By Michael Zezas, Head of U.S. Public Policy Research at Morgan Stanley
New presidential administration, same investor hand-wringing: what might come out of DC to push financial markets? If you’re struggling to pull some signal from the noise that is lawmakers hedging statements and debating mundanities like ‘budget reconciliation’, you’re not alone. So here are three shortcuts for making sense of the policy debates in DC that will affect markets in 2021.
The rule of two Joes: What’s the difference between an aspirational and enacted policy? In our view it is the difference between those espoused by President Joe Biden and those of Senator Joe Manchin, who along with other senators (i.e., Tester, Sinema, Kelly, Warner) represents the Democratic party’s more centrist cohort. With Democrats in control of the White House and Congress, they can pass a lot of legislation…assuming all 50 Democratic senators can agree on its content. The most progressive and most moderate member must agree, as losing either’s support will tank legislation. We think that the legislative power accrues towards the electorally vulnerable center, then, consistent with historical analogues.
Deficits break deadlocks: Even proposals which appear to have party consensus, like infrastructure and healthcare spending, face a challenge…there’s agreement to spend the money, but not how to finance it. Progressives and moderates appear far apart on their tolerance for tax increases. But we don’t expect that this will prevent policy enactment. Deficits will bridge the gap. Expanding the deficit does not appear to be a political liability, as surveys show that voters may permit such action in exchange for popular policies. This dovetails with the new economic orthodoxy of the party, where progressives’ flirtation with MMT and moderates’ Keynesianism for the moment agree that the US can push deficits further before inflation becomes a challenge. Said differently, we don’t think that Democrats will let tax and deficit disagreements get in the way of their spending agenda.
Boundaries from budget reconciliation: There are plenty of reasons to not expect Democrats to be able to get enough Senate Republican votes for any of their major initiatives to avoid a filibuster. This actually helps to clarify the policy path for investors, as it means viable legislation is only that which can be passed by a simple majority through a workaround called ‘budget reconciliation’. At the risk of oversimplifying, it helps to think about this process as one where legislators can change the numbers on the federal income statement, but not add or subtract any line items. Because of its painstaking process, reconciliation typically can only be executed once per fiscal year. With those boundaries, investors should expect two major pieces of legislation in 2021 with a focus on reconcilable items: stimulus first and then either infrastructure or healthcare after the October start of the next fiscal year.
In our view, one clear takeaway from these rules is that 2021 will be another year of US fiscal expansion: Applying those rules to the plans of the new administration and its allies in Congress, we think you end up with a policy path that is net supportive to US growth in 2021. Fiscal stimulus can likely get done earlier in the year, though the final number after intra-party negotiation (‘the rule of two Joes’) is likely closer to US$1 trillion than the US$1.9 trillion proposal. An infrastructure or healthcare plan can likely follow, but not until later in the year (‘boundaries from budget reconciliation’) and likely with more moderate tax hikes than progressives espouse (‘the rule of two Joes’) that don’t fully cover the spending (‘deficits break deadlocks’).
Importantly, this policy course reinforces the US growth path and outlook for a multi-year bull market, though it does not preclude a near-term correction: As our economists have pointed out, the economy is increasingly on solid footing, with substantial excess household savings ready to be deployed once vaccines enable the normalization of economic behavior later this year. Further fiscal support only underscores that the US economy is accelerating into a new, sustained growth cycle, which should support a multi-year bull market.
Yet this outlook is not without risk to markets, particularly in the short term. As our equity strategy colleagues have pointed out, there are pockets of the market where excessive optimism is priced in, warranting investor caution. US policy issues are one potential catalyst to watch. In the coming weeks, investors could easily conflate banal headlines about legislative negotiation with the more legitimate risk that Democrats are at an impasse on stimulus. Unless such headlines also reference a shift in view among moderate Democrats that improvement in the COVID-19 outlook has mitigated the need for further action, we would fade such confusion and view any related market weakness as an opportunity.
[ZH: translation – despite the record drop in US hospitalizations and plunge in covid cases, expect the fearmongering to only get worse in order to allow the Dems the green light to pass trillions more in stimulus.]