Will America’s “healthy reflation” end in inflation?

Has the stockmarket caught vertigo? US indices ended 2020 on record highs, with the S&P 500 registering a 16.3% gain for the year. The tech-heavy Nasdaq soared by 43.6%, its best annual performance since 2009. The end-of-year cheer was helped by last-minute agreement on a $900bn pandemic stimulus package in Washington. But things reversed on the first trading day of 2021: the S&P 500 fell back 1.5%, its biggest one-day drop since the end of October.

Stocks wobble…

By mid-week traders were digesting the results of two tight elections in Georgia that looked likely to give the Democrats control of the US Senate. The prospect of Democrats taking the “trifecta” of the White House and both houses of Congress raises the risk of tech regulation, says Randall Forsyth in Barron’s. The “blue wave” is back and with it memories of September when tech stocks tumbled back to earth. Nasdaq futures contracts fell by more than 1% in response to the results.

Equity markets remain generally bullish, but don’t expect a smooth ride this year, says Michael Mackenzie in the Financial Times. US valuations are more stretched than they were a year ago – never mind the small matter of a pandemic. In some ways this is a “rational bubble”: ultra-loose monetary policy pushes even reluctant investors into the stockmarket in search of returns. The general direction may be up, but at these levels highly strung stock prices are acutely sensitive to bad news. I expect at least one “serious wobble at some point” over the coming 12 months.

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The market is “fussing” over the Georgia elections, says Stephen Innes of Axi. Things are likely to settle once Wall Street digests the news. Biden’s administration has no intention of raising taxes in the near-term for fear of killing the recovery and spending is set to soar. Before too long resolutely bullish traders will have concluded that this is “close to a best-case scenario”.

... but the real action is in bonds

Democratic control of Congress would give Biden “huge scope” to stimulate the economy, writes Liam Halligan in The Sunday Telegraph. He has suggested a “vast infrastructure programme” to renovate roads and airports that could cost about $3trn. The market could end up cheering all the extra cash, but an additional “lather” of stimulus on top of already unprecedented monetary support will leave markets “deep in bubble territory and detached from reality”. The likelihood of more US government spending sent ten-year Treasury yields – the benchmark of the US government’s borrowing costs – above 1% for the time in nine months.

The key question now is whether all that stimulus means “healthy reflation” for the economy or whether things go too far, triggering inflation, says John Authers on Bloomberg. There are certainly reasons to worry. Commodity prices have spiked. The US savings rate hasn’t been this high since the 1970s, which could bring a consumer spending wave later this year that will push up prices. Democrat control of the Senate makes inflation more likely, not less.