October 14, 2020

Tectonic Shifts in Policy

By Michael McKeown, CFA, CPA - Chief Investment Officer

Tectonic Shifts in Policy

More fiscal stimulus is on the table after over $3 trillion was spent earlier this year. The plugging of the income gap for households and businesses was a key to the swift recovery. While income fell even more than in the 2008 recession, the transfer payments from unemployment benefits helped income to actually rise.

The 12.6 million people unemployed in the latest Employment Situation Report rely on these transfer payments. In turn, these payments lead unemployed households to support businesses with the goods and services they purchase.

The economy continues to improve from the depth of the COVID-19 recession. Unemployment fell from a peak of 14.7% in April to 7.9% in October. This is the same level of unemployment the economy was at the end of 2012, over three years after the last recession ended.

With many of the stabilizing policies set to expire, the Senate race becomes more important. The control of the Senate will determine whether or not the President for the next term will have a helping hand for the next stimulus package.

Currently, Republicans control the senate with 53 seats while Democrats have 47. There are 23 Republican seats up for reelection and 12 on the Democratic side.

It seems unlikely that a fiscal package will be enacted prior to the election. The last week has seen plenty of posturing and discussion of a bill in the $1.6 to $2.4 trillion range. The new baseline for expecting an agreement moves to post-inauguration in February. So far, markets shrugged off the delay.

In the big picture, fiscal policy is set to become more important.  The Federal Reserve pushed monetary policy near the limit.  This includes moving interest rates to zero, asset purchases, and many programs supporting markets. Federal Reserve Chairman Powell’s latest comments essentially said fiscal policy needs to step up and “don’t worry about over doing it.”

Last week, Cleveland Federal Reserve President Loretta Mester stated, “I’ve built a package into my forecast of continued recovery & certainly, the recovery will continue without it, I think. But it’s going to be a much slower recovery and it’s disappointing that we didn’t get a package done.”

This discussion is a major regime change from the past. Previously, Congress and both sides of the aisle were averse to expanding deficits. Though it is clear both sides are willing to expand deficits when in control of the White House.

The recovery was swift thanks to the fiscal action, getting us to an unemployment rate three years faster than following the Great Recession. Americans seeing that this is about willpower to combat recessions, and not ability, it may be difficult to put the fiscal genie back in the bottle in future recessions.

The worry with the shift to a greater emphasis on fiscal policy comes to inflation. Deficits do not lead to inflation, directly. Japan is a clear example. Spending beyond the productive capacity of an economy is the risk. With unemployment so high currently, there are productive resources available that are idle. The ability to change policy as the economic environment dictates will be important in the future.

For bonds, the current environment is keeping yields low. For stocks, it has led to growth outperforming as technology and healthcare sectors have longer dated cash flows, which benefit from low rates. Inflation expectations rising could be a catalyst that changes these trends. Over doing it on fiscal policy in the future would likely lead to inflation turning upwards.

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