President Biden is proposing an economic policy that represents a major shift in the role the government plays in driving growth. Biden’s plan, which has been likened to Franklin D. Roosevelt’s “New Deal,” contains two primary initiatives: a $1.9 trillion Coronavirus relief/stimulus package and a $2.3 trillion infrastructure spending plan. To pay for this, Biden is proposing a tax increase on corporations and higher-income earners. By expanding the government’s influence and positioning it at the center of economic activity, Biden’s proposals represent a significant change from the lower-tax, smaller government approaches that have defined U.S. economic policy since the 1980s. Meanwhile, COVID-19 vaccination efforts are accelerating, and states are assessing how they will return to full—or at least increased—economic activity. Some commentaries have described the economic recovery as v-shaped (because of the swift decline and bounce back), while others have deemed it to be k-shaped recovery (because of the divergence in how some classes of people and industries have participated in—or been left behind by—the recovery); some policymakers are pointing to this divergence to justify stronger government economic intervention.
Summary, Q1 2021:
The first three months of the year were defined by a dizzying sequence of events that affected financial markets, including a contested presidential election, a siege of the U.S. Capitol, vaccine roll outs, and an infusion of additional stimulus checks. The economy continued to recover as GDP grew 4.1%, according to the Bureau of Economic Analysis. Manufacturing and services reports continued to show robust growth, and employment improved slightly. Inflation fears rattled bond markets.
Stock markets experienced a style shift as investors moved towards old-economy, cyclical stocks and away from technology stocks. This shift resulted in the Dow Jones Industrial Average outpacing the NASDAQ Composite during the first quarter. Commodity prices have risen, and housing has been very strong, which is typical in an economic recovery. Bond markets have lagged as inflation fears caused 10-year U.S. treasury bond rates to increase.
As investors, we believe that the change in fiscal policy represented by Biden’s spending plans is a meaningful development, to say the least. Biden’s policies mark a dramatic move away from the belief that government is inherently less efficient than the private sector and that bureaucrats should generally defer to markets—stances that both parties generally agreed with for much of the past four decades. Government spending, which is already at high levels because of previous stimulus efforts and other policies, serves as a drag on economic growth. To further increase spending, the government must raise taxes, something Biden has pledged to do. The question is how much can tax rates increase before significantly impairing the economy’s growth potential? We would prefer to see a self-sufficient economy rather than one dependent on government intervention.
The Federal Reserve is enacting an “easy” monetary policy to support the economic recovery by keeping interest rates low and increasing the money supply. While these efforts have contributed to inflation fears among investors, Fed policymakers feel that inflation risks are well under control. Rising inflation decreases the value of future corporate earnings, which can hurt stock market returns. The dual threats of rising inflation and higher corporate tax rates can create a significant headwind for stocks.
Corporate earnings and overall economic activity will have to grow at a faster rate to pay for the proposed increases in government spending. Growth may be sufficient to keep up with government spending in the near term; the reopening of the economy as vaccinations are distributed should lead to record hiring in 2021. This, combined with the infusion of stimulus money, should lead to robust economic growth this year. But longer-term, it will be increasingly challenging for the economy to keep up with the proposed pace of government spending increases. That is why we are closely watching to see which aspects of Biden’s proposed infrastructure and stimulus plans become law.
Until next quarter,
-Leelyn Smith’s Investment Committee
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