Have the U.S. Senate run-off elections challenged our 2021 Outlook?

While the chaos in Washington was certainly one of the most shocking events of last week, it was the results of the special U.S. Senate run-off elections in Georgia that seemed to capture the bulk of the market’s attention. Last Wednesday, it became clear that both Democrats Jon Ossoff and Reverend Raphael Warnock had won their respective special elections for Georgia’s Senate seats, giving Democrats control of the Senate, the House of Representatives and the White House. Note, a thin blue wave has materialized. Today, we want to explain why this matters for markets, though probably not enough to make substantial changes to your portfolios.

Q: First, does the blue wave change the basic contours of our optimistic 2021 outlook?

A: We don’t think so. As a reminder, our 2021 outlook posits that the global economy, supported by coordinated support from central banks and governments, will continue to heal from the pandemic. This process will take time, and as it occurs, consumers and businesses will drive increased spending and investment, building a virtuous cycle that will propel asset prices higher. The results do not change this, and, in fact, could accelerate growth in the near term.

Q: But your outlook was predicated on divided government;.  Ssurely a Democratic majority will impact your view on policy, right?

A: Yes, but a little context is important here. This Democratic majority is one of the slimmest for either party since 1901. This matters a lot, as many of President-elect Biden’s biggest legislative priorities would require 60 votes in the Senate. Because of this, much of the new administration’s priorities will either be very difficult to pass, or would need to be watered down on their way to becoming law. So while we didn’t get the divided government outcome we penciled in as our base case, the very slim nature of the Democratic majority certainly muffles the ability to pass sweeping policy changes.

Q: So what do you expect from policy?

A: First, it seems more likely that additional stimulus could be passed given this outcome. At this juncture, we are assuming another support bill of around $750 billion will be passed sometime between February and early April, as the existing unemployment insurance support will be expiring in March. Democrats will likely use this opportunity to renew unemployment insurance benefits through the summer, provide additional support to state and local governments, and probably include another round of payments to households as well. We believe a package of this size could result in a small boost to U.S. GDP.

We also see potential for a bipartisan infrastructure spending bill, though the timing is uncertain. If an infrastructure bill is passed later in the year, the economic impact of this spending wouldn’t be felt until 2022 and into 2023, as it takes time to get projects up and running. Infrastructure spending would also boost growth, though the potential tax increases tied to greater infrastructure spending would partially offset this.

We urge investors not to overweight the risk of higher taxes as they make investment decisions. While the new administration has proposed raising taxes for wealthy and high-income earning households, as well as for corporations, a major change in tax policy faces significant hurdles given the very slim Democratic majority. We also believe that the economic tailwinds from increased government spending would outweigh the headwinds resulting from slightly higher taxes, resulting in a small net benefit to growth.

This is not just our view – sectors of the market that are traditionally most sensitive to economic growth rallied strongly yesterday after the election results, suggesting the market sees the same growth profile that we do. Indeed, small-cap stocks had their second best day of outperformance vs. the mega-cap tech-heavy NASDAQ in the last ten10 years.

Q: With all this new spending, are you starting to get more nervous about inflation?

A: Nervous isn’t the right word. We will likely see a quicker return to 2% inflation in the U.S., but that should be cheered not feared. With more stimulus and faster economic growth come expectations for higher inflation. Indeed, market-based measures of inflation expectations have risen to their highest level in five years, but still suggest average inflation of only 2% over the next five years.

Remember, the road to inflation is paved with growth, which is good for risk assets. Everyone, including the Fed, is pushing for that. In fact, the thin blue wave probably ensures that we remain in a period of reflation: a healthy rise in expected and realized inflation that benefits equities, real estate and other real assets.

Q: You said interest rates were likely to rise modestly, but would stay near secular lows – do you still believe that?

A: Yes, rates will probably go up a bit more than we expected given more fiscal spending, slightly faster economic growth, and higher inflation. Importantly, the yield curve will also steepen a bit more than we were expecting (meaning longer-term rates will rise more than shorter-term ones).

This is what we saw yesterday: U.S. 10-year Treasury yields are their highest since March, and the yield curve is the steepest since 2017. We still think extended credit (like high yield or select emerging market bonds) are the most attractive parts of the fixed income market, and the reflationary dynamics mentioned above make alternative sources (like real estate and infrastructure) even more compelling as a complement. Inflation-adjusted returns on cash will likely remain negative for a few years, and borrowing seems like it will remain an attractive option.   

Q: Ok, got the bond side. What does this all mean for your equity view? 

A: There are some impacts on our preferred sectors and themes, but not the overall view. We think that stocks will outperform bonds over the next 12 months. We think investors should add to equities, and focus on cyclically exposed sectors and regions (like emerging markets, industrials and materials), and beneficiaries of Democratic policy priorities (green tech and infrastructure). We are also marginally more positive on financials given our expectations for a steeper yield curve. These cyclical exposures should balance long-term secular holdings of stocks tied to megatrends like digital transformation, healthcare innovation and sustainability.

However, we aren’t blind to some headwinds that the thin blue wave does introduce. Given our updated expectations for interest rates, equity valuations may come under pressure sooner (remember, lower interest rates have supported higher equity valuations), and the potential for tax changes could threaten earnings somewhat in 2022.

On balance, we think the global healing process and further fiscal stimulus will outweigh the headwinds and will likely propel equity markets to new highs over the next 12 months.

Q: Will the dollar continue to weaken?

A: We think so. More fiscal spending leads to a quicker global recovery, and a larger government deficit, which should put more downward pressure on the dollar. Higher interest rates in the U.S. could neutralize some of the move as foreign capital is attracted back, but we expect that the net impact of more stimulus is further dollar weakness. This also supports our view that emerging market equities will do well in 2021.

Bottom line: While the thin blue wave is important for some parts of our view, it does not force us to change our overall outlook, or cause us to suggest material changes to portfolios. We still expect the global economy to heal. Investors should still be critical of excess cash. We still believe stocks are likely to beat bonds, and interest rates should remain near secular lows. We continue to focus on our three key themes of finding yield, harnessing megatrends and navigating volatility.

To concludeLastly, last week’s events remind us that there are always new challenges that investors have to face. While we can’t control what happens in markets or politics, we can control how we align portfolios to specific goals, and stay disciplined to achieve those goals in the long term.