Stocks continued to move higher, powered by strong earnings reports.
There is a lot going on today. More earnings reports will continue. But the two big news events will be the conclusion of a two-day FOMC meeting this afternoon and a speech tonight that President Biden will make before Congress outlining yet another huge spending program.
The combination of expansive fiscal and monetary policy is evidencing itself today via powerful economic growth. The Fed will certainly acknowledge that in its statement later today. While Congress has barely begun to dig into the President’s proposed $2.3 trillion infrastructure package, tonight he will propose spending another $1.8 trillion over the next decade to support family needs from low-income support to free community college. Tonight’s proposals are to be paid via a new package of taxes aimed at high net worth individuals and those making over $400,000 per year.
Let’s look at both in more detail.
First, the Fed. No one likes to put the lid back on the cookie jar. With an economy now growing close to a 10% annualized rate, there is little doubt that growth of that magnitude, if perpetuated indefinitely, will lead to overheating and, ultimately, excessive inflation. Some of the stimulus creating today’s growth rates will dissipate over the coming months. There will be no more stimulus checks. Extended unemployment benefits will expire. But Congress is authorizing massive spending with more proposed, and the Fed continues to keep interest rates near zero while buying $120 billion in bonds every month.
That course is unsustainable. Investors want to know when the Fed intends to taper its bond purchases, and when it might have to start raising interest rates.
The Fed has been pretty clear about its game plan. It wants to wait to see “substantial further progress” before beginning to take steps to take its foot off the accelerator. It has strongly suggested that it will announce its game plan several months before implementation. Today, however, is not likely to be the day. The Fed has to acknowledge the pace of economic recovery, it is too strong to ignore. Reporters will try to get Chairman Powell to give hints when tapering will begin in the post-meeting news conference, but he is unlikely to budge today. If he does, it will be a surprise and trigger a quick selloff in both bond and stock prices. He knows that.
But the day of reckoning is coming. It will probably start at the June meeting with some indication of when QE tapering will begin. But not today. Unless he slips. He did slip once or twice early in his term but has learned from experience.
The timing of the President’s speech, after the Fed meeting, is probably no accident. A strong stock market might assuage investors who will have to swallow hard as they listen to the litany of proposed added taxes coming their direction. 40%+ capital gains for those making more than $1 million. Higher top rates for those making more than $400,000. No stepped-up cost basis in estates. Greater IRS scrutiny. Those are just the headlines. The entire proposed $1.8 trillion package is to be paid for over the next decade by added taxes on wealthy Americans.
It sounds painful. But it is a wish list, not a law. If only part (or none) of the $1.8 trillion package (a combination of expenses and tax credits) passes, then the need for all the added taxes is reduced. Of all the proposals, the one that stands out is the proposal to raise taxes on long-term capital gains to over 50% in high tax states like New York and California. One can argue how much of a deterrent higher taxes might be, but it is hard to say that higher taxes would be no deterrent at all. Taxes are a cost, just like labor and raw materials. The capital gains laws gave some deference to long term investors to induce risk investment. In normal times where markets determine bond yields, there are alternatives for risk capital if potential after-tax returns are too low.
The above is not me politicizing, but rather a statement that members in Congress will have to consider before raising taxes so much. While the increase will only impact a small sliver of Americans, that sliver provides an outsized portion of campaign finances. For members of both political parties.
The infrastructure bill proposal is only a few weeks old and already is getting a lot of pushback, particularly for those elements in the package having nothing to do with infrastructure. The 28% proposed corporate tax rate is almost dead on arrival; 25% appears to be the new ceiling, and that might not last. My point is not to equate a wish list with reality.
We are barely more than 100 days into the Biden Presidency. So far, one pandemic relief bill has passed strictly along party lines. While some portion of proposed packages could be passed along party lines down the road, neither the infrastructure bill nor tonight’s proposals will pass that way. Several moderate Democrats simply won’t allow that. Thus, there will have to be some bipartisanship. That means a Republican voice will have to be heard and all pending proposals will be modified to some extent. The devil is in the details to come, but before investors react, we need to see a lot more clarity about what to consider realistically.
With that said, it is fair to assume some spending and some tax changes happen. But in your thinking, start with the less controversial items. Money for roads, bridges, and airports would be high on my list of what survives. On the tax side, a new top bracket for high income earners is more likely to survive than a 60% spike in capital gains for the wealthy. Thus, let’s wait to see the details before taking action. Judging from the way markets have been behaving, that is what most investors are doing.
So far, I have just discussed today’s news. What about the future outlook for stocks and bonds? As we have been saying, the surge in earnings today is the dominating factor driving markets. Hopefully, Mr. Powell won’t slip this afternoon and ruin the party. But the party has to come to an end. In June, he is likely to set a proposed timetable to slowly ease the rate of bond purchases. That tapering may not start until after Labor Day. Future rate increases could be a year or more away. But if the economic surge begins to ignite inflationary pressures, that would rattle investors.
We already see that in the housing market. Restaurants want to reopen but are struggling to find enough help. Pay raises are inevitable. As inflation pressures rise, and the benefits of stimulus slowly fade, the headwinds get stronger and the tailwinds dissipate. What remains unclear is the crossover point. There is no recession on anyone’s horizon, and Covid-19’s negative impact will continue to fade. With that said, year-over-year earnings increases will get tougher later this year. A year from now, comparisons will be formidable. But 2022 estimates are rising and will continue to rise for several more months. The bull market isn’t over. If I use an annualized earnings rate of $250 for the S&P 500 in the fourth quarter of 2022, the P/E on forward earnings would be less than 17x. Stocks aren’t that expensive. That doesn’t mean that there can’t or won’t be a correction at any time. But if there is one, its damage isn’t likely to be either severe or long lasting.
Today, Penelope Cruz is 47. Jay Leno turns 71. Ann-Margret is 80.
James M. Meyer, CFA 610-260-2220