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The S&P 500 index has staged a remarkable rally since its March low. This is quite an achievement given the considerable downward earnings revisions that have occurred over the same time. Rather, price gains have been driven by expanding earnings multiples.
What has fueled optimism, in our view, has been the massive policy response to the COVID-19 pandemic, with both monetary and fiscal initiatives chipping in. Given the magnitude of the crisis, officials had little choice but to “go big.”
But with respect to fiscal initiatives, we believe there is little guarantee that additional support is forthcoming. It is our view that the rancorous U.S. political climate has diminished the odds of a fourth package. Our concern is that investors have already priced in additional fiscal stimulus and should the reality be that no more is imminent, sentiment could quickly reverse, leading to a stock-market SPX, -0.93% sell-off.
All hands on the policy deck
Investors have had little to cheer about given the grim economic data in the wake of the pandemic. What they’ve been able to hang their hats on, however, is that future quarters will be better thanks to the lifeline of stimulus that policy makers have thrown to a floundering economy. At the forefront has been the Federal Reserve. The central bank’s actions and statements have telegraphed to markets that its extraordinary measures are not going away.
While we can categorize the Fed’s measures as “permanent,” fiscal measures have been transient in nature. These were a series of one-time adrenaline shots in the form of transfer payments with the intent of dampening the most acute blows thrown by the pandemic. The market should recognize the benefits of these measures are not long duration and thus won’t provide much support to the economy past this summer.
What has been absent from the fiscal tool kit are more permanent initiatives such as infrastructure projects or a long-term reduction in tax rates.
The Cold Math of the Multiplier
The type of fiscal stimulus the market expects matters.
Empirical data show that fiscal stimulus can have a multiplier of anywhere from 0.4 to 1.2, meaning that for every dollar spent, it translates to between 40 cents and $1.20 of economic activity. The upper end represents “permanent” initiatives like infrastructure and tax cuts. Transient programs, such as the transfer payments enacted thus far, have a much shorter duration, thus a lower multiplier.
More importantly, history indicates that the benefits of fiscal spending largely disappear after two quarters; in other words, fiscal spending gets the patient out of the emergency room, but not the hospital.
Given current equity valuations, we believe that the stock market expects a fourth round of fiscal stimulus to get the economy out of the hospital. Absent that we could foresee one of the foundations of the equities recovery become shaky.
Read: Coronavirus spike in the dog days of summer saps economy of momentum
A closing political window
As the pandemic spread through the U.S., lawmakers had little choice but to work across the aisle to meet an acute challenge to the nation’s public health and economic wellbeing. The political landscape — and the will to come together — has changed considerably since then. Foremost, it’s an election year and neither Democrat nor Republican is likely in the mood to help opponents achieve policy objectives.
Republicans and the Trump administration would like to see the economy return on a path toward growth. While Democrats likely want the same, they may be less agreeable to sign onto an initiative such as infrastructure that could push stocks higher in advance of the election. Furthermore, Democrats could insist on including measures addressing issues that have led to recent civil strife. Should Republicans balk, stating those are unrelated to the pandemic, Democratic leaders could withhold legislation, citing their core values.
While hypothetical, this scenario illustrates that neither side has much to gain in working together absent worsening public health or economic conditions.
Quantifying capitulation
We have reviewed data to arrive at an estimate of how much of equities’ recovery is attributable to already-announced monetary and potential fiscal stimulus. By measuring market moves on days with Fed activity — meetings, speeches, Beige Book releases — we estimate that between 450 points and 500 points of the S&P 500’s near-1,000-point gain since late March is attributable to the monetary accommodation. Given the Fed’s explicit forward guidance, we doubt that’s going away. But that only explains the S&P’s rise to about 2,750.
The remainder of the market’s gains — especially given the weak earnings outlook — are likely due to the expectation of continued fiscal accommodation, not one-time jolts already enacted. If such stimulus fails to be passed anytime soon or underwhelms due to the “closing political window,” we estimate the S&P 500 could correct below 2,700.
Market valuations are pricing near-perfect outcomes under the expectations that central banks and governments will do what is necessary to lessen market risk. However, this scenario is ignoring the possibility that with today’s divided government, fiscal support may not come about so readily.
A disappointing fiscal outcome would likely shatter market expectations, and with it, this historic market rally.
Ash Alankar is Janus Henderson’s head of asset allocation.
