bond buying) programme.¹⁴

It is worth recalling that the Fed has provided two pieces of forward guidance regarding its main policy instruments. First, it will continue to buy government bonds and mortgage-backed securities at a monthly pace of US$120 billion until “substantial further progress” has been made in achieving its twin goals of maximum employment and price stability. And second, it has signalled the intention to keep its official policy interest rate close to zero until maximum employment has been achieved and “inflation has risen to 2% and is on track to moderately exceed 2% for some time”.¹⁵

Taper tantrum 2.0?

With December’s 6.7% unemployment rate nearly double pre-pandemic levels¹⁶ and core inflation still some way below 2%, the Fed’s conditions for withdrawing stimulus are clearly some way off.¹⁷ However, markets are forward-looking and, in broad terms, the prospect of greater fiscal support implies less need for activism on the monetary policy front. Investors will be well aware of the ‘taper tantrum’ of 2013, when the suggestion by then Fed Chair Ben Bernanke that the Fed would at some stage start tapering its QE purchases caused US bond yields to jump by around 100 basis points.¹⁸ Although an actual tapering might still be some way off, it would be rational for bond investors to start selling down their holdings in anticipation of this occurring. Against the backdrop of elevated levels of debt issuance, this would threaten to put downward pressure on bond prices and further raise yields.

The issue then is whether the Fed, concerned that higher borrowing costs could jeopardise the recovery, would try and counter such a rise in yields, either by increasing its purchases of long-dated bonds, or formally adopting a policy of yield curve control akin to that currently pursued by the Bank of Japan.¹⁹ The jury is still out on this front. But it is a reasonable assumption that, while policymakers might be comfortable with an orderly upward drift in yields, they will be keen to avoid a sharp, potentially disruptive increase.

To be sure, several factors still need to fall in to place for the 2021 reflation narrative to play out: vaccination programmes must be rolled out swiftly and prove successful in establishing herd immunity; meaningful fiscal stimulus must gain congressional approval; and households and businesses must feel confident to go out and spend. However, with the Democrats now in control of both the White House and Congress, this chain of events looks increasingly likely. All in all, recent developments support the view that developed world government bond markets offer poor prospects for positive returns in 2021, and that the US 10-year yield will head towards 1.5% by the end of the year.

19th January 2021