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The Fed, taxes and inflation: How can they disrupt the stock market?

Despite the latest risks, we think growth will prevail. Here’s why.


 

Our Top Market Takeaways for June 18, 2021.

Markets in a minute: Headwinds

Last week, we released our Mid-Year Outlook. In short, we believe that a few more quarters of above-trend growth should continue to push risk assets higher, despite building headwinds from the Federal Reserve’s pivot toward more restrictive policy, inflation and potentially higher taxes. In today’s note, we want to take a look at three things that happened this week that gave us additional information about how strong those headwinds might be.

1. The Federal Reserve meeting on Wednesday marked the start of the pivot toward more restrictive policy.

The big news out of the meeting was that the “dot plot” (an output from the meeting that shows where Federal Open Market Committee members think policy rates will be) showed that the median FOMC member expects policy rates to be 50 basis points (bps) higher by the end of 2023. That marked a big change from its last meeting, when the median member did not expect any changes in policy through the end of 2023. While Fed Chair Jerome Powell tried to downplay the significance of the dot plot, it does suggest that the Fed is thinking about moving toward a more restrictive stance.

 

The markets thought the picture was worth 1,000 words. Yields, especially those in the 5–7 year space, moved materially higher. One of the trends we are watching this summer is five-year real yields, which spiked by almost 20 bps. This is a sign of more restrictive monetary policy on the horizon. Stocks are dealing with some indigestion (the S&P 500 is down ~60 bps on the week, and EM equities are down over 1%), but mega cap tech notably outperformed the market as inflation expectations fell. European shares have also managed to remain near all-time highs.

As always, context is key. The Fed is effectively still engaging in crisis levels of policy support. It is buying $120 billion of Treasury and mortgage-backed securities per month, and policy rates are pinned at zero. But things have changed. The pandemic is receding in the United States, demand is strong, the labor market looks set to recover rapidly through the rest of the year, and persistently higher inflation is a risk. We still expect the Fed to announce a more formal “tapering” process of reducing its purchases of securities later this summer or in the early fall, and to start hiking rates before the end of 2023. The simple way to think about all of this is that the Fed is starting to remove support because the economy doesn’t need as much anymore.

While the pivot to more restrictive policy is certainly a headwind to risk assets (higher rates tend to lead to lower valuations), we do not think it is enough to outweigh the support from strong demand and robust corporate earnings growth. Tapering and eventual higher policy rates will likely be consistent with continued solid economic activity and corporate earnings.

Let’s play out the hypothetical if the Fed is right, just for illustrative purposes. It’s September 2023. The unemployment rate is below 4%, Core PCE inflation is running at a consistent 2.1% pace, and the Fed is set to lift policy rates off zero for the first time since March 2020. It might even hike again in December. What do you think happens to stocks and the economy between now and then?

G r o w t h. 

2. Speaking of inflation, there are more and more signs that we are far from overheating.

There are signs that the global economy is coming off the boil. Commodities from copper (-15% from peak) to lumber (-44%) have corrected materially, and Chinese consumption, industrial production and property sales growth are decelerating. In the United States, the housing market and consumption are still very strong, but the pace of improvement has cooled in recent months.

The labor market is still millions of workers short of pre-pandemic levels, and wage growth has been remarkably stable.

 

To cap it all off, in the aftermath of the Fed meeting, long-term inflation expectations fell. That makes sense. The point of more restrictive monetary policy is to cool down the economy to prevent an overheating. Ten-year inflation expectations fell to around 2.2%, down from a peak of 2.5% earlier this month.

We still expect above-trend growth for the next few quarters, and we should see the concerns of overheating fade.

3. While President Biden was in Europe, Congress kept working on an infrastructure bill.

Negotiations for a bipartisan infrastructure bill continued in Washington, but it still seems like they are far from a breakthrough. The longer the negotiations continue, the higher are the chances of a bipartisan bill passing with a smaller headline spending amount (and less tax hikes). However, our base case is that we get a partisan bill through the reconciliation process that raises taxes on high-income earners and corporations. While taxes are top of mind for many, investors seem to be focused on the prospects for earnings, inflation and interest rates. Taxes are likely heading higher, but not high enough to make us reconsider our preference for stocks over bonds.    

The headwinds to risk assets are real, but we still think the tailwinds will prevail. Our Mid-Year Outlook calls for strong economic growth, robust demand, solid corporate earnings and higher interest rates. For more, please give it a read, watch the webcast, and contact your J.P. Morgan team to hear more about how it relates to your and your family’s plan.

 

 

All market and economic data as of June 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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This website is for informational purposes only, and not an offer, recommendation or solicitation of any product, strategy service or transaction. Any views, strategies or products discussed on this site may not be appropriate or suitable for all individuals and are subject to risks. Prior to making any investment or financial decisions, an investor should seek individualized advice from a personal financial, legal, tax and other professional advisors that take into account all of the particular facts and circumstances of an investor's own situation. 

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