Government Is Getting Bigger. What It Means for the Stock Market.
By Reshma Kapadia
Illustration by Lincoln AgnewFor decades, investors would say they couldn’t fight the Fed—but many took pride in ignoring both ends of Pennsylvania Avenue.
Long-term investors have grown accustomed to dismissing the type of wrangling that played out this week over the debt ceiling and continues with the $1 trillion infrastructure bill and the sweeping $3.5 trillion spending package.
Instead, investors stuck with what they could measure.
But that’s changing as the government is influencing the economy and markets in ways we haven’t seen in generations.
Investors must embrace the new reality: What happens in Washington, D.C., will shape what happens on Wall Street.
Many of this nation’s biggest challenges—pandemic response, slowing growth, crumbling infrastructure, climate change, and wealth inequality—cannot be managed through monetary policy.
Fiscal policy can target systemic issues that influence the economy and enable sustainable growth.
The next few weeks should offer more clarity on just how big government might get.
Most analysts expect the bipartisan infrastructure package to pass, which will help repair the nation’s water facilities, upgrade transportation systems, and improve broadband and make it more accessible.
The bigger question is the fate of the 2,465-page Build Back Better fiscal package that includes an array of provisions: expanded dental and vision benefits for Medicare recipients; drug pricing initiatives; increasing pay for caretakers, including relatives; green energy strategies; and corporate tax increases to pay for much of it.
That package isn’t likely to get through in its current form: Michael Zezas, head of U.S. public policy research at Morgan Stanley, says his base case calls for a smaller deal in the fourth quarter, anywhere from $1.9 trillion to $2.9 trillion over the next decade.
Even this smaller package could boost the deficit by a total of $550 billion to $990 billion over the next five years, he says.
This level of spending and a more active government could mean that investors will have to get used to some inflation, higher interest rates, more volatility, crimped returns, and a reassessment of the companies that emerge as winners and losers.
That’s a lot of change—but there are ways that investors can start thinking about and positioning for these shifts.
“Now, if portfolio managers ignore [government policy], it’s at their peril,” says Joe Amato, chief investment officer of equities at Neuberger Berman.
“We are spending a lot of time with our ear to the ground in Washington and accessing more consultants than we ever did before,” says Sarah Ketterer, CEO of value manager Causeway Capital Management, adding that she is increasingly interested in the concerns that politicians are hearing from their constituents about issues like the burgeoning deficit.
The more investors worry, she reasons, the more it could influence policy.
The recent market volatility is exacerbated by the polarization in government and the magnitude of policy changes—including some of the biggest legislative changes in many years for industries like energy and healthcare.
While the Senate hammered out a deal this week to push the debt-ceiling showdown off to December, there’s still a risk another round of brinkmanship could bring about a U.S. credit-rating downgrade and further rattle markets.
Indeed, the S&P 500 index has fallen as much as 5% since the beginning of September as the dysfunction has grown.
“Making big portfolio changes right now is almost like gambling because the political situation is fluid,” says Jason De Sena Trennert, CEO of Strategas Research Partners.
“There’s a lot of headline risk in the next couple months.”
There’s much more to this paradigm shift than the upcoming spending packages.
“We have had this period of great moderation and liberalization, with low inflation, low macroeconomic volatility, and massive returns, for nearly four decades,” says Joyce Chang, global head of research at J.P. Morgan.
“Now, everyone is questioning if that worked—and rewriting the rule book.”
Some of those new rules call for more targeted fiscal policy to deal with the side effects of years of easy monetary policy, such as income inequality.
Low interest rates have exacerbated inequality, as its benefits accrue primarily to people with financial assets: Just 56% of Americans own stocks and 65% own their homes.
Federal Reserve chief Jerome Powell has said that income inequality is the nation’s biggest challenge in the next decade, and economists such as Larry Summers and Jason Furman say the benefits of higher debt and fiscal deficits incurred to address inequality outweigh the risks, until inflation rises meaningfully.
That view could mean rethinking what level of debt to gross domestic product is acceptable, and the spending could usher in a period of higher inflation that will require investors’ attention.
The government is taking an outsize role in ways beyond spending, as well.
Expect to see efforts designed to tackle healthcare discrimination, student-loan debt, pollution, and a host of other issues next year.
Agencies like the Federal Trade Commission and the Environmental Protection Agency are largely staffed up, according to Beacon Policy Advisors, which indicates where we’ll see the first regulatory push—a potential yellow flag for companies in the crosshairs of antitrust, data-privacy, or environmental issues.
Foreign policy also could have a much bigger impact on markets as the U.S. tries to chart a new course with China, recalibrating a relationship that is crucial to the growth of many U.S. companies and how investors evaluate them.
Investors’ assumptions about things like supply-chain bottlenecks and inventory levels may need to change as both nations endeavor to become less dependent on each other, making supply chains operate less smoothly and historical averages less applicable, Chang says.
It will be a slow reckoning in the markets.
One potential catalyst could be an increase in interest rates: Rates have been so low for so long that many investors have essentially ignored the national debt.
