Part of the current market narrative is that record fiscal spending is becoming engrained in people’s expectations. It is a flirtation with Modern Monetary Theory, which broadly says governments can spend heavily as long as inflation remains contained.
US President Biden’s new infrastructure plan, launched just days after the COVID-19 relief bill had been approved, is the latest development to lure many into thinking this fiscal spending will continue for the foreseeable future. This in turn drives up prices and short-term inflation expectations. We are sceptical, seeing higher inflation as most likely being transitory.
The latest infrastructure plan includes tax hikes as well, which mitigate the positive impact of the fiscal expansion. Moreover, the expected spending benefits are more difficult to quantify than in the previous plan because they are expected to be spread out over eight years.
Overall, we expect the market-level impact of extra stimulus and higher taxes to be relatively small. Our head of economics sees a 1% positive GDP impact next year, with risk to the upside as the tax hikes could be watered down in the usual political horse-trading. Our general assumption is that with a tight majority in Congress, it will be easier to agree on spending than on raising revenues to pay for it.
Indeed, one of the reasons for doubting the return of a prolonged inflationary period is political. The November 2022 midterm US elections are already looming, with all seats in the House and 34 in the Senate up for grabs.
The Democrats have a meagre nine-seat majority in the House; since the 1950s, the president’s party has tended to lose more than 20 seats during the midterms. The betting odds favour the Republicans to win a House majority, even though Biden’s policies have so far been rather popular.
If the Republicans do win, US fiscal spending will become more complicated; with Donald Trump out of the White House, many Republicans have suddenly rediscovered their hawkish roots. This shouldn’t be a surprise: for the past 45 years, Republicans have done the same thing to every Democrat president.
Alongside these dynamics, we believe the market is entering territory where it will be hard for both nominal yields and inflation breakevens to push much higher without confirmation in the data of a new regime. We are therefore looking to lean against a further rise of US inflation. Moreover, all else equal, the lack of sustained inflationary pressures could mean the economic cycle lasts a bit longer than many expect.
On the latest infrastructure plan, we expect there to be stock winners and losers. This will depend somewhat on the detail, but the general direction seems good for green tech and infrastructure builders, while higher tax rates would in our view be relatively better for sectors like real-estate investment trusts that don’t pay much tax.