United States

Our Tesla-dominated S&P automobiles & components underweight is currently on fire (no pun intended) generating 34% in relative returns in just over a month. While our original rationale for the underweight exposure in this sub-sector remains intact, such impressive gains are forcing our hand to institute a 5% rolling stop as a portfolio management tool in order to protect profits. As a reminder, Tesla remains a mania stock that is due for a normalization phase especially given the melt up in the US 10-year Treasury yield that is weighing on still parabolic forward multiples, at the same time as new competitors are entering its end-demand market. Bottom Line: Institute a 5% rolling stop in the S&P automobiles & components index. The ticker symbols for the stocks in this index are: BLBG: S5AUCO – TSLA, GM, F, APTV, BWA. ​​​​​​​

Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries.   In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward.   Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights The Senate will pass the $1.9 trillion American Rescue Plan largely as it stands. Markets will now turn to Biden’s second major reconciliation bill for FY2022 – the one with tax hikes. Democrats will go forward with tax hikes on corporations and the wealthy. But they will spend more than they tax for fear of squandering their term in power. Tax hikes threaten sectors like tech that already face headwinds from rising bond yields. The health sector is also at risk. Stick with cyclicals and value plays.  Feature Markets have seesawed as volatility spikes in the face of rapidly rising bond yields. Value stocks such as financials stand to benefit relative to growth stocks as the market comes to grips with the first hint of normal inflation expectations since 2019 (Chart 1). Underlying the trend is a sea change in US fiscal policy. Chart 1Value Stocks To Reignite On Rising Bond Yields The House of Representatives passed the $1.9 trillion American Rescue Plan so it will now go to the Senate for revision, back to the House for approval, and then to President Biden’s desk by around March 14. Investors will now turn to Biden’s second major legislative act prior to the 2022 midterm election cycle: the fiscal year 2022 budget reconciliation process. Before we outline the time frame and tax hikes that that process will entail, we should take a moment to review the current bill. Senate Will Pass American Rescue Plan Largely As Is The House version of the $1.9 trillion American Rescue Plan contains $1,400 household rebates, direct checks via the Internal Revenue Service, for people who make less than $75,000 per year (double those numbers for married couples). Unemployment benefits are supposed to rise from $300 to $400 per week for 73 weeks instead of 50 weeks, with an expiration on August 29 instead of March 14. Those with children or other dependents will receive additional payments. The bill also includes $75 billion for fighting COVID-19, $350 billion for state and local governments, $170 billion for schools and universities, $225 billion for small business, $38 billion for the airline industry and various other tax benefits for families and workers.1 Those who have been let go from their jobs can more easily retain their previous health insurance. Chart 2 provides a visual comparison of the American Rescue Plan with the $900 billion in fiscal relief passed at the end of 2020 prior to House passage and Senate revision. Already the Senate version excludes a hike to the minimum wage, from $7.25 to $15 per hour, as the Senate parliamentarian ruled that does not qualify under the “Byrd rule” because it does not directly impact spending or taxation.2 Vice President Kamala Harris, who is also president of the Senate, could reverse this decision but otherwise the minimum wage will have to be considered in a separate bill later. Chart 2American Rescue Plan The Senate could pare back other aspects of the bill – such as state and local aid, given that local government revenues are in much better shape than expected. Chart 2 highlights that the state and local aid component is much larger this time around. Still, the purpose of Senate negotiations is to secure the votes of moderate Democrats, as winning over 10 Republicans is no longer feasible, and moderate senators are not going to sink the first legislative proposal of a president of their own party. The Senate is virtually guaranteed to pass the bill, likely by March 14 when current unemployment benefits expire. The bill’s economic impact will be to speed the vaccination process and provide another infusion of cash into households and various public institutions. Families are just starting to receive the last round of benefits passed in December and they had not exhausted the 14% year-on-year increase in real income that they saw as a result of last year’s CARES Act when the Coronavirus Response and Relief Act sent incomes soaring yet again (Chart 3). Economic growth will be supercharged as economic activity normalizes, consumer confidence recovers, and the service sector revives. Chart 3Washington Lavishes Households With Dole Biden’s Second Bill Will Pass This Fall The second budget reconciliation procedure, for fiscal year 2022, will begin in mid-April. The formal deadline to adopt a budget resolution is April 15 but the average delay would put the resolution in June.3 The maximum delay would see the resolution passed in October but that is unlikely in today’s context (Diagram 1). After the resolution passes, the House and Senate must reconcile their budgets, pass the same bill, and send it to the president for his signature.  