Federal Spending Strengthens U.S. Dollar

 The Biden Administration is clearly using FDR’s “New Deal” and Johnson’s “Great Society” playbooks to raise America’s living standards and establish ambitious work programs. With expectations for another $2.25 trillion spending plan for clean energy and infrastructure, investors expect even higher equity valuations this year. The debates over spending and taxes have started and the final bill will probably be negotiated to something smaller. Even so the added spending will propel growth in GDP, improve earnings and raise equity valuations even further.

While this liquidity injection is favorable for the economy and the equity markets, it has investors in the fixed income markets concerned that inflation is coming soon. Historically, government spending has led to inflation, with more money chasing fewer goods as demand rises. This cyclical recovery is already having just-in-time inventory shortages that have been augmented by the ship blocking the Suez Canal and causing shipping delays. Prices are rising on basic materials like copper and steel as well as finished goods like washing machines, paper towels, cars and food. Energy markets are well-supplied, yet the price per barrel of oil has risen 23% so far this year. Housing prices have also escalated dramatically with many markets seeing price increases over 10% this past year. With escalating inflation expectations, bond yields are rising, so fixed income returns become more challenging. We are currently invested in shorter-term bonds to lower the price risk of rising inflation and we favor buying dividend-paying equities instead of bonds.

While this liquidity injection is favorable for the economy and the equity markets, it has investors in the fixed income markets concerned that inflation is coming soon. Historically, government spending has led to inflation, with more money chasing fewer goods as demand rises. This cyclical recovery is already having just-in-time inventory shortages that have been augmented by the ship blocking the Suez Canal and causing shipping delays. Prices are rising on basic materials like copper and steel as well as finished goods like washing machines, paper towels, cars and food. Energy markets are well-supplied, yet the price per barrel of oil has risen 23% so far this year. Housing prices have also escalated dramatically with many markets seeing price increases over 10% this past year. With escalating inflation expectations, bond yields are rising, so fixed income returns become more challenging. We are currently invested in shorter-term bonds to lower the price risk of rising inflation and we favor buying dividend-paying equities instead of bonds.

The U.S. dollar has strengthened despite the consensus thinking that it would weaken relative to other currencies this year. Because of the vast federal spending programs, our economy is emerging from this global recession faster and in better condition than most other countries. The successful U.S. vaccination distribution is enabling a strong recovery, while lockdowns and infections seem to be on the rise again in other countries. This is sparking some conversations about “vaccine nationalism,” with the U.S. under pressure to export vaccines globally.

The leading sectors of the S&P 500 Index are energy, financials, industrials and materials. These groups all are part of the value-rotation story into cyclical stocks that have leverage to the improving economy. Prices on energy and basic materials like copper, lumber, and metals are rising quickly with demand increasing. Financial stocks have strengthened and merger activity among smaller and regional banks has increased recently. Small cap and mid-cap companies generally are outperforming the S&P 500 Index so far this year.
 

Index	First Quarter ended March 31, 2021
S&P 500 Index	5.8%
S&P Mid-Cap Index	13.2%
S&P Small Cap Index	17.9%
MSCI All World Cap Index	4.2%