But as interest rates rise, the cost of servicing that debt, now at record lows, will increase dramatically and have a meaningful impact on stocks, says Jean Boivin, head of the BlackRock Investment Institute.
If the 10-year Treasury yield—which recently ticked up to just over 1.5%—crosses 2.5%, he says, servicing the country’s $28 trillion debt burden will return to its historical average of 2% of GDP, up from the tiny fraction it is now.
Even this reversion to the mean will shine a much harsher light on the debt and its potential impact on variables that investors care a lot about: interest rates, inflation, multiples, and margins.
“The policy revolution is real, but it’s still under the surface in its impact,” Boivin says.
“As interest rates start to rise, we will discover fiscal policy as a driver becoming the focus of attention.”
We talked to money managers and strategists to see how they are thinking through this policy revolution, the potential effects they’re bracing for, and how best to prepare portfolios.
Adjust for Inflation
Perhaps the biggest byproduct of current fiscal policy is inflation.
And while economists, strategists, and investors can endlessly debate the minutiae involved in defining inflation, Americans know it when they see it: Dollar Tree (ticker: DLTR) is raising its prices on some items above $1, prices of used cars and trucks were 32% higher in August than they were a year earlier, and workers are discovering bargaining power over wages for certain positions for the first time in years.
Businesses are feeling the pinch, too: The cost of shipping a 40-foot container from Shanghai to New York City has gone from $2,500 a year and a half ago to $20,000 today, while the cost of fuel oil rose 65% in the past year.
“Inflationary pressures are likely to rise because everyone is spending—including the government—and it becomes a self-sustaining cycle,“ says Karen Karniol-Tambour, co-chief investment officer for sustainability, and a member of the investment committee at Bridgewater Associates.
Government spending drives inflation differently, since it is determined by a political process and public interest, rather than by what things cost.
“There usually isn’t a player who doesn’t make decisions based on prices or demand, so now you are adding more fuel to the fire.”
Money managers are closely monitoring fiscal proposals that could lead to more lasting inflation.
It’s not just about how much any given package costs, says Sonal Desai, chief investment officer of Franklin Templeton fixed income.
Investors also need to understand exactly how these packages are structured.
Spending on recurring items like child care or education subsidies, for example, will have a much longer impact than extended unemployment benefits, says Desai, who has long been warning that interest rates are likely headed higher.
Desai is tilting toward shorter-duration bonds like bank loans, and higher-quality high-yield bonds rated single-B.
Another option: inflation-linked bonds, including Treasury inflation-protected securities, or TIPS, whose principal is tied to the consumer-price index.
TIPS have historically been the single-most diversifying asset to equities, Karniol-Tambour says: Stocks do well when growth is rising and inflation is falling; TIPS do well when inflation is rising and growth is slowing.
Manage Volatility
The likelihood of Washington, D.C.–influenced volatility is exacerbated by the fact the S&P 500 is at near-record highs, and any ding to corporate profits could send stocks sliding.
If the Build Back Better package increases corporate tax rates to 25% from 21% and raises the tax rate on foreign income to 15%, it could spark volatility, says David Giroux, manager of the $52 billion T. Rowe Price Capital Appreciation fund (PRWCX).
The tax increase alone, he estimates, will cause a 5% hit to earnings-per-share expectations for the S&P 500, though that would be mitigated by benefits from the spending—ultimately, Giroux expects corporate profits to fall roughly 3%.
Most strategists say a potential tax increase is not yet baked into earnings expectations.
“There could be some October surprises and a correction,” says Neuberger’s Amato.
“You could have not just a repricing on the ‘e’ in the price/earnings ratio, but multiples may pull in because of the combination of a rate hike and tax policy.”
The typical buffers to volatility, like government bonds, may not be as resilient in the face of greater government spending.
While 10-year Treasury note yields have historically fallen some 25% during periods of stock market stress, Boivin, who has recommended underweighting government bonds, notes that they have barely budged recently.
This could mean that government bonds won’t offer the same type of buffer as in the past, especially for investors in bond funds, which can lose money when prices fall, as managers sell existing bonds to purchase higher-yielding ones.
While Amato isn’t bearish, he says that it’s wise to have extra cash and a more defensive portfolio, given the prospect for volatility.
Desai also favors a more balanced approach, and isn’t taking big bets with massive overweight or underweight positions that she had been willing to take in the past.
A longer-term shift that contributes to inflation and volatility could also spark a longer-term “return crisis,” warns J.P. Morgan’s Chang.
The 60% stocks/40% bonds portfolio may not generate the 10% average return that investors are accustomed to, but rather just 3% to 4%.
As a result, Chang recommends that investors consider higher-yielding fixed income, as well as some commodities—both actual commodities and commodity equities.
But instead of precious metals, Chang says that agriculture and livestock, as well as a small amount of energy futures, are good hedges for longer-term inflation risk.
A somewhat contrarian way to reinforce a portfolio is with small stakes in Chinese government bonds.
