3 Takeaways for Investors from a More Unified Government

The first week of 2021 was shockingly tumultuous in Washington, D.C., yet key indices reached new highs, with the S&P 500 index breaking through 3800. While sentiment has improved around vaccine rollout and the recently passed $900 billion stimulus package, the latest surge seems tied to the 11^th-hour sweep by Democrats of the two Georgia Senate seats, as well as formal resolution of the outcome of the November U.S. presidential election. 

Although markets usually prefer gridlock, that doesn’t seem to be the case this time around. Three main takeaways for investors from the final election outcome help explain why:

• Higher taxes or a major increase in regulation, both trends that usually upset markets, are unlikely in the near term. Instead, we think that the new administration will be laser-focused on ending the pandemic, including speeding vaccine rollout and economic recovery. Razor-thin majorities in the Senate and the House suggest legislative agendas will lean toward more centrist proposals, at least until the 2022 midterm elections.

• More stimulus is likely and, this time, could include additional aid to struggling states, small businesses and the unemployed, as well as a speedier vaccine rollout. Morgan Stanley & Co. U.S. Public Policy Strategist Michael Zezas estimates at least another $1 trillion in aid within the next six months and $1.5 trillion cumulatively by the 2022 midterms. Delays with the most recent stimulus package had raised the possibility that a Republican-led Senate majority might start advocating for fiscal prudence too early in the economic healing process.

• The economic recovery remains on solid footing, favoring a rotation from growth to cyclical and small-capitalization stocks. We expect not only faster growth, but rising inflation and a weaker dollar, which should accelerate the rotation from expensive mega-cap tech stocks toward cyclicals and small- and mid-cap equities. As the new cycle progresses, deciding how much to tilt from growth toward value and from defensives toward cyclicals will pose challenges for investors.

That last point raises potential risks for investors who use passive strategies, including investing mainly in the S&P 500 Index. Increasingly, investors should watch the level of the “real” yields, or the nominal interest rate minus the rate of inflation, that underpin stock valuations. As inflation expectations climb above 2%, real yields have fallen into historically negative levels. That decline has allowed stock valuations to rise, even as nominal interest rates have risen. However, as the increase in inflation expectations slows, real rates should start to rise, along with nominal rates, creating a growing headwind to valuations for expensive mega-cap tech stocks that dominate the S&P 500.

We recommend selectively adding to cyclical stocks with good valuation support in such sectors as financials, industrials, materials, energy, commodities, infrastructure, transports, and consumer durables and discretionary.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Jan 11, 2021, “Midnight Train to Reflation and Rotation.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.