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Prospective policy changes don’t dent a strong economy

Wells Fargo Investment Institute - August 31, 2021

A step closer to a Federal Reserve tapering announcement


by Luis Alvarado, Investment Strategy Analyst

Federal Reserve (Fed) tapering of its asset purchases does not refer to an outright reduction of its balance sheet, only to a reduction in the pace of its expansion. The Fed’s quantitative easing program has been useful in providing the economy with ample liquidity, and these conditions will remain regardless of a Fed tapering.

Key takeaways

  • We anticipate that further economic recovery — not tapering — will lift bond yields from current levels while supporting rising corporate earnings. Consequently, we prefer equities over fixed income and have reduced fixed-income allocations tactically.
  • However, we believe tapering will not signal imminent rate hikes and, therefore, do not expect tapering to cause a sharp sell-off in bonds.
  • Nevertheless, fixed-income investors who need to generate income should consider credit-oriented asset classes and sectors. We favor selectivity and the use of active managers to control credit risks.

Taper tantrum? Unlikely this time

The Fed has been purchasing $120 billion of securities every month ($80 billion of Treasuries and $40 billion of mortgage-backed securities [MBS]) since July 2020 in an effort to counter the pandemic’s negative economic impact.

However, as it has done in the past, the Fed will begin to slow its rate of purchases (i.e., taper) at some point. Back in 2013, when the Fed announced that it would begin tapering bond purchases, markets sent longer-term bond yields soaring. This event is commonly referred to as the “taper tantrum.” We think a repeat of such an event in this cycle is unlikely. We believe markets have a better understanding now that tapering does not refer to an outright reduction of the Fed’s balance sheet nor to an immediate increase in policy rates, only to a reduction in the pace of its expansion.

Importantly, in the July meeting, the Federal Open Market Committee (FOMC) had a deep conversation about the timing and makeup of a potential tapering of bond buying but evidently made no decisions. Chair Powell acknowledged that some — but not all — participants viewed tapering MBS purchases faster than Treasuries as attractive, so the debate remains active.

Chart 1. Fed balance sheet

Chart 1. Fed balance sheet

Sources: Wells Fargo Investment Institute and Bloomberg as of August 13, 2021. Weekly data from January 2, 2019, to August 13, 2021.

In our opinion, if current economic trends continue, the Fed will most likely make a tapering announcement over the next few months and may even begin to taper asset purchases just before year-end. Our expectations is that tapering will occur proportionately between Treasuries and MBS, probably at a pace of $12 to $15 billion per month with tapering lasting about 8 to 10 months.

Although the state of the economy seems to make a Fed tapering announcement imminent, we anticipate it will be close to one year before the Fed stops increasing the size of its balance sheet. The Federal Reserve Bank of New York projects that the Fed’s balance sheet could peak at $9 trillion by the end of 2022 and remain constant in size through 2025.

Investment implications

We believe that the Fed’s quantitative easing program has been useful in providing the economy with ample liquidity and that these conditions will remain regardless of a Fed tapering. However, banks have not loaned anywhere near all that cash, and there remains a massive amount of excess reserves, which we anticipate makes the economic impact of tapering relatively minor. As long as investors do not view tapering as a signal for earlier-than-expected rate hikes, we do not believe that it will weigh significantly on the economy or cause a sharp sell-off in bonds.

We anticipate that further economic recovery — not tapering — will lift bond yields from current levels while supporting rising corporate earnings. Consequently, we prefer equities over fixed income. Nevertheless, fixed-income investors will continue to need to generate income. The economic recovery should support credit-oriented asset classes and sectors.

We expect strong issuance of corporate bonds to continue along with positive inflows into credit-oriented investments. However, valuations for both investment-grade and high-yield corporate bonds are relatively expensive given the current level of credit spreads compared with the levels we have seen over the past decade. Therefore, while a full benchmark allocation is appropriate, investors should take care not to over-allocate to these asset classes despite the favorable environment.

Preferred securities are another yield-oriented fixed-income sector that could continue to benefit from the sentiment for risk appetite. We favor using active managers in these asset classes as they are better positioned to provide due diligence and assess credit risks.

The Biden administration expands its anticompetition stance


by Michael Taylor, CFA®, Investment Strategy Analyst; Ken Johnson, CFA®, Investment Strategy Analyst

In July, President Biden signed an executive order directing federal agencies to address anticompetition practices across sectors. Yet, this raises questions about the president’s authority over regulators and the agencies’ reach. We believe the courts will likely block certain provisions.

Key takeaways

  • In July, President Biden signed an executive order that aims to broaden the administration’s focus on anticompetition and industry consolidation.
  • The equity sector impacts appear narrow as the provisions should mainly affect subindustries. The potential negative industry impact from prescription-drug price controls is an exception.
  • Likely delays in regulatory legislation and judicial blocks on regulatory directives lead us to regard the economic expansion as a more important factor in sector preferences. Our favored sectors are those we believe most likely to benefit from continued strong economic growth.

Broadening the reach

Last month, President Biden signed an executive order (EO) that aims to broaden the administration’s focus on anticompetitive practices and industry consolidation. The order proposes 72 actions and recommendations across more than a dozen federal agencies that target increased competition in sectors including agriculture, health care, pharmaceuticals, technology, and transportation. The EO does not decree specific policies; rather it encourages regulators to craft strategies for executing the list of proposed actions. In fact, critics contend the EO is a vague outline of recommendations that will likely face legal roadblocks. 