That might seem like an odd choice, given the debt implosion of property developer China Evergrande Group, and the deteriorating relationship between the U.S. and China.
But Desai stresses that sovereign debt is different from corporate debt: China’s more restrained approach to stimulus in the past 18 months—reflected in its 2.9% yield for 10-year bonds—runs counter to most of the Western world.
Since China hasn’t expanded its deficit as much, Desai says the People’s Bank of China has more fiscal firepower to cushion any sharp downturns.
Plus, a stake in China’s sovereign debt offers a source of diversification as the two countries continue to butt heads.
Rethink International Strategy
It’s not just fiscal policy claiming the attention of fund managers: The reshaping of the U.S.-China relationship means that they need to pay much more attention to foreign policy.
This includes inside-the-Beltway nuances around measures coming out of various federal agencies.
The U.S., for instance, is trying to restrict China’s access to critical technologies through tools like export restrictions and entity lists, which can create ripples for U.S. companies that rely on China as a large customer.
The recognition that the rocky relationship with China needs to be recalibrated is one of the few pockets of bipartisanship in Washington, bolstered by the growing realization that China’s experiment with capitalism really isn’t going to change its political system.
China is imposing strict regulatory measures on its most successful companies, emphasizing social good over profitability, and is moving to become less reliant on an increasingly hostile world.
It’s encouraging its companies to buy locally rather than from U.S. suppliers, for instance.
The Senate already passed sweeping China legislation, and the Biden administration is continuing to review its policy, with a slew of additional measures expected in coming months, largely aimed at bolstering U.S. technology dominance by spending on research and development, and incentives to get companies to reassess far-flung supply chains.
Investors need to understand the political dynamics underpinning the geopolitical chess match between the world’s two largest economies, and think about the ramifications of globalization fraying.
S&P 500 companies have about 5% of direct sales exposure to China, but the ripples could be much more far-reaching.
Correlations between China’s GDP and S&P 500 earnings per share suggest that China’s importance to U.S. companies has gone from zero in 2010 to 90% today, according to a recent note from Bank of America strategist Savita Subramanian.
In fact, she writes that roughly 80% of S&P 500 margin expansion has come from globalization over the past 30 years, as companies have capitalized on things like cheaper labor abroad and supply-chain efficiencies.
T. Rowe’s Giroux worries that companies that get sizable business from China, like Nike (NKE) and Apple (AAPL), could get caught in the crossfire, a reason he doesn’t own companies with sizable exposure to China.
“If you have a three- to five-year time horizon and we see more actions from China that are antibusiness, you have to be more worried that China wants to be less dependent on the West,” he says.
“Multiples haven’t come down for companies that have a lot of exposure—and maybe they should.”
As both nations try to reduce their interdependence, it could raise the cost of trade, add inflationary pressure, and crimp profits.
Globalization has caused geographic diversification among asset classes to lose its edge over the years, but that’s beginning to change: Correlations between the S&P 500 and Chinese stocks recently fell to the lowest level since 2018, says Subramanian.
As the U.S. and China begin to hash out a plan for becoming less tightly integrated, the case for geographic diversification could grow.
BlackRock’s Boivin, for example, says investors need to be more deliberate in allocating to Asia directly, as tensions between the two countries potentially creates different ecosystems.
Consider ESG
Many of the administration’s plans line up nicely with the environmental, social, and governance, or ESG, factors that more investors are embracing.
“The minute that major players like government and business say they care about climate change, it becomes a major force that investors have to understand,” says Bridgewater’s Karniol-Tambour.
“These issues that were never important to investors are now drivers of huge parts of the economy.”
Much of the world is facing some sort of energy shortage crisis.
China was forced to ration electricity, Indian factories and households are grappling with the prospect of power cuts, and much of Europe is bracing for pricey heating bills.
The common thread is energy shortages and higher prices that are largely a byproduct of policy changes, as governments try to shift toward greener energy and energy efficiency, wrote Gavekal Research’s Tom Holland in a recent client note.
If inflation, taxes, and more difficult relations with China depress market multiples, it could help active managers who tend to do better against that backdrop.
More dynamic government policy could also speed up market rotations, which could help active managers, says Olga Bitel, global strategist at William Blair.
Indeed, Causeway’s Ketterer says that her portfolio is filled with companies that can benefit from government priorities, like Siemens (SIE.Germany), with its smart infrastructure, mobility, healthcare, and digital businesses all well positioned.
T. Rowe’s Giroux is looking beyond the most direct beneficiaries of the spending packages, like industrials, which he says already reflect the opportunity from increased spending but have not yet factored in potential costs from, for example, tax increases.
Instead, Giroux sees better opportunities from other beneficiaries of the proposed fiscal packages—like utilities, which could gain from provisions that support wind energy or nuclear merchants, and potentially pass on the less favorable parts of the package, like tax increases, to customers.
Potential winners include Exelon (EXC) and Ameren (AEE), which could benefit from solar and wind provisions in the package.
“You have to be in the weeds,’’ Giroux says.
In Washington this fall, there will be plenty of gardening for everyone.
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