Three market implications of the new policy landscape

This week’s events have illustrated again the major shifts in US policymaking set in motion recently – a more inflation-tolerant Fed, plus fiscal policy that is both more accommodative and more redistributive. Economists at Capital Economics think three possible implications of these shifts for financial markets are worth highlighting.

Combination of re-opening with extremely supportive fiscal and monetary policy to deliver the strongest economic growth since the early 1980s

“We suspect that the new policy mix will lead to a steeper Treasury yield curve, driven by rising long yields. Fed’s commitment to keep rates low as a very strong economic expansion gets going may simply tend to increase expectations for monetary tightening further ahead. In the absence of ECB/BoJ-style direct management of the long end, that would probably cause the curve to steepen.”

“We think that the new policy landscape may help drive further rotation in the stock market, with the factors and sectors hit hardest in the early stages of the pandemic outperforming. Arguably, there is some scope for this rotation to get going again anyway given the rapid pace of vaccination in the US, and the still-large gaps in performance between some of the main beneficiaries and victims of the pandemic since it began.”

“We think that the S&P 500 could rise by less than US nominal GDP over the next few years, unlike over the past few months and most of the 2010s. Biden’s plans for a more redistributive tax system could change that. They might largely reverse the decline of around 10pp in the median effective tax rate paid by S&P 500 firms over the past decade. Meanwhile, the plans to hike capital gains tax for high-income individuals could be an additional headwind for equities more than the overall economy, as could the tougher antitrust legislation floated by both Democrats and Republicans in the Senate. Finally, the already high valuation of the market may look even more stretched if long Treasury yields continue to rise.”

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