The Side Effects of the COVID-19 ‘Relief’ Plan

2/9/21: President Biden and congressional Democrats, citing economic urgency, are poised to move forward with a $1.9 trillion relief plan, opting not to compromise with Republican negotiators. Included in the package:

• $1,400 direct payment to households, although an income cutoff has yet to be determined
• $400/week in jobless benefits extended through September 2021
• $350 billion in state and local government relief
• $20 billion to support the COVID vaccination program
• $170 billion in education support
• $30 billion in rent and utility assistance

Biden’s plan comes on the heels of a $900 billion COVID-19 relief bill passed on December 21, begging the question: is the $1.9 trillion spending program pandemic relief, or is it fiscal stimulus? Lawrence Summers, former Treasury Secretary under Bill Clinton, worried aloud that the proposed package – of a scale not seen since World War II – could spark inflation or fuel a stock market bubble; these are valid concerns. Both President Biden and newly appointed Treasury Secretary Janet Yellen defended the plan, arguing that it would be better to err on the side of too much stimulus than to allow government support to fall short, given the number of struggling households.  The economy could use a boost. Private payrolls rose by a scant 6,000 new jobs in January, according to the Bureau of Labor Statistics, while December job losses were revised downward, disappointing economists and investors. The data was dampened by cuts in retail, construction and hospitality. Retail activity has suffered from stay-at-home orders, particularly at bars and restaurants. The number of seated diners nationally remains nearly 60 per cent below the level it was last year at this time, according to OpenTable.com data.

Meanwhile, with a little more than half of S&P 500 companies reporting, Q4/20 earnings releases are promising so far. The blended earnings growth rate for the S&P 500 is 1.7 per cent, according to FactSet.  If that number holds, it will mark the first quarter in which the index posted year-over-year earnings growth since Q4/19. Moreover, 72 per cent of S&P 500 companies are beating analysts’ revenue estimates, much higher than its historical median. More companies are beating their EPS estimates, and by a wider margin. In aggregate, positive earnings surprises have led to a net $39.2 billion of additional profits, according to FactSet.

Investors perceive the proposed $1.9 trillion package as stimulus, as evidenced by recent market action.  US stocks, both large and small caps, are hitting all-time highs, led by economically sensitive sectors like energy, materials and financials. Crude oil, a cyclical commodity, which had been hit hard in the global lockdowns, is spiking. West Texas Intermediate is surging toward $60/bbl, its best level in nearly two years. Bond investors, also sensing percolating economic activity, are pushing interest rates higher. The 10-year Treasury yield is approaching 1.2 per cent, its highest post-pandemic level and up from 0.5 per cent as recently as August.  While it’s encouraging that markets anticipate improving economic conditions, higher Treasury yields are a double-edged sword. Higher “risk-free” yields will eventually put pressure on equity market valuations, which have baked in a “low-for-longer” interest rate regime. Today’s historically high price-earnings ratios reflect today’s historically low interest rates. The relationship is derived from the earnings yield, which is the reciprocal of the price-earnings ratio. Lower interest rates will drive down earnings yields and widen P/E ratios. Likewise, rising rates would raise earnings yields and reduce P/E multiples.

It’s hard to determine how high rates could go, but our coincident models suggest rates should be nearly double where they are today. Tracking the relationship between pro-cyclical copper and defensive gold has offered us valuable interest rate insights. Our copper/gold model suggests the 10-year Treasury yield should be 2.2 per cent, not 1.2 per cent where it’s currently situated. A one percentage point rise in the S&P 500’s earnings yield would imply a price-earnings multiple decline from 30 times to 23 times.  That means that earnings would have to grow by 30 per cent to keep the S&P 500 Index price level unchanged. While $1.9 trillion in stimulus could have a meaningful impact on the economy and earnings, it’s unlikely that profit growth will be strong enough to offset valuation compression from higher interest rates. Chairman Jerome Powell has vowed to keep interest rates low. The second half of 2021 could test his resolve. We’re keeping an eye on interest rates.