A high-pressure growth gamble

Biden administration's mega-stimulus could set off a tug of war between growth and inflation and a churn in the markets

The US has just passed an additional $1.9 trillion fiscal stimulus, taking its total spending to counter the pandemic to $5 trillion. What’s more, it will not stop there. Already there are plans to put in place another large fiscal programme targeting green energy, infrastructure and education. Seemingly unfazed by warnings that the stimulus will cause an overheating of the economy and spur inflation, the Biden administration seems determined to push through it. It has to get the US back to full employment before the midterm elections in 2022, and will do whatever it takes to achieve this. Having learnt from the mistakes Barack Obama made and the subsequent democratic wipeout in 2010, President Joe Biden is determined to not become a lame duck within two years of taking office.

His administration is focused on moving the US economy back into a high-pressure paradigm, where growth is above trend and unemployment below the natural rate. This is where the US economy was in the years before the pandemic, fuelled by the Trump tax cuts. Unemployment was at 3.5 per cent. Advocates for a high-pressure economy point out that this setup is the best possible social programme. With extremely low unemployment, employers are forced to bring in new workers into the labour force and raise wages and invest in skills. It is the best way to improve the income prospects for minorities, low wage earners and women. Before the pandemic, with unemployment at 3.5 per cent, incomes for low wage earners were rising faster than broad wage growth and labour force participation was rising. Making the benefits of a strong economy more inclusive seems to be the number one priority of this administration.

To sustain a high-pressure economy in the US, the Biden administration will utilise hyper-stimulative fiscal policy, till such time as the politics allow. He has to keep his moderate senators aligned. This seems to be a clear policy objective.

If the White House can deliver a high-pressure economy through fiscal support, it is the Federal Reserve that will ultimately determine its sustainability. If the Fed were to hike rates, it is unlikely that high growth will sustain. Till now, Federal Reserve Chairman Jerome Powell has been dovish. He will not hike till end 2023. He has gone out of his way to try and calm markets and fears of early tapering. Mr Powell seems to genuinely believe that the US economy can run hot for a period of time, and that because of structural issues there is a more limited linkage between low unemployment rates and inflation today than has been the case historically. Mr Powell has made comments to this effect as far back as 2015, when he, in fact, disagreed with then Federal Reserve chair Janet Yellen and her decision to raise rates. The performance of the US economy over the last few years has only further strengthened his conviction, as despite unemployment hitting a 50-year low of 3.5 per cent, inflation remained subdued.

The Federal Reserve has given itself more room to maneuver with the change in approach to an average inflation targeting framework. They are looking for inflation to moderately overshoot for an extended period, and only then will they hike. They have also openly said that they will look through the inevitable base effect-driven rise in inflation, which will be visible from March onwards. Given a choice, Mr Powell has no interest in raising rates anytime soon. However, even he will have to react if long-term inflation expectations or average inflation rise above 2 per cent in a sustained manner.

Illustration: Binay Sinha

Whichever way you cut it, this is a bet the Federal Reserve is willing to make. Just because the US economy was able to run with extremely low levels of inflation pre-pandemic does not mean the high-pressure economy paradigm it is entering will lead to a similar benign outcome. The reality is that, as Larry Summers has pointed out, the $1.9 trillion fiscal stimulus far exceeds the gap between potential and actual output and risks triggering an outbreak of inflationary tendencies not seen in a generation. The US economy will grow by more than 6 per cent in 2021. It is the only developed economy, which will end 2022 at a higher level than estimates made before the pandemic struck. We are throwing more gasoline on the flames of growth. This is before even more fiscal stimulus, which is being planned and likely to be rolled out in 2021.

The bond markets will obviously test the Fed and judge its response function. What level will yields be allowed to rise to? Will the Fed resort to yield curve control? Will there be a spike in inflation or expectations? Can the Fed really allow inflation to overshoot but not lose control? Many unanswered questions. Markets will closely observe all incoming data points.

Already this year, yields on the 10-year treasury bond have risen by almost 70 basis points to 1.625 per cent. However, till now, beyond words, the Federal Reserve has not acted as rising yields are not going to short-circuit growth. Even if financial conditions tighten, the economy is strong enough to withstand this. Equity markets have also held steady. It seems likely that yields will push back towards 2 per cent, where they were before the pandemic. The risk is of an overshoot, which will be disorderly and terrible for risk assets and emerging markets in particular.

What is clear is that at the moment bond yields are not going down anytime soon. In a rising yield environment, caused by a strong growth and fears of inflation, markets will face the opposing forces of rising earnings but multiple compression. Markets consolidating, as this tug of war plays out, is par for the course at this stage of the market cycle.

What is clear is that we will continue to see rotations. Value will trump growth, as has been ongoing for the past couple of months. Rising yields are corrosive for growth stocks, which rely disproportionately on future earnings expectations compared to value stocks where a greater proportion of the valuation is accounted for by near-term earnings. The second rotation is between the pandemic losers gaining at the expense of the pandemic winners. As markets factor in a re-opening of the economy as vaccines roll out and infections decline, sectors hurt by the lockdown are gaining.

Both of these rotations have just begun, there is a lot more juice left in this trade. Positioning is still skewed to growth. Markets are stable, but there is a lot of churn internally, with big winners and losers. Stock picking will once again come to the fore as dispersion rises.

The writer is with Amansa Capital