Reflation trade rebound and infrastructure optimism buoy markets, but it’s complicated

Brian Nick

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Midyear Outlook :
  • U.S. economy: The growth rate has peaked but will remain high throughout 2021.
  • Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
  • Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
  • Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
  • Equities: The best opportunities may now lie outside the U.S.
  • Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.

Quote of the week:

"Compromise used to mean that half a loaf was better than no bread. Among modern statesmen it really seems to mean that half a loaf is better than a whole loaf.”
– G.K. Chesterton, What’s Wrong with the World (1910)

What’s next for the “reflation trade”?

Immediately following the Federal Reserve’s June 16 meeting, markets jumped to the conclusion that the Fed had taken a sudden and decidedly hawkish turn, but the meeting’s outcome was actually part dovish and part murky. U.S. equities threw a mini tantrum of sorts, while long-term Treasuries rallied. Most notably, the prevailing “reflation trade” — outperformance by cyclical and value stocks, rising commodity prices and a weakening U.S. dollar — seemed to come to a screeching halt.
What a difference a week makes! With the help of a few speakers from the Fed’s higher circle of leadership emphasizing that monetary policy is data-dependent and not “dot plot” driven, at least some investors realized they’d over-interpreted the changes to the Fed’s forecasts. While the dollar remains stronger and commodity prices broadly weaker than they were 10 days ago, the bleeding stopped last week.5 Inflation expectations, as measured by TIPS breakeven rates, reflated to their pre-Fed meeting levels (but still well below their 2021 peaks)6, and cyclical/value shares reasserted themselves.7
So what’s next? As the U.S. economy moves beyond peak growth to a more mature phase of recovery, the reflation/recovery trade will be more fragmented. Trades that depend on a steadily rising 10-year U.S. Treasury yield had already begun to stall before the June Fed meeting. In equity markets, the materials and industrials sectors — previously among the chief beneficiaries of the stronger-growth, rising-rate environment — are now underperforming the S&P 500 Index this quarter.8 On the other hand, assets that tend to shine during periods of stronger global growth (relative to the U.S.), like commodities and foreign currencies, seem likeliest to quickly regain their footing.
Then there are investment categories that need neither a higher 10-year yield nor continued upside economic surprises to do well but which still benefit broadly from looser financial conditions and strong growth. These include:
  • Higher-yielding parts of the fixed income market
  • U.S. and global growth stocks
  • Real assets like infrastructure and real estate
Read more about our investment views in Nuveen’s Midyear Outlook, “Growth is peaking. What comes next?”

Bipartisan infrastructure deal scrambles the outlook for taxes and spending

This spring, the Biden administration provided detailed outlines for two infrastructure packages: the American Jobs Plan (AJP) and the American Family Plan (AFP). Since then, Congress has been trying to figure what to do (and what not to do) with them.
Even taken together, the AJP and AFP would not pack the same economic punch as the pure stimulus bills passed during the last 15 months, starting with the CARES Act in March 2020. Instead, they’re designed to do two things: first, modernize various areas of the U.S. economy, thereby increasing its productive capacity and creating high-paying jobs along the way (much of that expected improvement comes from improved energy efficiency); second, reform the tax code, as well as other forms of collections and payments, to be more redistributive, so that the burden of funding falls more on those with the greatest ability to pay.
As of the end of last week, four scenarios are in play:
  1. Democrats in the House and Senate can’t agree on a strategy — bipartisan or otherwise — and nothing passes.
  2. A bill funding traditional “hard” infrastructure (e.g., roads, bridges, tunnels and other physical structures) without raising taxes passes with bipartisan support, and that’s it.
  3. A bill funding traditional infrastructure without raising taxes passes with bipartisan support, and then a second, larger tax-and-spending bill passes through the reconciliation process on a Democratic Party line vote.
  4. The bipartisan effort fails, and Democrats pass as much of the Biden agenda (taxes and expenditures) as they can through reconciliation.
Last week, the odds of each of these options seemed to rise and fall by the minute. Here’s what we know: a bipartisan group of 21 senators and the president has signed onto a framework for a traditional infrastructure bill. Biden remains hungry for a bipartisan win and shown a willingness to negotiate, disappointing progressives in the House and Senate who want a more expansive package, and sooner.
The most important development from a macro perspective is not the deal itself, but what it means for the fate of everything that was left out of it. This includes both corporate and individual tax hikes and new spending in areas like green energy and the child tax credit. In our view, two bills are always harder to pass than one, which puts the partisan provisions in some jeopardy.
The ultimate outcome is made more fraught because both House Speaker Nancy Pelosi and Biden have made it clear they will not support or sign the bipartisan bill unless it is accompanied, simultaneously, by the larger reconciliation package. We see this as a hardline negotiating tactic meant to prevent moderate Democrats from passing the small bill and then slamming the door on the big one.
So here’s the key question: will all 10 Senate Democrats who negotiated with Republicans on the first bill have the political appetite to ram through a partisan effort at the same time? The answer is probably yes, but the larger bill will have to be whittled down considerably from the ambitions of the original package. In other words, the total amount of tax and spending increases in scenario 3 (above) is likely significantly less than it would be in scenario 4. Otherwise, Republicans would have no reason to participate in the deal. In return, Biden can claim the mantle of bipartisanship and, by extension, a return to political normalcy.
Bottom line: Scenario 3 is the most likely of the four. Scenario 1 (nothing passes) looks to be the second-most-likely, because we simply don’t know whether a reconciliation bill can be crafted that is small enough to keep the deal together in the Senate but large enough to pass in the House.
This political drama, while intriguing, isn’t as pivotal for the economy as the last several rounds of fiscal stimulus have been, so markets have been giving it less attention. Yet reduced political uncertainty is almost always a good thing. It fosters greater resilience and less volatility in stocks, interest rates and credit spreads. We should know by September which, if any, of the infrastructure bills is likely to pass. Whatever the result, it will almost certainly be smaller in scope than the ambitious tax and spending measures Biden initially proposed. In the context of an already-booming economy, that’s not a bad outcome for investors.
  1. FactSet, MarketWatch
  2. treasury.gov
  3. Bureau of Economic Analysis
  4. Bloomberg
  5. Bloomberg
  6. Federal Reserve Bank of St. Louis via FRED
  7. FactSet, Russell
  8. FactSet
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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