by Peter Jones, CFA
Senior Vice President
All eyes were fixated across several facets of policy this week: the U.S. military withdrawal and civilian evacuation in Afghanistan, the much-anticipated bargaining in Congress to pass the budget resolution and lastly Fed Chair Powell’s comments regarding the plans for removing the extraordinary accommodation put in place during the pandemic-induced recession. Most importantly, our hearts go out to the lives lost in the senseless bombings in the Middle East and the families attempting to flee Kabul, living in terror of the reassertion of Taliban rule in Afghanistan. As always, we want to thank the service members overseas for giving their lives to protect our freedoms.
In the face of geopolitical tragedy, the markets continued their steady grind higher, with the S&P 500 now eclipsing 20% gains for the year. A theme we express to our clients every year and reiterate throughout this piece is that the economy drives markets, not politics. Right now, the economy is on very sound footing.
A lot can change in the next 14 months, but the administration’s approach to the withdrawal in Afghanistan, alongside rising inflation and COVID-19 cases has caused President Biden’s approval rating to drop precipitously in recent days. Mid-term elections are typically a referendum on the first two years of the presidency and current approval ratings suggest that Democrats will lose approximately 30 seats in the 2022 elections which would cause House control to flip Republican. However, ultimately it will be the economy that determines the fate of markets, not political control.
Source: Gallup, Strategas Research Partners
There has been consternation over Biden’s proposed $3.5 trillion budget resolution in recent weeks. Namely, Democrats hold very slim majorities in both the House and the Senate and moderate Democrats have been threatening to reject the resolution unless House Speaker Pelosi agrees to vote on the $1.5 trillion bipartisan infrastructure package first. After failing to reach a deal on Monday, Pelosi was able to bargain with moderate holdouts by guaranteeing a vote on the bipartisan infrastructure package by September 27 in exchange for passing the budget resolution in the House. While there are still hurdles in the Senate, every member voted along party lines and as such the resolution passed with a vote of 220-212. Much can be argued about the impact and rationale behind the largest budget (adjusted for inflation) in the last 50 years and the tax increases that come alongside in an economy already growing rapidly, with rising inflation and an already staggering budget deficit. However, once again, it is the economy that determines the fortunes of markets, not policy.
To combat the economic impacts of the pandemic in 2020, the Fed reduced interest rates to zero and initiated a “quantitative easing” program that allows the Fed to purchase $120 billion of fixed income securities each month. Lower rates and quantitative easing are measures used to inflate asset prices, ease the burden of borrowing, and thus stimulate economic activity. As evidenced by the 106% return produced by the S&P 500 since the low of March 23, 2020, stimulus has contributed materially to the economic recovery. Now that the economy is humming along with GDP growth exceeding 6% in both of the first two quarters this year and S&P 500 corporate earnings expected to grow 39% this year, investors have been wondering how and when the Fed will remove accommodation. More importantly, investors are clamoring over the impacts of policy tightening. This morning, Fed Chair Powell indicated that the Fed will likely begin “tapering” asset purchases by the end of this year. Moreover, Powell remarked that interest rate increases are still several quarters away and very unlikely to commence before the end of next year. While these comments are largely in line with consensus expectations, they nonetheless do represent the first stages of removing stimulus. Again, as evidenced by a continued upward trajectory in the markets, investors believe that economic strength can easily withstand a more hawkish policy stance.
In summary, policy dominated the headlines this week but once again markets shrugged off the news and continued to advance. With robust growth in both the economy and corporate earnings, inflation likely peaking and falling unemployment, we continue to believe that this will be a multi-year expansion. That said, with valuations and earnings growth likely to slow in 2022, we believe that asset price appreciation will accrue at a more modest pace for the balance of the year and into next year. We remain “bullish with a small b” towards risk assets. To explain market advances in the face of political clamor, we will draw from renowned political advisor James Carville in saying, “It’s the economy, stupid.”
Takeaways for the Week
It was a wild week politically with the evacuation in Afghanistan, the budget resolution and Fed guidance
The market continues to climb higher, now exceeding 20% for the year
It is the economy, not policy that ultimately determines market fortunes