Diagram 1Timeline Of Biden Administration’s Second Budget Reconciliation, FY2022 The average time between Congress adopting a budget resolution and the president signing a reconciliation bill into law is 150 days, putting completion on September 15, 2021. This period could easily extend to November. In the worst-case, judging by history, Democrats could fail to conclude the process until October 2022 – but that is highly unlikely. A delay till December of this year would be a fumble, but a more realistic fumble, say if moderate Democrats must be won over due to controversial provisions. The second reconciliation bill is supposed to consist of investments over a ten-year period rather than emergency relief for the lingering pandemic and economic recovery. Biden’s proposed $2-$3 trillion green infrastructure program is the highlight but we also expect Democrats to prioritize their health care plan, which is estimated to cost $1.7-$1.9 trillion. Hence $4 trillion is a reasonable expectation for new spending but in this case the headline spending figure will be at least partially defrayed by tax hikes, unlike the first reconciliation bill (Charts 4A & 4B). If Biden raises taxes by half as much as he intends, the full price tag would be $2 trillion. Chart 4ABiden Will Spend, Then Tax Chart 4BBiden Will Spend, Then Tax The precise contours of this bill will remain unknown until Biden presents an outline in April and the House of Representatives drafts a resolution. We test six different scenarios involving different assumptions about Biden’s tax-and-spend proposals, highlighted in Table 1. Generally, we assume that Democrats will much more readily compromise tax hikes rather than spending, given that they want to err on the side of firing up the economic recovery. They are just as capable as Republicans were in 2017 of manipulating the numbers when it comes to the reconciliation requirement that the budget deficit not increase beyond a ten-year time period. Table 1Scenarios For Biden’s Second Reconciliation Bill The results are broken down in terms of revenue, expenditure, and net interest costs in Chart 5. The baseline is Biden’s campaign proposal. Scenario 1 assumes that Biden gets all of the spending he wants but is forced to compromise on tax hikes. Scenario 2 is more realistic as it assumes that Biden gets half of what he wants on both spending and taxes. Scenarios 3-6 examine what would happen if Biden were forced to strike out either his green infrastructure plan or his health and social security plan, depending on different revenue assumptions. In Scenarios 5 and 6 we grant Biden only half of his proposed taxes on corporations and wealthy folks, leaving other tax proposals to the side – otherwise the result would be a net tightening of fiscal conditions, which is neither intended nor politically possible. Chart 5Scenarios For Biden’s Second Reconciliation Bill The impact on the budget deficit in each scenario is shown in Chart 6. The greatest economic stimulus would occur under Scenario 1, which would soon become a problem for investors as it would hasten inflation and rising interest rates. Chart 6Deficit Scenarios For Biden’s Second Reconciliation Bill Scenario 2 is the most realistic policy scenario while being the least inflationary. By contrast, Scenario 4 is realistic but hardly less inflationary than the baseline case. In each of these scenarios it is important to bear in mind that the new government programs would be administered over a ten-year period and therefore the increase to the budget deficit would be more gradual than is the case of the American Rescue Plan, which clearly aims to be disbursed in the first few years. In the case of the Obama administration’s American Recovery and Reinvestment Act (2009) the peak in spending occurred in 2013, four years after the bill was passed (analogous to 2025 today) (Chart 7). Infrastructure and green energy projects are also expected to increase productivity and hence potential growth. Chart 7Infrastructure Spending Could Peak Four Years After Bill’s Passage, As In 2009-13 The Byrd rule will become even more important with Biden’s second reconciliation bill because the bill will contain a mishmash of Biden’s campaign proposals. Democrats will try to pass as much of their agenda via fast track as possible so as to meet promises ahead of the 2022 midterm election. An advantage of health care spending is that it is unlikely to be struck down