President-elect Joe Biden has made it clear he intends to spend big after his inauguration on Wednesday. But while his US$1.9-trillion American Rescue Plan will nearly certainly help a stuttering U.S. economy, investors may want to be wary of the implications for a stock market that is already priced for perfection.
Mr. Biden’s proposed plan, unveiled Thursday evening, confirmed many of the expectations that had been built into share prices. He wants to send every eligible American a cheque for US$1,400. He also wants to raise unemployment insurance benefits, increase the child tax credit, funnel US$400-billion to virus testing and vaccine distribution and offer aid to cash-strapped state and local governments.
From the perspective of the broad economy, this gusher of spending makes sense. With interest rates at ultra-low levels, governments have strong incentive to borrow, especially if they can use the money to ensure a quicker recovery and prevent households and businesses from suffering long-lasting financial damage.
But the scale of Mr. Biden’s proposals raise concerns about whether they are also helping to inflate a stock-market bubble. If so, the aftermath of the stimulus package could be painful for investors – especially if it eventually leads to higher taxes that wind up pricking the market bubble.
Central banks and governments can lean against runaway financial markets with a combination of higher interest rates and reduced fiscal spending. In this case, though, Washington is doing the opposite: The Federal Reserve is pledging to keep interest rates near zero for a long, long time, while Mr. Biden is promising to shovel huge amounts of stimulus into the system.
The result is a stock market that appears to be in only occasional contact with the real world. This month alone, it has shrugged off Washington insurrections, a presidential impeachment, rising jobless claims and soaring infection counts. Rather than buckling, major market indexes have hit record highs on anticipation of more stimulus ahead.
The market value of U.S. stocks is now at its loftiest level in 20 years when gauged against economic fundamentals such as sales, after-tax profits, replacement value of assets or gross national product, according to calculations by Yardeni Research.
Investors are euphoric. In fact, they are even giddier than they were at the peak of the dot-com bubble in March, 2000, when assessed by Citigroup’s panic/euphoria model for tracking market sentiment.
The anecdotal evidence of investor ebullience is everywhere, Citi strategist Tobias Levkovich notes. He points to the tripling in bitcoin’s price over the past three months as one indicator of speculative fever.
Another is the torrent of money streaming into special purpose acquisition companies, or SPACs. These shell companies sign up investors willing to put their money into yet-to-be-identified businesses. Despite all the obvious risks involved in this highly speculative endeavour, SPACs raised an unprecedented US$83.4-billion last year, according to SPAC Research.
The key question for investors is whether the roaring optimism on display has any solid foundation. Some respected voices insist it does, at least for the most part.
“Despite signs of exuberance in a few markets, we don’t think that we are in the late stages of a bubble in ‘risky’ assets generally,” Capital Economics analysts led by Jonas Goltermann wrote this week.
They argue that most of the market’s exuberance is restricted to a few sectors. Furthermore, they say, the driving force behind higher stock prices is not financial leverage or financial imbalances. Instead, the run-up mainly reflects the lack of investing options.
So long as inflation remains stable and interest rates stay extremely low, most people have no realistic alternative to stocks, Mr. Goltermann’s team asserts. “In fact, we think that the prices and the valuations of risky assets could rise further,” they say.
For more gains to occur, though, a couple of things have to fall into place. For starters, the virus must be contained. Then the economy has to stage a strong recovery.
That is one reason markets have been rising in anticipation of Mr. Biden’s stimulus efforts ever since the Democrats won a pair of upset victories in Georgia’s senatorial elections on Jan. 5 and secured control of Congress. His plan is premised on the belief that the biggest danger lies in attempting to do too little. Rather than risk a grinding, slow-motion recovery, like the one that followed the 2008 financial crisis, his scheme aims to lay the foundation for a quick and vigorous rebound.
This has undeniable appeal. However, there is also no denying the cost involved. In inflation-adjusted terms, Mr. Biden’s plan is nearly twice as large as the 2009 recovery plan passed by the Obama administration in the wake of the financial crisis, notes progressive pundit Matthew Yglesias.
If approved, Mr. Biden’s super-sized rescue scheme would propel the already lofty level of U.S. federal debt to record highs compared with the size of the economy. And his administration’s spending ambitions won’t end there. Mr. Biden’s team has indicated the American Rescue Plan will be followed by an ambitious recovery plan focused on promoting green energy and building infrastructure.
The scale of both these plans will inevitably face opposition in Congress from Republicans, who are sure to rediscover the virtues of fiscal prudence now that Donald Trump’s massive deficits are a thing of the past. Mr. Biden and his fellow Democrats control the Senate by the thinnest of margins and will probably have to whittle back their proposals to get a deal done.
Assuming they succeed, the reaction of the bond market will be crucial. If bond yields surge to reflect the new borrowing binge and possible inflation ahead, investors could stream out of stocks and into fixed-income investments. If so, today’s high-flying share prices could fall back to Earth with a thud.
The prospect of higher taxes to pay for all the spending could also exert a sobering influence. In his speech Thursday, Mr. Biden called on wealthy individuals and companies to pay their “fair share.” To many investors’ ears, his injunction sounded rather ominous. A significant increase in taxes on corporate profits could knock a hole in stock prices.
But questions of who will pay for what still lie well in the future. For now, the Wall Street party is still raging and Washington is picking up the tab. Investors should enjoy the festivities. They should also remember that parties don’t last forever.
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