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Policy, Politics & Portfolios

Updates and analysis from Wells Fargo Investment Institute on what federal budget, regulatory, and trade decisions could mean for investors.

 

A step closer to a Federal Reserve tapering announcement

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

During the taper tantrum, 10-year Treasury yields increased by more than 100 basis points between May 10 and September 10, 2013. Source: Wells Fargo Investment Institute and Bloomberg, August 13, 2021. The Fed currently owns 24% of the Treasury market and 31% of the MBS Index. Source: Wells Fargo Investment Institute and Bloomberg, August 13, 2021.

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 sheetChart 1. Fed balance sheetSources: 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 2025.1

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

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

“Pay for delay” agreements block generic-drug competition, inflating prices and costing U.S. consumers $3.5 billion per year. Source: https://www.ftc.gov/news-events/media-resources/mergers-competition/pay-delay, “Pay for Delay: When Drug Companies Agree Not to Compete,” April 13, 2021. Higher prices and lower wages due to industry consolidation are estimated to cost U.S. households $5,000 annually. Source: www.whitehouse.gov, “Fact Sheet: Executive Order on Promoting Competition in the American Economy,” July 9, 2021. Today, nearly 30% of U.S. jobs require a license, up from 5% in the 1950s. Source: www.whitehouse.gov, “Fact Sheet: Executive Order on Promoting Competition in the American Economy,” July 9, 2021.

Last month, President Biden signed an executive order (EO) that aims to broaden the administration’s focus on anticompetitive practices and industry consolidation.2 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:3

  • 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.4 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

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…

Coverage of the expanded child-care tax credit rose to over 35 million households and nearly 61 million children by the time the second monthly check was disbursed in August.  Source: “More Households Receive Child Tax Credit Payments,” The Wall Street Journal, August 13, 2021. Lower-income households will benefit more now than in the past from a “fully refundable” tax credit.  Source: “Biden’s Child Poverty Plan Will Be Great, If It Works,” Bloomberg Financial News, July 19, 2021. The child tax credit is set to lift consumer spending by a not immaterial $5 billion monthly during the balance of the year.

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.5 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.

A closer look at the expanded child tax credit

  • A temporary increase in the credit from the existing $2,000 per child under 17 to $3,000 for each child aged six to 17 and to $3,600 for a child under six years of age.
  • A disbursement option of six monthly checks of $250 or $300 in 2021, depending on the child’s age, and a lump-sum balance when 2021 tax returns are filed in 2022 or a lump sum for the entire amount at tax time next year.
  • A “fully refundable” tax credit to maximize distributions to low-income families by providing the full amount even if income and taxes fall short of that needed for the entire benefit.
  • Middle-class eligibility for the full tax credit capped at adjusted gross incomes of $75,000 for single filers and $150,000 for married couples.

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.6

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.7 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.

1 Federal Reserve Bank of New York, May 2021.

2 See “The Biden Administration Targets Anticompetition” in July 2021’s Policy, Politics & Portfolios for EO effects on the tech sector.

3 See www.whitehouse.gov , “Fact Sheet: Executive Order on Promoting Competition in the American Economy,” July 9, 2021.

4 Our July 2021 report considered the prospects and likely impact of antitrust legislation. Please see “A Brief Look at Some Domestic and Foreign Policies,” Policy, Politics & Portfolios, July 27, 2021, pages 2 – 3.

5 “More Households Receive Child Tax Credit Payments,” The Wall Street Journal, August 13, 2021.

6 “More Households Receive Child Tax Credit Payments,” The Wall Street Journal, August 13, 2021.

7 Gopal Srinivasan and Jennifer Bartashus, “The Child Tax Credit May Boost Food and Staples Retail by $5 Billion,” Bloomberg Financial News, July 19, 2021.

Risk considerations

Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.

Different investments offer different levels of potential return and market risk. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Preferreds securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. In addition to the risks associated with investment in debt securities, investments in mortgage-backed securities will be subject to prepayment, extension and call risks. Changes in prepayments may significantly affect yield, average life and expected maturity.

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. Communication Services companies are vulnerable to their products and services becoming outdated because of technological advancement and the innovation of competitors. Companies in the communication services sector may also be affected by rapid technology changes; pricing competition, large equipment upgrades, substantial capital requirements and government regulation and approval of products and services. In addition, companies within the industry may invest heavily in research and development which is not guaranteed to lead to successful implementation of the proposed product. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Investing in the Financial services companies will subject an investment to adverse economic or regulatory occurrences affecting the sector. Some of the risks associated with investment in the Health Care sector include competition on branded products, sales erosion due to cheaper alternatives, research and development risk, government regulations and government approval of products anticipated to enter the market. There is increased risk investing in the Industrials sector. The industries within the sector can be significantly affected by general market and economic conditions, competition, technological innovation, legislation and government regulations, among other things, all of which can significantly affect a portfolio’s performance. Materials industries can be significantly affected by the volatility of commodity prices, the exchange rate between foreign currency and the dollar, export/import concerns, worldwide competition, procurement and manufacturing and cost containment issues.

Index definitions

Bloomberg U.S. Mortgage Backed Securities (MBS) Index includes agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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