A sweeping order

Promoting market competition has been a key priority for the White House. The administration maintains that industry consolidation has reduced competition, hurting consumers, workers, and small businesses. The EO provisions aim to spur competition in consolidated industries and reinvigorate innovation. Yet, certain obstacles will likely delay such broad edicts. The president’s authority over federal agencies is limited, and implementing antitrust policy is a laborious process stymied by court injunctions and industry blockades.

The order seeks to promote competition and growth across a number of sectors. Its highlights include:

Labor markets — Limits or bans noncompete clauses, occupational licensing requirements, and companies from sharing wage information. These actions complement the proposed Protecting the Right to Organize Act (PRO) that would grant workers unionization and collective-bargaining rights.

Health care — Encourages collaboration among states to promote drug importation and ban pay-for-delay agreements (see sidebar 1). It supports generic drugs and reducing prescription-drug prices.

Transportation — Advocates refunding of baggage and travel fees for unoffered services and requires fee disclosure. It also requires railroad track owners to provide rights of way to passenger trains and limits transport fees for maritime shipping.

Agriculture — Encourages new rules to reduce poultry processers’ pricing leverage over smaller producers. It also advocates new requirements for “Product of USA” meat labeling.

Information technology (IT) — Restores net neutrality rules, requires disclosure of broadband prices and speeds, and limits early termination fees. It also calls for greater scrutiny of IT mergers and data collection.

Banking and finance — Supports updating guidelines for financial mergers and requires banks to permit data portability for customers.

Investment implications  

We believe the EO will usher in changes in regulatory oversight. Antitrust legislation from Congress is another growing possibility, yet likely slow in coming. That said, we expect antitrust legislation to remain a priority for lawmakers ahead of midterm elections.

In reviewing the highlights above, we conclude that the equity sector impacts appear narrow as the provisions should have their main impact at the subindustry level. The Health Care sector is the notable exception because prescription-drug price controls are a significant negative for that industry. Nevertheless, we look for a gradual return of a broad range of health care spending as a potential counterbalancing positive for the sector. We maintain our neutral rating on Health Care and favor holding exposure at a market weight.

For other sectors, we expect little effect from the president’s order on our current tactical guidance over the coming six to 18 months. Congress has other legislative priorities, and the courts will likely block many regulatory agency directives. Consequently, our outlook for strong economic growth is a more important factor in guiding our sector preferences. Specifically, we hold a favorable view of the Communication Services sector along with cyclical sectors oriented to economic expansion, including Energy, Financials, Industrials, and Materials.

The American Rescue Plan’s last hurrah


by Michelle Wan, CFA®, Investment Strategy Analyst; Gary Schlossberg, Global Strategist

The child-care tax credit under the American Rescue Plan pales by comparison to the program’s income payments earlier this year. However, the tax credit likely will have a perceptible effect on spending power of lower-income groups and on the pattern of consumer spending.

Key takeaways

  • Spending from tax credits by lower-income groups likely will be tilted toward groceries, other necessities, and school supplies — good news for retailers in those segments of the market.
  • Moreover, this strength should support the Communications Services sector as well as cyclical U.S. large-cap equity sectors, that is, those sectors that should benefit the most from above-average growth. Those sectors include Financials, Industrials, Energy, and Materials.

The ARP’s final chapter…

What started with a bang is ending with more than just a whimper. The American Rescue Plan (ARP) enacted last March endures through enhanced unemployment insurance benefits in nearly half the states still offering them until their September 6 expiration and in enhanced child-care tax credits distributed to over 35 million households with nearly 61 million children this year and next as cash rather than the usual dollar-for-dollar offset to tax liabilities. Neither program has the dollar clout of the ARP’s lump-sum stimulus payments last March, but they could play a part in supporting consumer-led gains by the economy in a maturing growth cycle.

Policy, Politics & Portfolios: Prospective policy changes don’t dent a strong economy

Source: https://www.whitehouse.gov/child-tax-credit/.

…and what it means for the economy

The $110 billion in child-care tax credits pales next to last March’s $400 billion in direct income payments both because of the size and distribution of payments into next year. If the estimated $15.4 billion in monthly child-care payments is divided equally between savings, spending, and debt reduction, as they were for the ARP’s direct income payments, monthly spending of about $5 billion would be equivalent to 0.4% of total consumption this year. That’s material but less than half the estimated 0.9% lift to spending from front-loaded income payments by the government last March. The good news is that coverage has been expanded by more people signing up for the program between July and August than the estimated 1.6 million households opting out of monthly payments because of concern over the credit’s potential tax liability.

Child-care tax credits skewed to a greater extent toward lower-income groups likely mean that a larger share of the payments will be spent rather than saved. That plus the moderate size of the monthly tax-credit payments help explain the disproportionate share of planned spending on school supplies, paying monthly bills, and buying groceries and other necessities, according to Bloomberg estimates based on a Stash.com survey of how consumers planned to use the child-care funds. We view this as good news for retailers, particularly if the back-to-school selling season — second only to Christmas in holiday sales — isn’t affected materially by disruptions from the delta variant.

More generally, we believe that ARP’s unemployment benefits and child-care credits will help support consumer spending and business investment to drive the economy through 2022, providing a backdrop favoring stocks over bonds. What’s more, with help from these programs, the economy’s reopening should manage a pace significantly above its historical average. In turn, this strength should support the Communications Services sector as well as cyclical U.S. large-cap equity sectors, that is, those that should benefit the most from above-average growth. Those sectors include Financials, Industrials, Energy, and Materials.

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