Covid-19 Still Biggest Risk
- Note that each subsequent surge in case counts has seen less and less of an economic impact.
- Companies and the economy have broadly learned to cope with the virus, and earnings have been nothing short of spectacular.
- Policy makers are shifting tack with a greater focus on vaccinations, understanding that coexisting with the virus is the likely path forward.
- The private sector is leading the charge as vaccination mandates become more the norm than the exception. This should help those vaccination penetration rates push higher.
Boosters: The risk we do want to highlight is the need for booster shots. If mRNA vaccine efficacy is deteriorating faster than anticipated, the ability to completely win the battle against the virus will become that much harder. And if we assume mutations will remain the norm, this battle becomes even more complex. The strategy going forward will certainly be coexisting if this is the case.
Taper, No Tantrum
Learn Your Liquidity
- Systemic Liquidity – the resources within the banking system that are used to settle inter-bank payments. This system is actively managed by the Fed and is not fungible outside of the banking system in any way. Only the Fed can add or withdraw liquidity from this system.
- Credit Liquidity – the ability of individuals and corporations to increase debt or roll over existing liabilities. Banks create credit and this credit creation is independent of reserves. Our fractional reserves-based system is often misunderstood within this context and often creates confusion with this concept. Sure, banks have regulatory issues that can constrain lending. But if banks want to lend, they will lend. If I have the risk appetite to borrow and you have the risk appetite to lend, credit liquidity will find a way to make this happen – independent of the Fed’s balance sheet or systemic liquidity.
- Transactional Liquidity – the ease with which investors can buy and sell financial assets. This backdrop is often influenced by market structure or regulatory issues. But in the end, the Fed’s balance sheet has little to do with it. This form of liquidity is often pro-cyclical, but ultimately, transactional liquidity is a function of risk appetite from you and me.
Here is one other point to highlight regarding tapering concerns: Chair Powell and the Fed have been very articulate in their forward guidance. Tapering is coming – that has been made crystal clear. The timing and size are still up for debate. But more importantly, they made a concerted effort to de-link the relationship between tapering and interest rate hikes during their Jackson Hole meeting comments. These two events are disconnected and mutually exclusive. The Fed will taper and step back and reassess the economy. Rate hikes will follow accordingly should they be appropriate. Rate hikes matter far more than tapering and the commencement of any hiking cycle is still quite a ways off in the future.
More Demand, Less Supply of Treasuries
Peak Momentum Doesn’t Mean Peak Growth
Government policy-response impulse is certainly fading from a rate of change perspective. China is tightening and the Fed will be tapering. Fiscal tailwinds in almost every country will turn to headwinds in 2022. But while these fiscal tailwinds fade, they are far from over. Note the Child Tax Credit payments, back-to-school spending, rising wages (especially for the cohorts with the strongest marginal propensity to consume), European recovery-fund payments, and infrastructure spending. Add in inventory restocking, an emerging capital expenditure1 (CapEx) cycle, increased vaccination penetration rates, and further progress on the economic reopening, and it’s clear that the impulse may have peaked but it’s far from over. And we remind our readers that all of this US fiscal cliff talk is occurring at a time when the US is effectively operating with a closed output gap. This is a very different economic context from previous cycles, which typically saw slack still in the economy.
Shift from Demand Side to Supply Side?
As we stated earlier, Covid-19 is the new enemy. We are trained to assume a reversion to the mean in terms of past experiences with peak growth. However, this time could very well prove different. We could see a durably higher level of nominal growth.3 Of course, this is certainly not a base case scenario for the markets in 2022. But remember: Corporate America’s earnings performance has been genuinely spectacular for the second quarter. They’ve learned a thing or two in the Covid economy. Never bet against the US consumer. Never bet against the dynamic and flexible US private sector.
A September to Remember?
- September 6 – $300 unemployment benefits expire
- September 13 – Senate returns from break
- September 15 – Committees deadline for input on the $3.5T reconciliation bill
- September 20 – House returns from break
- September 27 – Pelosi commitment to hold a vote on the $1.2T bipartisan infrastructure deal
- September 30 – Fiscal year 2021 ends and a continuing resolution is needed to avoid a government shutdown
- September – Decision on Powell replacement and Fed picks expected
- October – Debt limit needs to be addressed
Congressional approval of the budget resolution has enabled the $3.5T human infrastructure proposal to move forward, but the road ahead will certainly be a slog. The budget resolution is a non-binding one, giving cover to moderate Democrats who voted to support the procedure but who may not support the final act due at the end of the month. With only a four-seat majority there are at least nine moderate House Democrats who won’t support the entire $3.5T package. Complicating the issue even more, the reconciliation bill must also pass the Senate where Senators Manchin and Sinema have made it clear they won’t support the entire $3.5T bill. In addition, when the House calls for a vote on the bipartisan infrastructure package later this month, the Speaker could get some pushback from progressive members of her caucus who have been demanding action on the large package prior to a vote on the bipartisan bill. If the Speaker keeps to her commitment to the moderates, it’s hard to see the progressives tanking a $1T proposal, which represents not only a major step forward for the USA’s crumbling infrastructure, but also what will be a big win for President Biden.
Plenty of political tape bombs could come out of September. And we did not even discuss the debt ceiling and the government shutdown. While we view these two events as headline risk, markets have grown accustomed to the political theater involved with these two issues. With Democrats in charge of Washington, DC (House, Senate and White House), the last thing they need is to be blamed for a default and shutdown of the US government in front of the 2022 midterms. We expect any market-related weakness from a knee-jerk reaction to a headline to prove short-lived. Political gamesmanship is rarely lasting on the markets.
In Summary: Stay the Course
Sure, the ride may be a bit bumpier as we weave through a political battlefield and a world where we need to learn to coexist with a virus that may never leave us. But we don’t find enough evidence to flip bearish risk assets. Stay the course for the rest of the year. It’s all about earnings. Sure, they will ease. They have to. But we don’t see them underwhelming just yet.
2 Earnings per share (EPS) is a company’s net profit divided by the number of common shares it has outstanding.
3 Nominal growth refers to the nominal gross domestic product (GDP) evaluated at current market prices. Nominal differs from real GDP in that it includes changes in prices due to inflation, which reflects the rate of price increases in an economy.
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