Will US political backdrop be supportive of risk assets in 2021?

WHILE US President Joe Biden's Democratic Party will hold only a slim majority in Congress, we believe his key policy initiatives will provide a supportive backdrop for risk assets in 2021. After the surprising Democratic wins in Georgia's recent Senate races, Democrats control both chambers of Congress. Although the Senate is split evenly between the Democrat and Republican caucuses, Vice-President Kamala Harris holds the tie-breaking vote, tipping the balance of power to the Democrats. In the House of Representatives, the margin will also be narrow; in fact, the 11-seat Democrat majority is narrowest for either party in two decades.

With Democrats taking control of Congress, the prospects for a large Covid-19 relief package have improved. Just last month, the prospects of a divided Congress, in which the Republicans control the Senate, seemed like the most likely outcome. President Biden has outlined his vision, arguing that Congress needs to pass a US$1.9 trillion package. The plan calls for fresh cheques of up to US$1,400 to be sent to nearly every American and provides a US$400 per week federal supplement to unemployment benefits. Massive fiscal spending packages have previously been supportive of risk assets, as direct payments help boost consumer spending and, in turn, aggregate demand.

President Biden's plan also aims to accelerate vaccine distribution, with the goal of reaching 100 million vaccinations in his first 100 days in office. The vaccination roll-out has thus far been sluggish. As of Jan 20, the day he became president, about 16.5 million Covid-19 vaccines had been administered across the country, far short of the Trump administration's goal of 20 million by the end of 2020. President Biden's proposal targets more Federal involvement to expand vaccinations, testing, and contact tracing - a sharp difference from the Trump administration's preference to leave most decisions up to states.

The success of these efforts will be critical for economic activity at a moment when the Covid-19 situation remains dire. Many countries continue to experience surging case counts, and new Covid-19 mutations are raising questions about vaccine immunity.

VACCINE + STIMULUS

An effective vaccine roll-out coupled with a significant fiscal stimulus package could encourage the beginnings of a new economic expansion. Indeed, inflation expectations have steadily climbed since the November election, with the 10-year breakeven inflation rate recently crossing 2 per cent for the first time since 2018.

And, new economic expansions have historically been great for risk assets. In fact, in looking at the last 10 business cycles dating back to 1950, US equities have returned an average 13 per cent annualised in the first three-year period of a new expansion, while US bonds have returned just 7 per cent annualised.

We would expect this backdrop to be a tailwind for cyclically sensitive assets, such as small-cap and value equities. Both have been consistent laggards in recent years. But markets are forward-looking, and signs of rotation emerged in the fourth quarter as investors focused on the potential for future stimulus and vaccine approvals, lifting small-cap and value stocks. These out-of-favour segments of equity markets are steeply discounted relative to broad equities and appear poised to benefit in a cyclical upswing.

Of course, there are risks to these views. Equity valuations are at or near all-time highs. The Federal Reserve could preemptively spook markets if it signals intent to raise rates too quickly to control inflation. And most importantly, the Biden administration will have little room for error as it inherits the critical challenges of distributing the vaccine to millions of Americans and contending with risks that new virus mutations could present. Despite these risks, we think the US political backdrop will be supportive of risk assets in 2021.

• The writer is investment director, global investment research at Cambridge Associates