By Michael Zezas, Chief US Public Policy & Municipal Strategist at Morgan Stanley
Full disclosure: This is NOT another tea leaf reading on exactly how and when Congress will manage to raise the debt ceiling, keep the government open, and pass a multitrillion-dollar package of spending offset by tax hikes. To be clear, we continue to think that it will do all of the above. But rather than focus on the palace intrigue, we’ll deal with DC’s policy choices in classic Morgan Stanley Research fashion…by focusing on tangible market impacts.
Let’s start with new government spending, which can be a positive catalyst in equity sectors such as construction and clean tech: Sure, Democrats may be stuck on exactly how much new spending to approve across their bipartisan infrastructure and ‘Build Back Better’ plans. But in our view, a conservative estimate of the ultimate outcome would be a still robust total US$2.5 trillion between both plans over 10 years. While that number might fall far short of some progressives’ ambitions, it should get your attention. For example, the Bipartisan Infrastructure Framework, which would make up about US$500 billion of this total, would nearly double the US’s current baseline infrastructure spend. As we argued earlier this year in a report led by our colleague Nikolaj Lippman, this would catalyze an infrastructure ‘supercycle’ where factors like a surge in cement demand could lead to a positive re-rating of the construction sector. Additionally, we estimate that the infrastructure framework could include ~US$500 billion in new spending and tax credits aimed at clean energy production. That means a substantial ramp in demand for clean tech companies, which our colleague Stephen Byrd sees as a clear bullish catalyst for the sector, particularly names like PLUG, which he upgraded last week, and RUN.
As for corporate taxes, yes, DC is likely to push them higher. Yet for now we don’t see this as more than a near-term challenge that shouldn’t impede bullish medium-term outcomes for the equity sectors we’ve highlighted: As Mike Wilson and the equity strategy team have argued, enacting higher taxes could bring down forward guidance, something investors may not yet be pricing in, given current valuations. In the near term, that may prompt US equity indices to price in a greater chance of a sustained economic slowdown. But such weakness would likely be more of a correction than a bear market signal, as we expect that the total fiscal package would ultimately be GDP-supportive. Likely incorporating more spending than taxes, our economists expect it to boost net aggregate demand and support the view that the US can continue to grow at a brisk pace in 2022.
Investors could also view fiscal policy as a catalyst for stagflation. We don’t buy it, and see opportunities in macro markets to take the other side: As my colleague Andrew Sheets effectively broke down in last week’s Sunday Start, recent data (i.e., slowing GDP growth and rising inflation) are summoning up the idea of stagflation rather than proving that it’s a serious risk. Notably, unemployment continues to decline, and there’s firm evidence that demand is driving inflation as much as supply chain disruptions, which our economists expect to abate over time. Hence, investors concerned about rising prices may need to attune themselves to the market risks of stronger-than-expected inflation rather than stagflation. Here, our macro strategy colleagues offer a suggestion that seems counterintuitive at first: short TIPS. But with the breakevens curve pricing in above-Fed target inflation, a stronger realized inflation environment could usher in a more hawkish Fed and higher real yields at the expense of TIPS.
All that said, if you still want a breakdown of the what, how, and when of DC’s fiscal journey between now and year-end, I get it. We’ll be closely tracking the policy paths into year-end, but always with an eye towards what you, the investor, can do about them.