Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, March 31st, at 10:30 a.m. in New York.
As President Biden unveils his Build Back Better plan—a spending proposal covering a wide variety of infrastructure issues—investors continue to ask: how will it be paid for? It's an important question to ask, since the answer has ramifications for the economy and markets.
Higher taxes are likely to be a part of the equation, but in our view, enacted tax hikes will end up meaningfully smaller than those initially proposed by the Biden administration. Leading up to the presidential election, Biden's campaign stated support for a variety of tax hikes, whose totals match the reportedly $4T spent over 10 years for the Build Back Better plan. But we think the total tax hikes get filtered down substantially. Why? Because the Democrats' slim majority in Congress means tax hikes likely cannot exceed levels supported by its most electorally vulnerable members. This includes moderates who, as reports suggest, want to see a lighter touch on taxes. It also includes other members who publicly stated that the return of the state and local tax deduction is a condition of their support for any changes to the personal tax code. This is a key point for investors because it likely means that the planned spending will outstrip its tax increases, creating a net benefit to U.S. GDP.
But if taxes won't be raised to offset spending, then that means deficits are going higher to help pay for Build Back Better. That may not be the first position the administration takes, but we think that's where the bill ends, something that's been hinted at by administration officials like Transportation Secretary Buttigieg. That's begging the question from investors, will adding more to a deficit already swelled by multiple rounds of covid stimulus lead to inflation? In the view of our economists: yes, it will. In what they call the new 'high pressure' economy, this aggressive fiscal policy will, together with aggressive monetary policy, push core PCE to 2.5% in 2022, leading the Fed to get back to hiking in 2023.
So how does it all play out in markets? Basically, as the economy rebounds, inflation could pressure the Fed back to tightening and, as a consequence, ending the growth cycle faster than in recent economic expansions. In the bond market, expect that to show in the yield curve continuing to steepen, as it has in recent months. In the equity market, expect this dynamic to play out with sector outperformers switching quickly from traditional early cycle sectors to mid cycle sectors, which is why our colleagues currently favor autos, retail and capital goods, all sectors that tend to do well in the middle part of an economic expansion.
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