The “blue wave” hit later than expected, but with enough strength to force a reordering of global financial markets.
Victories in US Senate run-off elections in Georgia held on January 5, which handed the Democratic party control of Congress to add to the presidency, jolted investors into overhauling their portfolios in anticipation of the beefed-up fiscal stimulus promised by US president-elect Joe Biden — who detailed his $1.9tn plan on Thursday.
The effects have been far reaching: technology stocks have struggled, while the prices of commodities used in infrastructure projects, such as copper, and shares in machinery manufacturers such as John Deere and Caterpillar have advanced. Global crude oil prices reached above $55 a barrel for the first time since the pandemic rattled markets. And lower-rated US state and local debt has rallied on the promise of extra federal support.
But perhaps the most important impact is in the government bond markets that form the basis for other asset prices around the world. Analysts now expect a splurge of extra debt issuance, and higher inflation, putting pressure on the Federal Reserve to wind down its bond-buying programme and potentially even increase interest rates earlier than expected. Ten-year and 30-year government bond prices have dropped since the start of the year, pushing yields to around their highest level in almost 10 months.
“A lot of assets have been built on the prospects of extremely low interest rates for the foreseeable future,” said Mike Stritch, chief investment officer at BMO Wealth Management. “In terms of financial risks, we think that is one of the big ones.”
The promise of extra spending — which comes on the heels of a $900bn spending bill passed by Congress last month — was “setting the stage for a rise in inflation”, Morgan Stanley economists said earlier this month.
The so-called 10-year “break-even” rate, a measure of market expectations for price rises which is derived from the price of inflation-protected government bonds, has climbed above 2 per cent. That is up from less than 0.5 per cent at the depths of the crisis last year.
Meanwhile, the leader board in US stocks has switched. Long-favoured tech stocks including Apple, Microsoft and Salesforce have lagged behind the broad market since the run-offs on January 5. By Friday’s close of trading on Wall Street, tech stocks on the Russell 3000 index were slightly down for the year, trailing a gain of 4 per cent for basic materials groups, an almost 5 per cent rise for financials and an advance of about 14 per cent for energy companies.
The tech sector has outperformed since the financial crisis, against the backdrop of lacklustre global economic activity — a trend that was exacerbated during the pandemic. Rock-bottom interest rates bolstered the appeal of businesses whose valuations were dependent on profits in the distant future, while dragging on sectors such as banks.
A rotation away from tech into economically sensitive sectors such as small-caps and unloved “value” stocks, including financials, began to take hold last year as prospects grew for a “blue wave” in US elections. But the Democrats’ initial failure to secure a majority in the Senate in November left many investors positioning instead for gridlock in Washington.
The Georgia run-offs reignited this trade. The results were “the straw that broke the camel’s back”, said Bob Doll, a senior portfolio manager with asset manager Nuveen. “After years when you wanted to brag about how many big growth stocks you owned . . . you’re now at the point where you need to have small, value and international stocks in your portfolio.”
Consumers and businesses are likely to remain reliant on the technology companies that filled gaps during the crisis, but the rollout of coronavirus vaccinations and the extra government spending should lift those sectors hardest hit by the pandemic.
In anticipation of an economic recovery filtering across the American heartland, investors have ploughed roughly $27bn into small-cap stock funds since the start of November, more than reversing the entirety of outflows the funds had tallied in the first 10 months of the year. Small businesses are expected to flourish as Americans plot a path back to normal life. Emerging market exporters are also predicted to benefit as demand rebounds.
Demand for hedges against rising prices has also been strong, with US funds that buy Treasury inflation-linked securities, or Tips, attracting almost $1.5bn of net inflows in the week ending Wednesday, according to data from EPFR. That marked the 15th consecutive week where more money entered these funds than left them.
The question now is just how much fuel the Democrats will add to the world’s biggest economy, at a time where monetary policy remains ultra-loose.
“The global economy and US economy are experiencing early cycle dynamics characterised by rising growth, rising corporate earnings, rising prices,” said Erik Knutzen, Neuberger Berman’s chief investment officer of multi-asset strategy.
“But [that is] still in a very accommodative monetary policy environment and . . . with a fair bit of fiscal stimulus coming through.”