Goldilocks with a side of stimulus, markets roar back to life

The Dow Jones Industrial Average soared to a fresh record on Wednesday, closing the session above 32,000 for the first time. The driver was weaker than expected core inflation in the US, along with news that the US House finally passed a $1.9 trillion coronavirus-relief bill that will see a round of spending and anti-poverty measures get signed into law by President Biden later tonight. Weaker than expected inflation has dampened expectations of a rapid rise in US interest rates, while the passage of President Biden’s stimulus spending package has enhanced the prospects for US growth later this year. The question is, how long will this ‘sweet spot’ last. 

Not too hot, not too cold: the blue chips versus the Nasdaq

Investors like it when the economy is not hot, not too cold. It is the sweet spot for the economic cycle, when growth stocks tend to come into their own. When financial markets are in the sweet spot, we tend to see the staid, more conventional blue chips out-perform the faster-growing more exciting tech stocks. In recent weeks, the Dow has started to outperform the Nasdaq, and we expect this pattern to continue for some time. The ‘not too hot, not too cold’ scenario is beneficial to stocks that react well to stronger growth prospects and even the prospect of rising interest rates in the future are not negative for their prospects, as long as rising rates are not a threat to economic growth. In contrast, the tech sector needs low interest rates to enhance the size of its future cash flows. Discounted future cash flows, which use market-based interest rates, are higher when the interest rate is lower, and the cash flows are lower when the interest rate is higher. To highlight this theme in financial markets, Boeing, the aircraft maker, rose more than 6% today on the back of news that the company had logged a positive order tally for February, despite the coronavirus pandemic and issues with cancellations for orders of the 737 Max and 787. This compares with losses for major US tech stocks, for example Tesla was down 0.82%. Stocks that are sensitive to economic growth, such as Boeing, are likely to do well in an environment where economic prospects are strong. 

Why inflation won’t run out of control 

This sweet spot is reliant on inflation remaining under control. Fears earlier in the year about rampant inflation and higher bond yields and their impact on the economic recovery seem to be overdone. The latest US inflation data for last month shows that annual core inflation, minus food and energy, was 1.3% last month, down from 1.4% in January. Monthly increases were a mere 0.1%; this is hardly the type of inflation increase that will send shivers down the spines of Federal Reserve board members, especially since the Fed has raised the bar for inflation growth by saying that it will allow inflation to overshoot its 2% target in periods of economic recovery. With inflation not a pressing concern, there has been some rolling back of higher interest rate expectations so far this week. This was manifested in lower US bond yields. The 10-year yield has slid back to 1.51% this week, which reinforces our view that 1.6% is a critical level of resistance for 10-year US Treasuries that will not be breached easily. 

Inflation and President Biden’s Covid relief package 

But why are there lower levels of inflation when President Biden’s economic relief package has now been passed, and US job growth is strong? The reason is spare capacity caused by the Covid pandemic. While stellar NFP reports are to be welcomed, the US economy lost 10 million jobs during this pandemic, so it will take many consecutive months of outstanding job creation to fill the gaps that have emerged in the labour market. That is a lot to ask for an economy that was battered by the pandemic. Added to this, President Biden’s massive spending package is so large because it needs to be; states and local government are under extreme pressure, and when the economy still has plenty of slack, as today’s inflation figures suggest, then the cheques that will be mailed out to US taxpayers are not merely designed to boost US debt levels, but they are necessary as a means to try and reduce that spare capacity. 

Will President Biden’s rescue package be inflationary? 

The question is two-fold, is the package inflationary, and will it cause the Fed to start tightening sooner than expected. We do not think so for two reasons. Firstly, the $1,400 mailed out to many Americans could be inflationary, but only in the short term (there’s only so much that $1,400 buys), and some people may save it rather than spend it, particularly if they are not confident about their economic prospects. For example, the last University of Michigan consumer sentiment survey unexpectedly declined due to a fall in sentiment among lower income households. Since people earning low incomes make up a significant proportion of the US labour force, we should listen to them. When they turn sour on their economic future, it is a sure sign that there is spare capacity in the economy, which is 1, not inflationary and 2, signs that the economic recovery could be fragile. 

The second reason is linked to the other elements of the spending package. It will include a hefty child tax credit, more money for schools, vaccination efforts, more money for local government and support for struggling corporate pension plans. This type of spending tends to take some time to take effect, thus we would not expect any inflationary bias from these parts of the spending bill, at least not in the short term. The bill will also include the biggest changes to the Affordable Care Act since 2010. This is a laudable move, it is right and proper that poorer Americans should be able to access healthcare, however, it is not particularly inflationary. Added to this, major expansions to several aid programmes for low-income Americans will be temporary. Also, one of the most inflationary aspects of the proposed package, the rise in the minimum wage to $15 per hour, was dropped from the bill. Economists are expecting this package to help propel US growth to its fastest levels in almost 40 years. While growth of 5.95%, which is expected for this year, could be reached, we shall have to see if the digitization of the US and global economy dampens inflation. Due to the importance of this data going forward, we think economic data could return as one of the key drivers of markets in the weeks and months to come, so make sure that you have your economic calendar handy. 

What to expect from the ECB

Elsewhere, the ECB meets on Thursday. In the build-up to this meeting, there was growing expectation that ECB President Lagarde would have to speak out strongly about rising bond yields. However, bond yields have backed away from their highs this week, as mentioned above, so the pressure may be off. We expect her to call out the EU on their slow rollout of vaccinations and on the slow dispersal of Covid recovery funds to the countries’ most in need in the Eurozone. She is also likely to remind the markets that Eurozone growth prospects are weak and that a double dip recession is likely, after the Eurozone economy contracted in the last quarter of 2020. It is also worth watching the ECB economic projections that will also be released at this meeting. EUR/USD has bounced off of recent lows, and the dollar remains muted, if Lagarde fails to sound too concerned about rising bond yields then $1.20 for this pair could be on the cards. 

Overall, US stock markets are likely to continue to favour the conventional blue chips over the tech darlings in the Nasdaq for the medium term. Added to this, while US Treasury yields may have backed away from recent highs, we think that this is a pause, and the market will attempt to breach the 1.6% level in 10-year Treasury yields in the next few weeks, which could keep tech stocks on the backfoot.