Three Key Thoughts:

1. A Blue Breeze Moves In

2. Will Inflation Return?

3. Looking Through the Chaos

A Blue Breeze Moves In

In last quarter’s Thoughts, we called out the possibility of a “Blue Wave” in the November election that could fundamentally change the “lower taxes, less regulation” mantra of the last four years. We can’t really call what has now transpired a Blue Wave – it is more like a Blue Breeze that has descended on Washington DC. In December, stock markets cheered the prospect of a divided government, as it appeared that the Republicans would retain control of the Senate so long as they won at least one of the Georgia Senate run-off elections. However, mishandling of the latest stimulus bill, the President’s bizarre election-related behavior, and an enormous turnout effort by the Democrats allowed them to win both Georgia seats. The resulting 50/50 split gives control to the Democrats as the Vice President can cast the tie-breaking vote, if needed. With this narrowest of margins, the Democrats will be able to control the agenda but compromise will likely be needed on major initiatives.

Surprisingly, stock markets cheered this result as well. However, they did so with a twist as the leadership switched from technology and consumer discretionary stocks to energy and banks. We wonder how long this leadership shift will last under a Biden administration which will undoubtedly be in favor of phasing out fossil fuels and more regulation for the banks and other financial companies.

For right now, the market is focusing on the likelihood of far more stimulus to help the unemployed, small businesses and state and local governments which have been devastated by the pandemic. In addition, the market is expecting the vaccination rollout to accelerate, allowing the economy to reopen somewhat faster than it would on the current pace. Combined with the support of the Federal Reserve (low rates and bond purchases) and the new Treasury Secretary (former Fed chair Janet Yellen), it is clear that stimulus will be the order of the day for some time to come. With this backdrop, we expect the economy to bounce back strongly in the second half of 2021.

Beyond the two main initiatives noted above, we don’t know what the Biden administration’s priorities will be. With the shift in Senate control, it will be much easier to get new cabinet appointees confirmed. So the new administration should be able to articulate its plans relatively soon. We will be particularly interested in tax policy as this has the potential to negatively affect financial markets.

Will Inflation Return?

If there is a dark cloud on the horizon for investors, it is the prospect of higher inflation returning faster than expected (and hoped for, by the Federal Reserve). We have been living in a relatively ideal environment for stocks with earnings growing (at least in several key sectors) and interest rates at extremely low levels. This combination makes high price/earnings ratios tolerable. But if inflation returns – and if inflation expectations and interest rates move higher – then we can expect that stock prices will get marked down harshly. Historically, these kinds of adjustments tend to come quickly as investors who had previously ignored small increases in interest rates suddenly realize that higher rates have a real impact on stock prices.

We believe there is a risk that we could apply too much stimulus to the economy and create an inflation problem where one doesn’t exist today. However, we are far away from that right now, with recovery from the pandemic a huge hill yet to climb.

Looking Through the Chaos

To say that the last twelve months have been chaotic would be a colossal understatement. Yet we sit here with stock markets at all-time highs, seemingly poised to go higher by the day. The recovery in employment from the initial pandemic shock has stalled, the vaccine rollout in going slower than expected and, at least for another week or so, we have chaos in Washington. Stock markets even rose when rioters attacked Congress on January 6th! How do we make sense of this?

Stock market trends are about one simple thing: are the drivers of value (economic growth, earnings, taxes) getting better or worse? If the answer is better, then stock prices go up. If the answer is worse, then prices go down. We see this pattern repeated over and over. Yet it is difficult for us to understand when we see so much chaos in the daily news.

Right now, the markets are seeing progress on vaccine distribution (though slower than we all would like), leading to a reopening of the economy and an unleashing of a great deal of pent-up demand. On the political front, markets are expecting more stimulus, a more rational approach to government and relatively benign tax and regulatory policy. These expectations reinforce the bigger reopening story and make today’s bad news far less important.

Investment Implications

We have long discussed the three themes that have been prevalent for more than a decade now: US stocks over foreign stocks, growth stocks over value stocks and US dollar denominated assets over non-dollar assets. In the fourth quarter, these trends reversed and that reversal has continued into the new year. We will be looking at ways to adjust portfolios if we believe it is warranted. To a great degree, we are already positioned for an international stock turnaround, which is further benefited by dollar weakness.