by the Senate parliamentarian given that the Obama administration relied on reconciliation to pass a critical second installment to the Affordable Care Act (Obamacare). Biden’s health care plan is more popular than climate change policy, with both the general public and moderate Democrats, and it is guaranteed to pass reconciliation. Infrastructure spending faces greater challenges under reconciliation but they are not insurmountable. Infrastructure is normally handled via the traditional budget process or the Highway Trust Fund and some measures are likely to run afoul of the Byrd rule. Still, workarounds can be found.4  Hence the infrastructure plan is likely to be compromised but not prohibited due to technicalities. Even if infrastructure fails to make it into reconciliation, Biden can use the deadline to top up the exhausted Highway Trust Fund or to reauthorize the Surface Transportation Act as alternative pathways. It is not impossible to get Republican cooperation on infrastructure though the green agenda will meet resistance. The reconciliation process is nominally forbidden from increasing the budget deficit beyond ten years. Short-term spending is exempt, as is the case with the American Rescue Plan and its crisis-response measures, but the purpose of the second reconciliation bill is to invest in long-term, productivity-enhancing programs. A new government health insurance option and/or a green infrastructure buildout will take many years to implement and could increase deficits beyond the ten-year window. But Democrats, like Republicans, will be able to use accounting chicanery and gimmicks to make the budget outlook serve their purposes in passing the legislation. As long as they keep moderate members of the party on their side.   Yes, Taxes Will Go Up … But That May Not Be All Bad For Markets Why should Democrats raise taxes at all? Why not focus on stimulus without taking on the political risk of higher taxes? After all, Republicans passed tax cuts via reconciliation without offsetting them by spending cuts. Was it not the higher taxes in Obamacare that greatly fueled resistance from Republicans and their victory in the House of Representatives in 2010? First, on the level of intentions, the Democrats clearly seek to increase taxes on corporations, high-income earners, and capital gains: Both Biden and Harris said they would raise taxes on the campaign trail and in the presidential debates despite the risk to their election prospects. Biden committed only to prevent tax hikes on those making less than $400,000 per year. Harris’s weakest moment in her debate with Mike Pence was her insistence that she would raise taxes but she stuck to her guns. Both factions of the Democratic Party want to raise taxes. Traditional Democrats view tax hikes as a way of paying for a larger government role in addressing social and economic imbalances. Populists view tax hikes as a way of redistributing from the ultra-rich. While budget deficits are not a general concern, combating inequality is a theme shared across the party. Second, on the level of capability, Democrats can get at least some of the tax increases that they want: The US is not overtaxed on the whole. True, Biden’s full tax agenda would push the US back up to the top of the OECD countries in terms of the corporate tax if an “integrated” view of both firm-level taxes and taxes on dividends and capital gains (Chart 8). But this point suggests that Biden will moderate his tax plan rather than abandon it altogether. Popular opinion did not favor Trump for cutting corporate taxes. Chart 8Biden’s Corporate Tax Proposal Would Make US An Outlier Again The macroeconomic impact of raising taxes is manageable in the context of the extraordinary fiscal stimulus that the US is passing. There is no clear relationship between tax rates and economic growth but it is natural for the Democrats to fear that they could squander their term in power by excessive fiscal tightening. Yet the negative economic impact of raising the corporate rate is only 0.8% of GDP over the long run, and half of that if the corporate rate is raised only halfway to what Biden intends (25% instead of 28%) (Table 2), according to the conservative-leaning Tax Policy Foundation. Table 2Economic Impact Of Corporate Tax Not Dramatic President Biden has the political capital early in his term to revise the Trump tax cuts according to Democratic prerogatives. His popularity will not hold up for long (Chart 9). And he only just has enough legislative power. While household sentiment is weak and economic conditions are moderate, both are set to improve as the pandemic fades and fiscal stimulus takes effect (Table 3). While tax hikes will embolden Republican opposition and the Democrats will have lost their chance to affect the tax code if Republicans win in 2022. At the moment, Republicans are divided and unpopular, so Democrats have a window of opportunity (Chart 10). Chart 9Thesis, Antithesis, Synthesis? Chart 10Independents Up, Republicans Down Table 3Political Capital Index