As you would expect post-election, I’ve been getting lots of questions about the economy and the markets. To help investors, I’ve put together my thoughts on the outlook for the economy and markets. While reviewing the list, keep in mind that all crystal balls are cloudy, including mine. The list is based on the assumption that while the Democrats will hold the White House and the House of Representatives, the Republicans will hold the Senate, but only if they win at least one of the two Georgia seats in the January runoff election. All bets are off if Democrats hold all three branches of power. Following is my assessment of what to expect:
There will be no big tax increases. Some compromise is possible due to deficits and the need for fiscal stimulus. This benefits equities, which would have been hit by a large corporate tax increase in the event of a Democratic sweep. There will be no Green New Deal. There will be a stimulus deal, but not as large as Democrats proposed. Less fiscal stimulus means the Fed will have to do more. Fiscal stimulus helps growth, corporate earnings and creates some upward pressure on inflation. We have had record fiscal stimulus all around the globe, and that will continue. The budget deficit likely will approach the $2.5 to $3 trillion range in 2021 (estimated 12-15 percent of GNP), pushing the net debt to GNP ratio to over 100 percent and putting us on pace to exceed the levels reached during WWII. The level of debt is manageable in the short term due to near-zero financing costs and weak demand. However, if/when the economy strengthens and/or inflation rises, a rise in interest rates would create the need to raise taxes and/or cut spending, as the increased costs would not be sustainable because they would crowd out investment.
Total U.S. debt will approach $30 trillion in 2021. Thus, even a modest 2 percent rise in rates (which would leave the 10-year Treasury at about 3 percent) would increase the budget deficit by $600 billion. Research by the World Bank found that such high levels of debt create drags on economic growth. The Fed will be under pressure to keep buying bonds and keep rates low for a long time. Financial suppression will continue. That creates a positive tailwind for stocks and helps finance deficits, at least in the short term. Equity valuations could remain elevated. They might also keep a tailwind for growth stocks, which are longer-duration assets. On the other hand, the Pfizer (NYSE:PFE) vaccine and the Eli Lilly (NYSE:LLY) antibody treatment becoming available could lead to faster opening of the economy, reducing the risks to value stocks and leading to a factor inversion with value outperforming (value-to-growth spreads are at historic levels favoring value).
On other hand, the dramatic increase in coronavirus cases could lead to a further shutdown of the economy. Investors will keep searching for yield, especially those who use a cash flow, instead of a total return, approach. An easier Fed policy will put downward pressure on the dollar, which helps international equities and especially emerging markets (they have U.S. dollar-denominated credit). More money will be spent on infrastructure, with the likely focus on broadband access for social policy reasons – every household needs access and COVID increased the urgency with schooling issues. But there’s also a massive need for rebuilding roads and bridges, which can now be financed at record low rates. Trade tensions with all partners, not just China, will be reduced. That reduces tail risks in stocks from that source. Corporate profits will likely rebound faster than most expect due to large spending cuts that won’t come back as quickly as revenue. And companies will utilize productivity gains they learned during the COVID crisis. While there won’t be the big legislative changes we would have if Democrats control all the branches of power, we can expect lots of regulatory changes, such as elimination of fracking on government lands and restoration of CAFE mileage standards.
An increased regulatory environment is not good for business profits or economic growth. There will be small changes to health care, such as the government negotiating drug prices. Immigration will increase, which is good for economic growth (which stems from population growth and productivity). This might offset the drag from regulatory tightening. Energy independence will continue. It is a big deal for foreign policy reasons and it has kept U.S. energy costs down, helping U.S. companies be more competitive. Thus, there are risks here under a Biden administration. Credit spreads have widened in a flight to quality and the liquidity premium widened, making investments such as Stone Ridge Alternative Lending Risk Fund (MUTF:LENDX) and Cliffwater Corporate Lending Fund (MUTF:CCLFX) attractive, as they have large risk premiums and very limited inflation risk (LENDX duration is just over one year and CCLFX is all floating-rate debt, with floors on LIBOR in most cases).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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