Ameriprise Financial: Investors Watching Fiscal Policy Changes Closely



The stimulating federal policy regime that has supported the current bull market so much is changing. The Federal Reserve is about to begin the process of removing monetary stimulus, while fiscal policy is about to refocus. Taken together, these emerging developments create a degree of uncertainty, to the point that some market watchers warn of a period of higher volatility, and perhaps a correction in the stock market. The fact that such uncertainty coincides with a period of seasonal weakness historically makes such warnings all the more troubling. Of course, it remains to be seen whether the markets react unfavorably to these developments.

The Federal Reserve has been preparing the ground for the start of its reduction in its bond buying program for some time. It is not a question of if, but when this process will begin. The Fed is meeting next week and could then present its plan. The weaker-than-expected August employment report could push that decision back to November, although the Federal Open Markets Committee (FOMC) hawks would rather not wait. But how much of a difference a few weeks makes is debatable. Either way, the weakening is coming. The bigger question for investors is how quickly the tapering ends, further setting the stage for the first rate hike of the next tightening cycle. President Powell was careful to point out that the rate cut and the rate hikes must be considered independently. And while this distinction may be important, it’s also likely that rate hikes are unlikely to start until the cut is complete. If the Fed acts faster than expected to end its bond purchases, it would advance the market’s estimate of how quickly rates might rise and how quickly the Fed would get rid of them.

Rising inflation gives the Fed a reason to act quickly; But the employment situation justifies caution

The argument for moving faster down this path is rising inflation. The Fed has stuck to its judgment that much of the increase is due to supply side constraints that will dissipate over time, and therefore a modest concern. But not all FOMC members agree. On Tuesday of this week, the August Consumer Price Index (CPI) report will be released and should show some welcome moderation from the previous month. The headline rate is expected to rise 5.3% year-on-year, down slightly from 5.4% in July, its highest level since 2008. The policy rate is expected to rise 4.2%, from 4%. 3 in July. and 4.5 percent in June.

An uneven recovery in the labor market has been the counter-argument for moving more slowly towards reduction. The Delta variant is partly responsible for this, as is the mismatch between job vacancies and skills. But it is undeniable that jobs are plentiful and working conditions are improving, despite the disappointment of August. Initial jobless claims last week fell to a new recovery low, and the July Job Openings and Workforce Turnover (JOLTS) report showed a record 10, 9 million job openings.

Fiscal policy is changing and investors are on the lookout for any surprises

Fiscal policy is also changing. Emergency spending designed to move the economy forward rapidly in the aftermath of the pandemic has been financed primarily through debt. The federal budget deficit for fiscal 2020 was 14.9% of GDP. The 2021 budget deficit, which ends in three weeks, is expected to total 13.4% of GDP. (For those with a nostalgic inclination, the budget was last balanced twenty years ago).

By contrast, the current surge in spending on both physical and social infrastructure is expected to be funded, at least in part, by higher taxes. High income businesses and individuals are in the crosshairs. Developments are moving rapidly, although Democratic Senator Manchin said yesterday that he doubts the September 27 voting deadline can be met. But a glimpse of the proposed tax increases is starting to emerge. A discussion paper released to Congress would call for an increase in statutory corporate income tax to 26.5 percent, from the current 21 percent. That’s lower than the 28 percent preferred by the White House, but higher than the 25 percent rate preferred by moderate Senate Democrats. The top individual bracket would rise to 39.6% and include a surtax on income above $ 5 million. Capital gains would drop from 20% to 25%, excluding the current increase in investment income. The proposal also contains some changes to the inheritance tax regime, although an effort to eliminate the current raised base provision has met strong opposition, even among Democrats.

There is no doubt that politics is changing and investors are on the lookout for any surprises. But it’s also important to remember that the economy remains healthy and that balance sheets, both corporate and personal, are strong. And while some tax code changes are on the way, they will come against the backdrop of yet another round of massive federal spending, even if that spending turns out to be lower than the White House would prefer.

Important disclosures:
Opinions expressed are as of the date indicated, may change based on market trends or other conditions and may differ from views expressed by other associates or affiliates of Ameriprise Financial. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether on its own behalf or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into account the individual situation of investors.

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