While Democrats could chuck all the Senate rules out the window in order to pass their spending plans without any offsets, this would anger moderates who tend to uphold Senate rules and norms. The party cannot afford to lose a single vote from their caucus in the Senate. Yet moderate Democrats are not against tax increases in principle. What they would oppose is either excessive tax hikes or a fiscal spending bonanza without any revenue offsets at all.5  It is entirely feasible to back-load tax increases so that they take effect in the latter half of the ten-year budget window, especially after the 2024 election. Treasury Secretary Janet Yellen is advising precisely this course of action and has herself argued that corporate tax hikes will go through.6 There may be some risk that Democrats go full left-wing populist and abandon any semblance of fiscal responsibility so as to supercharge the economy. So far they have agreed to maintain the Senate filibuster and scrap the minimum wage hike but this acceptance of Senate norms may not last as pressure builds. The second reconciliation bill is the last chance to fast-track major initiatives before the midterm. Vice President Harris could overrule the Senate parliamentarian across the board. This scenario is unlikely. The White House and Congress will find a balance that raises some revenue but errs on the fiscally accommodative side, as our scenarios above highlight. Investment Takeaways The market’s concern is that the Democrats will “overdo” the fiscal response and we fully share this concern. The American Rescue Plan alone will plug the output gap by almost three times more than the amount required. The coming tax hikes will not offset the wave of new spending that is coming down the pike. Democrats will partially reverse Trump’s tax cuts in the context of additional pump-priming that constitutes a net increase to the budget deficit. The net effect is inflationary.   If Congress were to pass another $2 trillion bill without any substantial revenue offsets then the market would face an even bigger inflationary jolt and an even earlier return to rate hikes by the Fed. But this scenario is unlikely. So the inflationary risk is clear but investors need not panic in the short run.  Our infrastructure trade is back on track as the reflation trade rumbles onward (Chart 11). The Democrats will get at least one more major bill passed and it will likely include at least half of Biden’s agenda, including around $2 trillion on green infrastructure. We will discuss the renewable energy portion at length in a forthcoming report. The health care sector faces headwinds from both Biden’s health policies and corporate tax hikes. The sectors that stand to benefit the most from a higher corporate tax rate are those that benefited least from Trump’s Tax Cut and Jobs Act – namely energy, industrials, materials, and financials, in that order (Chart 12A). These are also the cyclical plays that we favor in today’s accommodative policy environment. Chart 11Infrastructure Trade Back On Track   Chart 12ACyclicals Outperforming Health Care Chart 12BCyclicals To Outperform Tech? The same cyclical sectors are also trying to make headway against the tech sector, which stands to suffer from higher interest rates as well as higher taxes, including a minimum tax on book earnings, if that part of Biden’s agenda makes it through the negotiations this fall (Chart 12B).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Table A1BPolitical Capital: Household And Business Sentiment Table A1CPolitical Capital: The Economy And Markets Table A2Political Risk Matrix Table A3Biden’s Cabinet Position Appointments Footnotes 1See Jeff Drew, “House passes $1.9 trillion stimulus bill with a variety of small business relief,” and Alistair M. Nevius, “Tax provisions in the American Rescue Plan Act,” February 27, 2021, Journal of Accountancy, journalofaccountancy.com.     2See “The Budget Reconciliation Process: The Senate’s ‘Byrd Rule,’” Congressional Research Service, December 1, 2020, fas.org.            3The current delay centers on whether the Senate will confirm Biden’s appointee for director of the Office of Management and Budget, Neera Tanden, who lost support from key moderate Democrat Joe Manchin. If she does not receive a compensatory Republican vote then Biden will have to appoint someone else and the Senate will have to confirm. Thus the budget resolution could easily be delayed into May or June.       4For the difficulties, see Peter Cohn, “Democrats plan a spending blowout, but hurdles remain,” Roll Call, January 11, 2021, rollcall.com. For workarounds, see Zach Moller and Gabe Horwitz, “Reconciliation: How It Works and How to Use It to Help American Workers Recover,” Third Way, February 1, 2021, thirdway.org. 5See Alexander Bolton, “Democrats hesitant to raise taxes amid pandemic,” The Hill, February 25, 2021, thehill.com. 6See Saleha Mohsin and Christopher Condon, “Yellen Favors Higher Company Tax, Signals Capital Gains Worth a Look”, Bloomberg, February 22, 2021, Bloomberg.com